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The Emerging Market for
Carbon Trading:
A New Business Opportunity for Banks
E. V. Murray*
Introduction
The earth and all life on it requires gases; water vapour, methane,
ozone, carbon monoxide, nitrous oxide and carbon dioxide
generated via the greenhouse effect. The earth regulates the
concentration of greenhouse gases through a system of sources
and sinks. In nature, carbon (in the form of CO2 and methane) is
sourced or emitted by burning and rotting of vegetation and other
organic matter (called carbon sources). Conversely, CO2 is
absorbed (or sequestered), by trees, plankton, soils and water
bodies, which are termed 'carbon sinks'. Increase in CO2
emissions are a result of either nature (e.g. volcanic eruptions) or
the actions of man (e.g. burning fossil fuels), and thus, could be
'mopped up' only by the increased capacity of sinks, through
growth of forests, or increases in water bodies (and the plankton
within) in which CO2 could be stored or dissolved. The burning of
fossil fuels like oil in which CO2 has been stored for millions of
years has led to unprecedented rise in greenhouse gas emission
in the atmosphere which, the current CO2 sinks cannot keep up
with. This imbalance calls for greater attention and precautionary
measures to be put in place.
The international response has been the Kyoto Protocol, under
which over 150 countries have agreed to strive to decrease CO2
emissions, accounting for an estimated 55 percent of global
greenhouse gas emissions. Under the Kyoto Protocol, a country
can emit more CO2 than its assigned amount only if it can
simultaneously sequester the equivalent amount in 'allowable'
carbon sinks, which include undertaking afforestation and
reforestation activities. The USA and Australia are among the
countries that have not yet ratified the Kyoto Protocol. India and
China, have ratified the protocol, but are not required to reduce
CO2 emissions.
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Member of Faculty, College of Agricultural Banking, Reserve Bank of India, Pune. The lead provided by Ms. Shefali Beri of ICICI
Bank for undertaking study of this area is gratefully acknowledged.
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Implications of Kyoto Protocol
The flow-on effects of the Kyoto Protocol is that
governments, businesses and consumers have to
consider the precautionary measures that need to be
incorporated in their regulatory and decision making
process to meet international requirements. Governments
need to consider 'carbon regulation' issues such as,
rationing or taxing of net CO2 emitting entities and providing
credit allowances or tax-breaks for net CO2 absorbing
entities.
Businesses need to consider issues such as trading in
carbon allowances (or permits), investment in low CO2
emission technologies, counting the costs of carbon
regulation compliance and passing on the increased cost
to consumers. Consumers need to consider if, given a
choice, they are willing to pay a higher price for CO2 neutral
products and services so as to play their part in reducing
CO2 emissions.
The Kyoto Protocol provides for three mechanisms for
countries with quantified emission limitation and reduction
commitments to acquire greenhouse gas reduction credits:
Joint Implementation (JI): Here, a developed country
(say USA) with relatively high costs of domestic
greenhouse reduction can set up a project in another
developed country (say India) that has a relatively low cost,
such that the CO2 emission of the project is counted within a
country that has a surplus.
Clean Development Mechanism (CDM): Here, a
developed country (say USA) can take up a greenhouse
gas reduction project in a developing country (say China)
where the cost of greenhouse gas reduction project
activities is much lower. The developed country would be
given credits for meeting its emission reduction targets,
while the developing country would receive the capital and
clean technology to implement the project.
are not issued (at least not yet) by a single International
Emissions Trading Authority. Instead, different countries
issue these carbon credits based on a monetary price.
This means that until the market becomes 'efficient',
significant arbitrage opportunities will arise where 'CO2
emitters' in high cost countries can buy credits from trading
exchanges in low-cost countries.
Most countries are considering 'managing' their CO2
targets through the regulation of businesses and
individuals in their countries in three ways:
By taxation, the government imposes a tax on CO2
emissions. The advantage could be that it is
immediately implementable, transparent and tax
regimes could be harmonised around the globe,
perhaps under international oversight. The
disadvantage is that business may absorb or pass on
the tax to consumers, and not cut emissions.
By allocating carbon credits or 'permits' to entities or
individuals for the emission of a certain quantity of
greenhouse gases in a particular period (i.e. a
permitted quota). These permits may be given away
free, sold at a predetermined price or auctioned. This
is a carbon emission 'rationing' or a cap and trade
system.
