Emissions Trading

Certainly, people want to buy or sell products or services with a scarcity value in a market. The price of any product or service is determined by the point where demand and supply intersect in a market and by the degree of scarcity of the products and services.

Transition of time and place changes the value of a product or service as well. People no longer use seashells as units of currency, while emissions have become the latest hot commodity (e.g. greenhouse gases), something which had no value in ancient times. Emissions have been traded since 1990 at national level (e.g. United States Acid Rain Program). With the coming into force of the Kyoto Protocol on 16 February 2005 a new global market has been created for the purpose of emissions trading. For this new market to function well a diverse infrastructure of tax, project finance, financial goods, commercial transactions and trade systems at both national and international level is required.

What, when, how and where emissions are traded

Narrowly speaking, “emissions trading” means trading of Assigned Amount Units (AAUs) and Allowances on an international and national level. As testified in the European Union Emissions Trading Scheme (EU ETS) however, market participants (i.e. a party to the Kyoto Protocol or legal entity authorised by a party to the Kyoto Protocol) can trade Emissions Reduction Units (ERUs) and Certified Emissions Reductions (CERs). Classification and characteristics of AAUs, CERs, ERUs and European Union Allowances of EU ETS are illustrated in Table 1:

As the Kyoto system and national emissions trading schemes impose specific obligations on limited parties and companies, only the limited parties and companies (including some investors) can enjoy rights to join the global and national emissions trading schemes 3 .

Figure 1: Operation of Emissions Trading System

Emissions trading in the global context

As shown in Figure 1 4 the United Nations Framework Convention on Climate Change (UNFCCC) and the Kyoto Protocol provide the basic framework of the global emissions trading market. In turn, when designing national rules on emissions trading markets and climate change countermeasures, most countries incorporate the rules of the Kyoto Protocol into their national rules. In essence, global emissions trading requires a systematic link and interaction between national and international rules.

Having entered into operation on 1 January 2005 the European Union Emissions Trading Scheme (EU ETS) offers the most advanced emissions trading system. Through the Linking Directive, the scope of emissions trading under the EU ETS can be extended by trading project-based credits (i.e. via the Clean Development Mechanism and Joint Implementation), which would add more liquidity and variability to the emissions trading market.

Japan and Canada are the main industrial nations outside of the 25-nation European Union block where there is potentially a large demand to implement emissions trading schemes. Businesses ranging from steel mills to oil companies are expected to be in line to buy rights to emit extra greenhouse gases.

Emissions trading in the regional and national context

As already mentioned, emissions trading and compliance with the greenhouse gas emission reduction targets under the Kyoto Protocol can only be assured within a national legal framework. Incorporation of the rules of the Kyoto Protocol into a national legal system provides the basis for the functioning of emissions trading market at a national and international level.

Looking at the European Union Emissions Trading Scheme, around 12,000 installations in the 25 member states are covered. The main market participants include combustion installations, electricity generators, oil refineries, steel production, processing cement, glass manufacturing, pulp and paper, and brick manufacturing. Among these main market participants, power companies are the dominant players, producing around 60% of emissions covered under the European Union Emissions Trading Scheme.

Pursuant to the Registry Regulation of 29 December 20048 each of the 12,000 installations shall open an “operator holding account” in the national registry, into which its own allowances will be issued. Any individual or legal entity wishing to participate in the emission trading market can open “person holding account” in any of the registries 9.

There are no decisive national emissions trading schemes in Japan and Canada yet, even though several pilot emissions trading programs have been carried out 10 .

Emissions trading in the corporate context

As the scope of the emerging emissions trading scheme is likely to cover the upstream sector (i.e. heavy energy users), companies involved in energy activities (e.g. combustion installations with a rated thermal input exceeding 20 MW, mineral oil refineries), iron and steel manufacturers, installations involved in the mineral industry and pulp and paper manufacturers would be subject to a mandatory emission reduction obligation and, in turn, have grandfathering rights to obtain greenhouses gas emission allowances from a national authority. To ensure its right and identify the financial implication of its greenhouse gas emission allowances, a company participating in an emissions trading market should take monitoring and reporting of its greenhouse gas emissions and corporate accounting into account.

