Carbon Credit Watch

Gasping for air: Carbon markets stumble, again

Probe International Editorial
Probe International
April 13, 2010

To save the planet from man-made global warming, the EU created a cap-and-trade system under which polluters can buy ever- diminishing rights to emit CO2. That “market,” created by regulatory fiat to satisfy the Kyoto Protocol, has been up and running since 2006. But last month, Hungary brought Europe’s carbon market to its knees. How? It sold “used” or “spent” carbon credits that found their way back onto the market, casting doubt on the authenticity of all credits.

When the action came to light, “all hell broke loose,” said The Economist [PDF] , and spot trading on the European emission trading system (ETS) came to a compete halt for three days.

Hungary, as it turns out, didn’t break any laws and won’t rule out more “recycling,” as the technique has become know in this green-inspired market. Nor will Lithuanian officials who call the recycling of old carbon credits [PDF] , “legal carbon trading.”

But traders in the EU’s emissions trading system don’t agree. Hungary may be playing by the rules, says Emmanuel Fages of Paris-based Societe Generale SA’s carbon trading venture, “but they’re not playing the spirit.”

In Europe, the “spirit” allows CO2 “polluters” to go beyond their EU-allowed emissions by buying carbon credits from, for example, Chinese dam builders or Indian chemical producers whose investments are intended to reduce global CO2. The UN certifies these projects as emission-reduction credits (CERs)—also known as carbon offsets—for sale to CO2 emitters in other countries, such as Hungary.

As it happened, the Hungarian CO2 emitters bought their CERs and then correctly surrendered them to Hungary’s Ministry of Environment and Water after emitting the CO2. Used credits are supposed to be worthless on the European carbon exchanges. But the Hungarian government, using what many have called a legal loophole, sold the used credits—some 1.7 million for nearly 20 million Euros—expecting them to make their way to a buyer in Japan and for re-use by Japanese firms to meet that country’s imminent carbon cap-and-trade regulations. Yuichi Takayama, the boss of Tokio Marine Asset Management, saw no harm in the transaction: “so long as some environmental benefit has occurred, then the CERs have a value.”

Not so, said the European Commission. The market didn’t like the recycled credits either and the spot price for CERs went into free fall.

Not surprisingly, consumer confidence in carbon markets has been badly shaken and investors are now “questioning the authenticity” of what they are buying, said Paul Kelly, chief executive officer of JPMorgan’s EcoSecurities unit.

Indeed, until February, ETS regulators were not checking whether CERs were new or used.

Abyd Karmali, global head of carbon markets for Bank of America Merrill Lynch warned that secondary trading of CERs may come to a “grinding halt” as traders question their validity.

Though prices have bounced back somewhat, market jitters remain. If some CERs were found to be worthless, or untradeable on the EU ETS, it is unclear who—the EU, the UN, trading houses, the seller or the buyer—would be on the hook for the losses.

Meanwhile, the market players are all quick to point fingers. Yvo de Boer, the UN’s top climate official, says it is the EU’s responsibility to fix the problem in its trading system. Jos Delbeke, head of the EU’s environmental unit says the EU trading system is just fine, “it’s a problem of the Kyoto system.” Meanwhile, Henry Derwent, head of the traders group which includes Morgan Stanley and Barclays Plc, blames faulty drafting by the European Commission [PDF] and calls the whole recycling phenomena “fishy.”

In an email to Probe International, the European Climate Exchange says the European Commission has since adopted an amendment, set to take effect in August 2010, to prevent the re-entry of surrendered CERs into the ETS—effectively closing the loophole of recycled CERs.

Other countries considering cap and trade systems, such as the U.S. and Australia, are watching closely as this latest carbon market fiasco unfolds. It comes on the heels of a string of earlier embarrassments.

When the EU program began in 2006, member states gave too many initial carbon allowance permits to their industries for free, leading to a surplus—“a disaster, for a market that depends on scarcity for its existence,” said FT.com. Then, the EU cut back on permits, but the financial crisis destroyed its calculations, leading to more turmoil in the market.

One of the problems, says FT.com is that the carbon market is man-made, with bureaucrats trying to second-guess economic cycles so that they can get the price of carbon right in order to stimulate a reduction of CO2 emissions.

Carbon credits might also create perverse incentives. Corus, a steelmaker in northeast England, received millions of dollars worth of carbon credits after mothballing a plant and laying off 1,700 workers—a move that could create windfall profits for the company.

Security weaknesses also emerged in January, when hackers on a “phishing” expedition broke into some of the registries where permits were stored.

But worst of all, say experts, is the open invitation that carbon credit markets give to fraud artists and organized crime. Forensic auditors Deloitte, and the EU law enforcement agency Europol have been warning that carbon trading markets are “a fraudster’s dream come true” because they deal in an “intangible commodity”—CO2. Last year, European authorities admitted that 90% of the carbon trading volume occurred for the purpose of value-added-tax fraud.

At its root, the problem with CO2 markets is that, unlike other commodities, CO2 has no inherent value. Parties to carbon permits have no interest in the CO2 per se, but in the permit. If no CO2 is actually offset, neither buyer nor seller would suffer a loss. Without an army of regulators to check on the veracity of every carbon offset permit, right back to the Third World where the project originates, there will be virtually no way to protect the value of permits.

Fraudsters aren’t the only ones to take delight in carbon markets. Lawyers, too, will find plenty to cheer about with class action lawsuits by investors in a market that defies effective regulation.

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