By approving certain organisations as being able to
issue legitimate carbon credits (called 'abatement
certificates') by undertaking work to either increase the
capacity of sinks, or reduce CO2 emissions from
sources. Known as a cap and trade system,
greenhouse performance levels are set whereby those
that can deliver a particular product with emissions
below the benchmark can earn (create) abatement
certificates.
International Emission Trading (IET): Here, countries
can trade in the international carbon credit market.
Countries with surplus credits can sell them to countries
with quantified emission limitation and reduction
commitments under the Kyoto Protocol.
Examples of organisations that can 'create' carbon credits
(abatement certificates) are, power stations (to the extent
their greenhouse intensity of their electricity is lower than a
predetermined level), foresters that grow trees for the
purposes of CO2 sequestration, and organisations that
reduce their carbon footprint by getting employees to work
closer to home or replacing incandescent light bulbs for
energy efficient lamps. These abatement certificates are
then sold to polluters.
In all the three mechanisms (especially the latter two), the
concept of a 'carbon credit' as a measurable and tradable
instrument that is acceptable across nations is required. As
per the Kyoto protocol, each carbon credit represents one
metric tonne of CO2 either removed from the atmosphere or
saved from being emitted. Theoretically, a carbon credit
need not have a monetary value, and can be 'bartered'
across nations. The problem is that these 'carbon credits'
Carbon credits, thus, create a market for reducing
greenhouse emissions by giving a monetary value to the
cost of polluting the air. This means that carbon becomes a
cost of business and is seen like other inputs such as raw
materials or labour. There are significant strategic
implications in how companies incorporate such costs
(and potential revenue streams) into their pricing and
related marketing decisions.
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As emission levels are predicted to keep rising over time, it
is envisaged that the number of companies wanting to buy
more credits will increase; hence pushing the market price
up and thus, encourage more groups to undertake
environmentally friendly activities which create more
carbon credits to sell. Whilst high CO2 emitting entities will
have an extra cost of running their businesses, there could
be money for others who do not, at present, consider CO2
as a separate line of business.
Carbon Emissions Trading
A cap-and-trade system should ideally be based on freemarket principles whereby those best placed to reduce
their emissions can reduce emissions for those less well
placed and then sell these reductions. In a cap and trade
program, each individual emission allowance has a
'vintage year' designation (that is, the year an allowance
may be used). Emission allowances with the same vintage
year designation are fungible within a particular jurisdiction
and can be used by any party to satisfy pollution from any
source. Vintage year swaps are common among
participants in a U.S. cap and trade program.
Brokers and other non-participants typically buy and sell
emission allowances in secondary markets. The
secondary market for emission allowances is quite vibrant.
Many believe worldwide markets will continue to develop
for the trading of emission allowances. One of the earliest
trading schemes is the European Union Emission Trading
Scheme (EU ETS) which is the world's largest multi-country
cap and trade system. The EU has established a cap that
limits emissions of its member states, each of which has
been given a specific number of credits. The total amount
of credits cannot exceed the cap, limiting total emissions to
that level.
The EU ETS is only open to countries that have signed the
Kyoto Protocol. Japan has a voluntary scheme. Having not
signed the Kyoto Protocol, the US has no formal carbon
emissions trading market, although two regional emissions
trading zones have developed in the East and West Coast.
Many companies from overseas countries have joined the
Chicago Climate Exchange. Despite not having signed the
Kyoto Protocol, Australia had the first operating carbon
emissions trading scheme in the world,
the NSW
Greenhouse Gas Abatement Scheme, which began
operating in January 2003. Participants can trade 'carbon
offsets' among themselves or with outside parties such as
banks.
In many parts of the world, therefore, there is a recognition
that CO2 emission is an environmental issue that can be
monetised. When the New South Wales Greenhouse
Abatement Certificate (NGAC) scheme in Australia first
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started, a carbon credit was priced at A$ 3.50 per tonne.
The prices have traded in recent years between A$ 3.50
and A$14.75 per metric tonne in the spot market. This
range in prices is minor compared to the volatility of the EU
ETS where, due to uncertainty, there has been a significant
slump in carbon prices of Emissions Allowances (known as
EUAs) over the years from with a high of 30 Euro to a low of
less than 1 Euro. A crash in the EUA followed the release of
National Emission Compliance Reports for 2005 indicating
that there had been an over-allocation of allowances to
emitters for that period. This apparently caused a rush of
sellers into the EUA market and a resultant large drop in
their value.