GHG monitoring and reporting

Monitoring of greenhouse gas emissions is essential for accurate and transparent calculation and reporting of emissions as well as for third party verification of baseline and annual performance. Even though differences in emissions trading systems in national and regional markets can be managed by various risk management techniques, the creation of a solid foundation based on consistent greenhouse gas (GHG) monitoring protocols and GHG valuation is the very basis on which quality management of trading emissions rests. A corporate participant of a national emissions trading scheme will have to use best practices to monitor its GHG emissions and is required to monitor and report emission reductions at the source level (e.g. on-site combustion of fossil fuels, on-site consumption of electricity, on-site consumption of heat or steam, CO2 process emissions 11 ). In the case of the European Union, Decision 2004/156/EC establishing guidelines for the monitoring and reporting of greenhouse gas emissions of 26 February 2004 sets out detailed criteria for monitoring and reporting of greenhouse gas emissions from activities covered by the European greenhouse gas allowance trading scheme 12.

Corporate accounting

In an accounting guidance on greenhouse gas emissions, the International Accounting Standards (IAS) Board recommended that if a company participates in a government scheme (i.e. cap and trade scheme) aimed at reducing greenhouse gas emissions, the company would have to account for the emission allowances it receives from the government as intangible assets in accordance with the IAS 38 Intangible Assets, recorded initially at fair value. As the company produces emissions, it recognises a liability for the obligation to deliver allowances to cover those emissions in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets 13.

A company should check the following before making a strategic decision on whether to participate in a national emissions trading scheme:

– existence of a registry for the establishment of a baseline

(e.g. Kyoto registry, European Union registry and national registries)

– compatible regulatory framework

– transparency in international trading and compliance

– integrity of markets

– private-sector regulation

Functioning of global emissions trading market 2005

The role of sound national frameworks is critical to emissions trading. Entry into force of the Kyoto Protocol, an increasing number of Designated National Authorities (DNAs), Designated Operational Entities (DOEs), and the opening of the European Union emissions trading market all give positive signals for the transactions of certified emission reductions and emission reduction units. Pursuant to EHSMONITOR 14, around 116 climate change-related regulations (e.g. general climate change policy, emissions trading, energy efficiency) were proposed or adopted between January 2004 and February 2005 at a national level.

As expected, European countries were very active in this field, with 56 and 16 regulatory measures being taken in Western and Eastern European countries respectively. Asia-Pacific and Latin American countries are also taking climate change-related policy and regulatory measures, benchmarking against international and European policy measures, with 23 and 11 regulatory measures being taken in the Asia-Pacific region and Latin America respectively 15 .

Natsource and Point Carbon announced that GHG trading continued to increase during the first four months of 2004 compared to activity in 2003. Point Carbon estimated that the value of all transactions in the 2004 carbon market was around 360 million Euro (96 million Euro in 2003). In its 2005 GHG market forecast, Point Carbon said that “total financial value of the market in 2005 is expected to be more than five times larger than last year. Most of the expected increase is found in the EU ETS, but there is also substantial growth in CDM and JI 16”.

European firms would also increase their participation as they begin to hedge their positions by recognising the role of certified emission reductions (CERs) for compliance-risk management. However, only quality CERs would be preferred by potential buyers. Natsource pointed out that around 95% of trade volume of project-based reductions may ultimately be recognised by governments as eligible for compliance with legally binding emission reduction requirements. Despite the higher potential of Clean Development Mechanism (CDM) investment, for example, China has not become a popular hosting country for CDM projects due to the lack of a sound regulatory framework.

The liquidity of the emissions trading market in 2005 can also be dependent on Japan and Canada’s participation in the global emissions trading market by linking their schemes to the European Union emissions trading scheme. As Russia joins the Kyoto Protocol, the supply of assigned amount units from Russia would affect the liquidity and price in the global emissions trading scheme.

60% emission reduction by 2050?

The climate change regime beyond 2012 has been on the national and international agenda since 2002 17 . Even though there are divided opinions over the topic of future actions by developed and developing countries, developed countries send their signals of strengthened climate change policy to the international community. The United Kingdom Energy White Paper of February 2003 stated that the United Kingdom would reduce carbon dioxide emissions by some 60 per cent by 2050 18 . In the case of Japan, it solicited broad participation of all countries, including the USA and developing countries 19 . By recognising signals of the international community and the commercial impacts of climate change and emerging policy and measures to combat it, companies should create a strategic plan on carbon management, analysis of competitiveness, investment planning, and risk management.

Emissions trading is one of the global market solutions for reducing emissions by introducing technological innovation and energy efficiency. It must be said that the entry into force of the Kyoto Protocol and the launch of the European Union emissions trading market give clear signals to a company as a case for action. Having said that, global companies should also recognise business risk arising from various domestic policies and measures which could expose them to more regulatory risk. By setting up a tracking system of global climate change regulations, companies can maintain the best position from which to deal with rapidly emerging business risk from climate change.

