Carbon Credits

For those who want to save the planet, the market can help via carbon credits. Profits from these are like a breath of fresh air. It’s been several decades since we’ve received the first reports about the concerning and critical state of air pollution. As measuring equipment continues to become more sophisticated and increasingly larger quantities of raw data are amassed, it’s becoming increasingly obvious that emissions are on the rise.

Although many still debate the extent humans have on the changing climate, going by the Kyoto Protocol and Paris Agreement, there is some level of consensus across the world. This also raises some questions about the sustainability of global industrial and economic growth.

Radically reducing carbon emissions requires tremendous sacrifice. Doing so certainly takes a toll on both the current economy and its potential future. That’s simply not a risk most heads of state were willing to take. As a consequence they added some loopholes to the agreements mentioned earlier. Chief among them is the free distribution and trade of emission quotas.

Table of Contents:

• The History of Carbon Credits
• How Carbon Credits Work
• Practical Issues
• The-Future-of-Carbon-Credits

The History of Carbon Credits

Carbon credit trading was first championed by the economist Ronald Coase in the 1960s. He believed that economists should focus their analyses on real markets. One of his most famous contributions is the Coase theorem, which states that if people can trade externalities, it leads to the most efficient outcomes. Partly due to this work, Coase won a Nobel Prize in Economics in 1991.

Externalities are benefits to one economic party that download costs onto another party who did not agree to this arrangement. This is important because pollution is the externality people tend to see most often.

This idea is the backbone of the Kyoto Protocol and more recently the Paris Agreement of 2015. The idea is that if an amount of acceptable pollution per year is determined and then industry is allowed to trade these emissions, then the market will not over-pollute. Not only that, but industry will price pollution efficiently as well.

There have been some struggles getting all countries to remain committed, with Europe showing the most resolve so far.

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How Carbon Credits Work

These so-called carbon credits are distributed to various countries by international organizations based on estimates of the likely emissions for each respective country. Once the quotas are set, they can be further distributed domestically by each country. The basic idea is that environmentally minded businesses would lower their emissions. That in turn creates a surplus that they can re-sell to other companies. This would force companies that produce high amounts of pollution to have higher operating costs, forcing them into a competitive disadvantage.

Each unit of these futures represents a metric tonne of CO2 or equivalent gas emissions. Currently, futures contracts for them represent 1000 such units/tonnes. The going rate for EUA contracts is around 5 euros, and for CER only around 0.2. This highlights the difference in how seriously people take the European Scheme (with EUA contracts) vs the Kyoto Protocol (with CER contracts).

Where Can You Cap and Trade?

Initially these quotas were traded Over The Counter (OTC) outside of the regulated markets. However, in the span of a few years they were already available on various quasi-exchanges. Then, finally the Intercontinental Exchange (ICE) released its own official carbon credit futures. Today they come in different forms based on the climate agreement they connect with. There are Certified Emissions Reduction (CER) credits for the Kyoto Protocol and EU Allowances (EUA) for the European Union Emissions Trading Scheme.

Practical Issues with Emissions Trading

Although it seems plausible in theory, in practice these quota estimates end up being overly generous. This allowed most companies to meet their emission targets with relative ease.

Having the ICE pin a trackable price on it was the final nail in the coffin for the original plan. As countries started publicly coming out with the numbers on how much they’ve saved, it became obvious that there was an overwhelming seller surplus. The fact that everyone was trying to get rid of it made it impossible to sell. It meant the market had practically no liquidity. This caused speculators to flee ten masse. Once they left, liquidity dried up completely. The result was quota prices dropping even further, completely collapsing it as a tradeable asset.

Let’s look at it from a trader’s perspective. We can see that there’s a rising number of companies looking to sell their credits. Meanwhile the demand for them has plummeted. The result of these circumstances is that carbon credit prices also dropped sharply. It’s no surprise that when emissions trading is cheap, companies are willing to spend a little extra to keep up or even increase their emissions. The invisible hand of the market once again shows that it’s a force to be reckoned with. On some level this policy failure can be traced back to the fundamental unworkability of planned economies. Trying to control economic outcomes top-down through careful calculation is the same pitfall the USSR and most other communist countries fell into.

The Future of Carbon Credits

The emissions market is about to go through some major changes in 2020. These could completely alter the carbon credits market. The addition of a linear reduction factor would mean that allowance caps would continually diminish at a fixed rate. Instead of statically holding their value, they would depreciate on a yearly basis.

This could affect the market in a similar fashion to how central banks often regulate the supply of money. When they sense that inflation is accelerating, they tend to tighten their interest rate policies. That in turn reduces the amount of money in circulation and pushes down inflation.

New Institutions

This type of solution could bring speculators back to the emission market. On the other hand it may also be necessary to create a new institution to support it. In this particular case that’s the Market Stability Reserve (MSR). Its purpose is to act as a sort of market maker by draining the surplus from the quota market. Purchasing excess emissions also helps inject liquidity into the market. News of the MSR’s creation could fundamentally revolutionize this market and the wheels for it are already in motion.

The price of the European Union Emission Allowance (EUA) ranged approximately from 3 to 7 euros in the first month of its creation. However, following the European Parliament’s decision to create the MSR, these prices jumped above 25 euros in 2019. This was mainly due to companies who are major producers of carbon emissions. They were hurrying to buy up these futures in large numbers. Their plan was to get as many as possible before these changes go into effect in 2020. They even purchased those with expiries up to as late as 2025. The revived interest in the asset also puts even more pressure on other companies to also join. Could this be the first market segment where top-down government meddling produces an efficient outcome? Time will tell.