There is a price for everything and that is now true for carbon emissions where the market is becoming more liquid, allowing policymakers to set more aggressive reduction targets.

To avoid the predicted cataclysm, many countries have agreed to the Kyoto Protocol to reduce their carbon emissions. Of course, the most concerned countries are Organization for Economic Cooperation and Development (OECD) members, which currently account for 50 percent of the global emissions. Some countries have agreed to develop their own carbon emission reduction schemes either to go further than the Kyoto Protocol, such as the European Union Emission Trading Scheme (EU ETS), or because they did not sign the Protocol, like the US and Australia.

The majority of the emission reduction schemes have been developed on a "cap and trade" system, meaning that emissions are capped at a specific level, and emission allowances and credit can be traded among participants

UNTAPPED POTENTIAL

The carbon emission market has great potential, growing from less than €9 billion ($13 billion) traded in 2005 to an expected value of €25 billion ($37 billion) in 2007. Celent estimates that the market could reach a yearly transaction value of €40 billion ($59 billion) by 2012. The overall market size could increase further after 2012, with strong interest from California, the eastern US states, and Australia. The question remains, however, whether they would participate in a global carbon emission reduction market. Some signs of evolving federal legislation are quite encouraging toward that end, but overall, the future of the regulatory framework that created and supported this market is still very uncertain.

The carbon emission market is based on "negative assets" formulated by regulators. Therefore, it is highly dependent on an established regulatory framework and its evolution. Unfortunately, there is significant uncertainty about the future of existing carbon emission reduction schemes. While most market participants are convinced that the market will still exist in the post-Kyoto era, it is impossible to know what the scope of emission reduction targets in future schemes will be. The current delay between the definition of schemes and their implementation is of major concern for market participants and prevents them from forecasting their future involvement. For the carbon emission market to develop, it will require planning from regulators to create more predictability.

Recent developments demonstrate that we are far from reaching a global consensus. When the EU decided to include the airline industry in its scheme by 2010, the US said that the EU had no right to impose emission caps on foreign airlines, alleging that such restrictions would breach international civil aviation rules and air agreements between the US and Europe. So while it is interesting to see NYSE Euronext's commitment to launch a global carbon emission exchange, in addition to the recently established alliance between the Chicago Climate Exchange and Bourse de Montréal, the reality is that there is currently no global regulatory harmonization that would play in favor of the emergence of a global carbon emission trading market.

There is a lack of harmonization among the various carbon emission reduction schemes that are implemented around the globe-Japan, the US, Switzerland, Australia, the EU, and so on. Some markets are voluntary, while others are mandatory; some target specific industries, while others only focus on countrywide emissions. This situation prevents the market from achieving the full standardization that is necessary for a global carbon emission market. The EU ETS represents the bulk of the market, with a value of €19 billion ($28 billion) accounting for 82.6 percent of the overall market value. The Clean Development Mechanism (CDM) and the Joint Implementation (JI) projects represent 16.5 percent of the market; voluntary markets less than 1 percent. The dominant position of the EU ETS is not surprising, since it represents the largest mandatory scheme in terms of scope and geographical coverage. The fact that industry operators have mandatory targets for carbon emission reduction is a clear impetus for trading. Therefore it is no surprise to see that the majority of expected carbon emission and credit exchanges to be launched post-2008 are targeting Europe, from NYSE Euronext to Icap and the coming alliance between German-based electronic European Energy Exchange (EEX) and Eurex.

ATTRACTING PARTICIPANTS

Currently, market participants in the various carbon emission exchanges are limited to the financial community, the big utilities and industrial companies, and a few precursors. Many corporations that are or could be impacted by the cost of carbon emissions, however, remain untapped. In a recent survey conducted on the EU ETS by McKinsey & Co. and Ecofys for the European Commission, 14 percent of corporations and 23 percent of market intermediaries mentioned lack of trading understanding by market participants as a major barrier to increased liquidity in the market. And corporations are not the only ones under-served. It is very surprising that retail banks do not offer their customers carbon emission offsetting capabilities. With all the publicity surrounding global warming and the increased concern from individuals about the future of our planet, retail customers are an amazingly untapped market. Expanding the scope of participants in this market will be crucial to increasing its liquidity.

Attracting participants is more feasible because the carbon emission market includes two distinct animals with different characteristics: emission quotas (AAU and EAU) and credits (CER and ERU). While emission quotas are rights created by regulators, credits are generated through projects that need to be built and approved by certification bodies. With credits, the buyer can invest at different stages in the CDM or JI project-such as early stage or registered project-to eventually receive credits. Therefore, based on the time of investment, the cost and the risk are very different. Additionally, because CDM projects are conducted in developing countries, while JI projects are implemented in developed ones, the country risk varies.

To summarize, the carbon market replicates, on a smaller scale, the variety of risk exposure an investor can get in a more traditional securities market, such as equities. On top of these instruments, financial products such as futures, options, and swaps have been developed. There are currently six to seven different products available. Carbon emission instrument pricing is also closely related to a country's economic situation, the price of energy commodities, and the weather. Therefore, despite regulatory uncertainty, carbon emission instruments should be included in the investment strategy of any trader targeting these markets. The obvious challenge for the market will be its expansion.

OTHER CHALLENGES

For carbon emission markets to emerge on a global level, interoperability between the various schemes is crucial. An efficient and operational International Transaction Log (ITL) that would record the trading of emission allowances and credits is key for the development of this market. But an efficient ITL needs to be linked to the regional logs, such as the Community Independent Transaction Log (CITL), in order to allow efficient operations of the various emission reduction schemes.

Standardized systems are needed on a global and regional level, not only to monitor the impact of reduction schemes on the emission level, but also to guarantee a fair trading ground to market participants. Unfortunately, this might not even be sufficient because transactions are only a portion of what needs to be monitored and reported to market participants. The current level of information in the various carbon emission markets is still too limited. This lack of reliable information such as current level of emission, CER stocks, EAU stocks, and so on, is a hindrance to the development of the market. Today, there is considerable research about possible surplus CERs or the flood of AAUs from the former Soviet countries, but a lot of this analysis is conducted as a thumb in the air due to the lack of reliable information. Trading in the carbon emission market today is like trading in the equity market without industry research and company annual reports.

The market today is dominated by over-the-counter (OTC) transactions that account for 72 percent of trades. Nevertheless, there are discrepancies among regions, and some exchanges, such as the European Climate Exchange (ECX), are able to capture significant market share: Four hundred transactions are conducted daily on the ECX. The concentration of the market among a few leading players and a lack of transparency do not play in favor of electronic trading at this time.

But electronic trading is expected to gain market share as the scope of emission reduction schemes expands and new participants enter the market. Celent certainly believes that the carbon emission market is benefiting from the emergence of carbon exchanges such as the ECX or the platform that will be launched by NYSE Euronext.

The question is more about the economic viability of these carbon exchanges. While we hear from numerous market participants who want to leverage their existing technological infrastructure and financial know-how to enter the high-margin paradise that the carbon emission market is considered to be, we believe that this market is still plagued with a lot of uncertainty, and the economic viability of the many exchanges to be launched remains in question.