Author

DaeYoung Park

Climate Change Expert & Asian EHS Regulatory Consultant

Enhesa-Environmental Policy Centre

www.enhesa.com

References & Further Information

1 Annex I Parties means the industrialised countries listed in this annex to the UNFCCC who have accepted emissions targets for the period 2008-12 as per Article 3 and Annex B of the Kyoto Protocol. They include the 24 original OECD members, the European Union, and 14 countries with economies in transition (e.g. Croatia, Liechtenstein, Monaco, and Slovenia, Czech Republic, Slovakia)

2 LULUCF: Land Use, Land-Use Change and Forestry (e.g. afforestation, reforestation and deforestation and forest management, cropland management, grazing land management and revegetation)

3 Under Article 17 of the Kyoto Protocol, only Parties to the Kyoto Protocol can participate in international emissions trading (legal entities authorised by an eligible Party to join emissions trading scheme under the Kyoto Protocol can also participate).

4 Model modified from the data of Australian Greenhouse Office

5 Source: http://europa.eu.int/comm/environment/climat/emission.htm; Fiona Mullins and Jacqueline Karas (November 2003), EU Emissions Trading Challenges and Implications and National Implementation, Royal Institute of International Affairs

6 Percentage change in emission for 2008-2012 compared to base-year levels

7 Adopted from P. Capros and L. Mantzons (May 2000), The Economic Effects of EU-Wide Industry-Level Emission Trading to Reduce Greenhouse Gases: Results from PRIMES Energy Systems Model, Institute of Communication and Computer Systems, National Technical University of Athens

8 Commission Regulation of 21 December 2004 for a standardised and secured system of registries pursuant to Directive 2003/87/EC of the European Parliament and of the Council and Decision 280/2004/EC of the European Parliament and of the Council (Text)

9 Source: http://europa.eu.int/comm/environment/ets/

10 In case of Canada, the Greenhouse Emissions Management Consortium (GEMCo), which was established in 1996 by Canadian energy companies, is developing voluntary and market-based approaches to greenhouse gas emissions management. The Greenhouse Gas Emission Reduction Trading (GERT) Pilot, which was run from 1998-2002, has been carried out for project reviews and emission quantification guidelines to explore greenhouse gas trading for a full-scale emission trading system. Japan has rune Prototype voluntary domestic emissions trading scheme in 2003, in which around 39 companies were participated.

11 The following sources can be referred to for GHG monitoring: Revised 1996 IPPC Manual on Inventories, UNFCCC Good Practice Guidance on Reporting and Uncertainty Assessment, Guidelines on National Communications and Annual Inventories (FCCC/CP/2002/8), EU Council Decision on GHG Monitoring (Decision 389/93/EEC, as amended by Decision 296/99/EC), UK Environmental Reporting Guidelines

12 Commission Decision of 29 January 2004 establishing guidelines for the monitoring and reporting of greenhouse gas emissions can be found on- line at: http://europa.eu.int/eur-lex/pri/en/oj/dat/2004/l_059/l_ 05920040226en00010074.pdf

13 International Financial Reporting Interpretations Committee (IFRIC) (2004), IFRIC 3 Emission Rights and IFRIC 4 Determining whether an Arrangement contains a Lease

14 EHSMONITOR (http://www.ehsmonitor.com/) contains global regulatory monitoring and compliance information having business risks of marketing, administrative or criminal sanctions

15 For the analysis of regulatory trends, the following countries are covered: Western European Countries (Belgium, UK, Ireland, Portugal, Greece, Spain, Austria, Germany, Italy, Sweden, Norway, Netherlands, Denmark, Finland, France + Swiss); Eastern European Countries (Poland, Czech Republic, Slovakia, Hungary + Russia); Asia-Pacific countries (New Zealand, Australia, Hong Kong, China, Japan, Taiwan, Korea, Indonesia); Latin American countries (Colombia, Brazil, Peru, Argentina, Mexico, Venezuela, Ecuador); North American countries (US, Canada); South Africa

16 Because as allowance transactions are less complicated and less risky than CER transactions (e.g. lack of potential for delivery failure, assured compliance value and ease of contracting) and the seller receives a higher price, allowances have historically been preferred.

17 The Kyoto Protocol states that the Conference of the Parties serving as the Meeting of the Parties to the Protocol (COP/MOP) shall initiate the consideration of commitments for subsequent periods no later than 2005.

18 Department of Trade and Industry (February 2003), Our Energy Future – Creating a Low Carbon Economy (http://www.dti.gov.uk/energy/whitepaper/ ourenergyfuture.pdf)

19 Ministry of Environment (January 2004), Climate Regime Beyond 2012 Basic Considerations (Interim Report) (http://www.env.go.jp/en/topic/ cc/040217.pdf)

Published: 01st Mar 2005 in AWE International