If a carbon emission trading (monetised or bartered)
becomes a widespread phenomenon, there will be
significant changes in the countryside of many countries.
Countries that have got rid of their trees because they
hindered agriculture, or were required for building and
even for fuel will now recognise that these very trees
deserve a bit more 'credit'.
Carbon Emission and Sequestration Accounting
Before carbon emissions trading can be considered,
however, quantification in terms of carbon sourced or
sequested by undertaking the activities that make up the
supply chain must first be undertaken. The mechanism for
calculating the quantum of CO2 either emitted by a source
or sequestered in a biomass sink is referred to as 'carbon
emission and sequestration (CES) accounting'. The CES
accounting mechanism must be sufficiently robust that the
carbon trading market has confidence that the amount of
carbon sequestered can be both measured and
considered to be equivalent in its impact on global
warming potential to the CO2 released to the atmosphere
from activities producing greenhouse gases. The detailed
requirements for a CES accounting system are still in the
process of being developed by organisations such as the
Intergovernmental Panel on Climate Change (IPCC, 2007)
under the United Nations Framework Convention on
Climate Change (UNFCCC). Any CES accounting standard
developed by a country or agency will need to be
consistent with the IPCC principles before carbon credits
generated from carbon sinks can be used in an emissions
trading regime under the Kyoto Protocol.
In general, although the interest in carbon trading is high,
the new market is largely unregulated and lacks
transparency. In essence business organisations and
individual customers have no way of discriminating
between providers who claim that in their scheme: X trees =
sequestration of Y tonnes of CO2 emissions = Z Amount.
There are very few surveys comparing different schemes,
and for those that exist, there is need for independent
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checks. Currently, the auditing and ranking of
environmentally sustainable initiatives is in chaos with
dozens of organisations offering accreditation and auditing
services, across the globe, but none being committed to a
standardised methodology. Once these CES accounting
and assurance issues are resolved, there should exist an
efficient carbon trading market that would put a price on
carbon related activities in terms of a carbon credit (or
allowance). Once a monetary value is obtained, cost
analysis and pricing decisions along the supply chain can
easily be undertaken.
Impact on Demand of Carbon Lifestyle Changes
which they can source a second source of income via
carbon credits.
Suppliers of such alternative energy sources will also have
a competitive advantage as they market the technology or
processes that net-emitters will then purchase to offset their
CO2 emissions. Other items where carbon regulation can
provide lucrative lines of business are: building carbon
efficient skyscrapers; capturing the CO2 in sinks; burning
clean coal; manufacturing bio-fuels; and providing
telecommuting services to reduce the physical commuting
by people working in traditional offices. The lifestyle
changes that individuals can consider are listed in Table 2.
A number of lifestyle changes (by countries, organisations
and individuals) are needed to achieve a substantial
decrease in emissions, such as reduced energy demand,
increased energy efficiency, using less fossil fuels and
more renewable energy sources. It will also require
research and development of sustainable technologies
that reduce CO2 emissions. Such activity will be considered
by some countries as reducing GDP and by others as
having a potential for increasing GDP. Similarly,
organisations will view carbon regulation as either a cost or
a potential source of revenue. Details of what businesses
can do for carbon reduction are given in Table 1 (based on
TIME magazine August 2007) Global Warming Special
Issue).
A majority of companies may not, however, have
opportunity to reduce their emissions via 'lifestyle' changes
in any significant way to impact the bottom line, let alone
reduce global warming. These companies will treat carbon
regulation as a cost. Further, for some companies, the
embrace of a 'carbon efficient lifestyle' by (other)
organisations and individuals will have a significant impact
on the demand for their traditional products and services.
For example, incandescent light bulb, paper, business
attire, energy, packaging, transportation, airline and car
manufacturing companies will have to adapt or die. There
will be job losses in such industries as lifestyles change.
There may also be movement of employees from carbon
efficient (but less comfortable) business environments to
those that do not implement such measures.
