Carbon emissions trading allows companies to buy and sell government-granted allotments of carbon dioxide (CO2) output. The standardized nature of these carbon allotments or credits allows derivative instruments, such as forwards, futures and options to be created and traded on securities exchanges, opening up new opportunities in carbon emission trading and investing.
Cap and trade system
Carbon emissions trading forms part of the so-called cap-and-trade system. Governments cap the amount of carbon emissions by distributing a finite number of credits or permits to companies.
Each carbon credit represents the right to emit one tonne of carbon dioxide (or an equivalent amount of other greenhouse gases).
Companies can only emit as much CO2 as they have credits for. Unused credits can be sold to other companies that exceed their limit to offset their surplus carbon emissions.
Carbon credits are traded on carbon markets, which creates a market mechanism for allocating permitted emissions among regulated entities. An open market for carbon credits allows traders and investors to participate in the market and play a role in price setting.
Carbon emission reduction
The goal of the cap-and-trade system is to slow down global warming caused by greenhouse gas emissions. Utilities that burn coal and other fossil fuels are the biggest contributors to greenhouse gases in the atmosphere and are the main target of the carbon emission reduction scheme.
Carbon credits and the related market mechanism were established in response to the agreements reached with the Kyoto Protocol and subsequent accords. Carbon emissions trading only started in earnest when the European Union instituted a cap and trade program in 2005 by issuing EU allowances. This program is currently in its third phase, with annual reductions in the cap set at 2.2%.
The Kyoto Protocol also provided for the issue of Certified Emissions Reductions credits to projects in developing countries that reduce greenhouse gas emissions and other pollutants. These credits can also be traded. The credits awarded for carbon emission reduction schemes must be verified and validated to ensure a properly functioning market.
Corporate and individual entities interested in lowering their carbon footprint can offset their emissions by purchasing carbon credits on the market, or through intermediaries that have aggregated credits from individual projects.
Carbon markets
Exchanges have been established to provide a spot market in credits, which also allows for derivative instruments such as futures and options to be created, to help discover a market price and maintain liquidity.
Exchange traded futures and funds
The futures products of the European Climate Exchange (ECX) (now owned by ICE Futures) are based on the underlying EU Allowances (EUAs) and Certified Emission Allowances (CERs). They trade on the ICE Futures Europe electronic platform and on the London Stock Exchange.
Holders of the EUA Futures Contract must make or take delivery of EUAs or CERs to or from the EU Registry on expiry of the contract.
More than 100 leading businesses have signed up for membership to trade ECX products. In addition, several hundred clients can access the market daily via banks and brokers through order-routing, without having to be a member themselves.
Investment fund
WisdomTree Carbon is an exchange traded commodity (“ETC”). Its securities can be created and redeemed on demand by authorized participants and traded on exchange just like shares in a company. WisdomTree Carbon is designed to enable investors to gain a total return exposure to movements in the price of ICE Futures’ EAU futures contracts plus a collateral yield.
Further reading:
Make money from carbon permits with ETFs