Considering the items listed, it is clear that there will be
winners and losers. Jobs will be created within companies
in some industries that are in a position of being able to use
carbon credits earned by switching from coal fired to gas
generators or alternative energy sources like wind farms to
offset carbon debt. Similarly, forestry and companies can
expand as they now have assets (if grown after 1990) from
Lifestyle changes will not only affect demand forecasts in
industries already impacted by business actions, such as
energy, paper, housing, petroleum, packaging,
transportation, airline, white goods and car manufacturing
companies, but also impact on fashion, food,
entertainment, farming and horticulture industries.
Table 1 Carbon Reduction Methods for Businesses
Change light bulbs to low emission
Switch off lights at closing time
Pay the carbon tax
Shut off computers (no standby)
Build a skyscraper
End the paper chase
Let employees work close to home
Trade carbon for capital
Pay your bills online
Set an organisational Carbon budget
Open a window
Plant trees in the tropics
Ask for an energy audit
Change company vehicles to bio fuels
Buy green power
Set higher carbon emission standards
Remove the tie
Illuminate public spaces with LEDs
Turn food into fuel (bio fuels)
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Table 2: Carbon Reduction Methods for Individuals
Change light bulbs to low emission
Support your local farmer
Move from the mansion to a high rise building
Plant a bamboo fence
Hang up a clothes line
Have a green wedding by buying wine etc. locally
Give new life to your old warm clothes
Remove the tie (casual business attire)
Use more geothermal heat
Take another look at vintage clothes
Say no to plastic bags
Work close to home
Switch off lights at closing time
Ride the bus
Shut off your computer
Pay your bills online
End the paper chase
Open a window (natural cooling)
Make your garden grow
Ask for an energy audit of your home
Wear green eye shadow
(made from renewable resources)
Buy green power, at home or away
Fill car up with passengers (car pool)
Check the label (the cheap price for overseas
sourced products may be because no carbon
costs are paid)
Drive green using bio-fuel cars
Properly insulate water heater
Check car tires
Avoid meat products
Set a personal carbon budget
Fly straight between locations
Consume Less, share more, live simply
Carbalisation
‘Carbalisation' is based on the concept of productdistance, i.e. the distance a product travels to get to its
place of final purchase for consumption. Studies reveal
that the world's shipping could have a serious impact on
global warming. Annual emission from shipping make up 5
per cent of the global total, while the aviation industry,
which is subject to far greater scrutiny, contributes only 2
per cent. CO2 emissions from ships do not come under the
Kyoto Protocol. Although CO2 emissions on a per-kilogram
basis were significantly lower for shipping when compared
with air freight, it is distance that has been targeted as most
imports of fast moving consumer goods (FMCGs) are
mostly imported via shipping lines.
An example is given of imported bottled water from Europe
using approximately 80 kg of CO2 emissions per metric
tonne to be shipped to Australia, whilst from Egypt it is 70
kg and from nearby Fiji only 20 kg. The urging is buy from
sources as close as possible to point of purchase.
Further, as consumers in developed countries become
'carbon sensitive' by checking labels before buying, any
labour cost advantages of products from countries like
China and India may diminish. Another concern expressed
is that if the developed world takes the cost impact of CO2
emission cuts, this will reduce the purchasing power and
the standard of living of their people. Thus although
developing countries like China and India are allowed to
catch-up by not having stringent CO2 emitting standards,
the economic growth of these countries will anyway be
affected by the loss of purchasing power in the developed
world.
Mandatory or voluntary carbon costs are eventually going
to flow on to prices and competitiveness of industries and
countries. Manufacturers in countries subject to more
controls will feel penalised if these controls allow offshore
manufacturers from developing countries (who are
possibly less environmentally efficient) to get a competitive
advantage. Such an imbalance will not only cause
concern from an economic perspective, but may do little to
prevent global warming from an environmental
perspective, as eventually from where the CO2 is emitted is
of no consequence to the warming of the globe. It is clear,
therefore, that Carbonomics and carbalisation will produce
winners and losers in organisations and countries. In the
products and services market, the winners will be 'low
carbon intensity' firms and those that can pass on their
carbon costs.
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The Indian Carbon Market
India and Brazil will be the largest players in the carbon
emission market by 2010, when the market for carbon
trading is estimated to grow to around $5 billion. Already,
companies like SRF, Gujarat Fluorochemicals and Grasim
Industries have started generating revenues through CDM.
Reliance Industries, ONGC and RCF are also exploring
possibilities of entering the CDM business. Chemical firm
SRF has sold 2.5 million units of carbon credits to European
agencies for Rs 250 crore. It has appointed trading
partners in France, the UK and Germany to sell carbon
credits. Refrigerant maker Gujarat Fluorochemicals
expects revenue of about Rs 500 crore over the next 6-7
years through the sale of carbon credits. Grasim Industries
has encashed the carbon credits it earned and until now
received Rs 17 crore by selling these credits in Europe and
expects to earn Rs 55 crore over the next couple of months.
In recent times, banks in India have woken up to the new
opportunity for money to be made by protecting the
environment. From, identifying and funding projects likely
to generate carbon emission to offering prepayment
facilities to local sellers on behalf of buyers in overseas
markets, different banks are trying to find a niche area.
Banks like SBI, IDBI and ICICI Bank and multinational
banks like HSBC, Standard Chartered and ABN Amro are
bullish on this business. Though the business is at a
nascent stage, it's very much emerging and evolving, say
bankers.
Indian banks are working on two business models in the
CDM segment. The first model involves identifying CDMenabled greeenfield projects and financing them. Many
renewable energy projects that banks are now financing
are capable of generating large quantities of carbon credit
which can be sold in the market. The other model is giving
upfront payment through securitisation of carbon credits.
In this model, banks facilitate trade in carbon rights
between local corporate and overseas buyers; serve as an
escrow account between the two parties involved and even
fund local corporate on behalf of the overseas buyer. Banks
facilitate a long-term contract where the seller in the
domestic market and the overseas buyer enter into an
agreement for purchase of carbon credits for a specified
period, say five to ten years. Instead of the overseas buyer
making periodic payments to the Indian company, the
overseas buyer makes advance payment to the seller in
India. This prepayment is advanced as a loan to the
overseas buyer by an overseas bank and is repaid by the
overseas buyer in a phased manner as and when the
carbon credits are supplied by the Indian company.
Apart from margins generated out of the funds lent to
buyers abroad, banks also earn a fee for structuring the
transaction. HSBC has a dedicated desk for structured
trade finance, with professionals based in India, Hong
Kong, Singapore and London, while ABN Amro has one in
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the UK. While most banks deal with larger corporate for
such trades, ICICI Bank is looking at motivating SMEs to
move towards CDM projects by encouraging SMEs to use
non-conventional sources of energy like wind mills, solar
energy. Exim Bank, on the other hand plans to provide
funds against carbon credit receivables, financing against
future cash flows likely to be generated by such projects.
Going ahead, there could be a futures market for Carbon
Credits, where once a new project shows potential to
generate Carbon Credits, there could be derivative
products rolled out which banks could trade in. The other
possibility could be the creation of Carbon Credits through
other "greening" activities. For instance, when people are
evacuated from say a tiger reserve and the area used for
plantation purposes, the owner could be entitled for
receiving Carbon Credits fast -growing trees of the right
quality are planted.
Summary
Concentration of greenhouse gases in the atmosphere has
risen dramatically leading to an out-of-balance
greenhouse effect that most scientists believe will continue
to cause a rapid warming of the world's climate. The
possibility of costly disruption from climate change either
globally or locally, calls for greater attention and
precautionary measures to be put in place. Governments,
business entities and consumers would be impacted by
the extent to which such precautionary measures are
incorporated in their decision making process.
Governments need to consider 'carbon regulation' issues
such as rationing or taxing of net- CO2 emitting entities and
providing credit allowances or tax-breaks for net- CO2
absorbing entities. Businesses need to consider issues
such as trading in carbon allowances, investment in lowCO2 emission technologies, counting the costs of carbon
regulatory compliance and passing on the increased cost
of carbon regulation to consumers through higher prices.
Consumers need to consider if, given a choice, they are
willing to pay a higher price for CO2 neutral products and
services so as to play their part in reducing CO2 emissions.
These decisions and their consequences will impact the
economics and strategic decision analysis and reporting
significantly.
The new carbonomics and the return to localisation due to
place-distance carbon emission costs (termed
carbalisation) will produce winners and losers in both the
product and allowances markets, and in organisations and
countries. Those organisations and countries that move
fast to embrace the implications of the Kyoto Protocol
would be the 'winners' in this new economic paradigm.
India will be a big beneficiary and will contribute
significantly to the Carbon Credits market. It is a new
business opportunity for banks, which so far few have
recognised.