MARKETS:

Proliferation of emissions offsets threatens to depress Europe's carbon trading

NEW YORK -- A huge influx of international greenhouse gas emission offsets looms over the carbon markets, but traders and banks don't know yet what to make of the situation.

Participants in Europe's Emissions Trading System (ETS), the main market for the credits, are normally used to worrying about an oversupply of government-allocated emissions allowances sinking carbon prices. Many of them are now wondering if they're now facing an oversupply of offsets having a similar effect.

Procedural reforms and new hires at the Clean Development Mechanism (CDM), an agency established by the Kyoto Protocol and headquartered in Bonn, Germany, have led to record issuances of offset credits from that office since December. As a result, credits are getting approved and flying out the door faster than ever before.

Some experts worry that the incoming rush of new offsets could depress the total value of carbon trading globally this year.

"If it continues accelerating like it has since the end of November, it will, because obviously, this is not what is priced in today," said investment analyst Emmanuel Fages at Orbeo, the carbon market arm of Société Générale. "What was priced in even some weeks ago was very regular, average issuance level."

But Fages and others also caution that the influx could be a temporary phenomenon not likely to last for the entire year. Indeed, most carbon market experts expect supplies of the CDM's Certified Emission Reduction (CER) credits to become much tighter into 2012, because uncertainty of whether the CDM will even exist after that year is causing the number of new projects to shrink fast.

"Our predictions for the issuance volumes are very high in the third week, but going into week four or five, that goes down significantly," said carbon market expert Milo Sjardin at Bloomberg New Energy Finance. "In the longer term, we're still having the problem that the issuance volumes in general are not as high as they could be."

For the moment, more feast than famine

Last week, the office that runs the CDM hit a milestone when it announced that the program had hit 500 million CERs allocated to offset project developers since the system began. About 60 million more credits are pending, and up to half of these are expected to be delivered this month.

The end of 2010 saw monthly CER issuance hitting new record highs, and January is on track to again break the record, with up to 47 million CERs possibly heading to the offset projects that are requesting them.

CERs can be sold to governments seeking to meet their Kyoto Protocol emission reduction targets or to firms facing compliance rules under the European Union's ETS. For years, supply into the carbon markets was predictably slow, as project approval and CER issuance had difficulty navigating the CDM's cumbersome bureaucracy, but reforms to the system and more manpower are speeding things up much faster than analysts had earlier predicted.

CDM officials express confidence that the new quicker pace is now permanent, and not a temporary rush to clear up a backlog of work at the end of the year as some observers theorize.

"We'll be keeping a close eye on the number of submissions and will be working to reduce the wait times to 15 days," CDM spokesman David Abbass said. "As a result of the concerted push in December, which made use of outside experts, the secretariat now has a pool of contractors that it can draw on to help deal with peaks."

Point Carbon expects 253 million more CERs will be issued in total this year, more than half the amount of all CERs put out since 2006 and about 90 percent above the volume issued in 2010, 132 million.

Fages and his team at Orbeo only expect issuance to be about 30 percent higher this year, rising to 170 million CERs by the end of 2011. But they admit that they may have to revise this figure upward if the current trend continues.

Bloomberg New Energy Finance predicts a 40 percent growth in CER allocations this year. Predictably, CER prices have been trending lower in recent days.

From a high of about €14 per metric ton of carbon dioxide equivalent pollution reductions, CER prices are now running in the €11 range, and some market analysts are warning that they could dip lower. Thus far, the dip has not affected prices for E.U. allowances (EUAs) traded under the continent's ETS, but that could change should the downward momentum continue.

Newly approved HFC-23 projects add to offset influx

The spike in CER levels is attributable not only to the end-of-year push that Abbass described, but also to the release of credits requested by hydrofluorocarbon-23 (HFC-23) destruction projects that were earlier held up while the CDM Executive Board investigated accusations of fraud. HFC-23 is a potent greenhouse gas caused by manufacturing refrigerant gases in the developing world.

A large quantity of CERs were also recently issued to projects that destroy the greenhouse gas nitrogen oxide (N2O) recently, further inflating the numbers. Together, HFC-23 and N2O destruction have historically accounted for around 75 percent of all new CER supply entering the markets.

Though some argue that the picture will return to normal once these three factors are accounted for, available data suggest that CER supply could continue to rise even without the help of HFC-23 and N20.

For instance, numbers available on the CDM's website shows that the majority of new CERs are being issued to renewable energy projects, mainly large wind and hydroelectric operations in China. Of the more than 4 million credits issued on Wednesday last week, none went to large industrial gas projects.

Analysts at the investment bank Barclays Capital in London see a trend here. They predict that industrial gas destruction's share of the CDM will continue to slide, from about 75 percent today to 68 percent by the end of the year, and moving further lower after then.

CER issuance volumes will continue to stay high for some time, they predict.

Longer-term trade prospects remain 'strong'

"We do expect that heavy CER issuance in the coming weeks and we have seen some pressure on prices," said Barclays Capital analyst Trevor Sikorski in an e-mail. "Generally the supply of CERs will help moderate price gains across 2011 and this was reflected in our recent revision downwards of our price forecasts."

But despite the inundation, most experts don't see carbon prices falling through the floor this year.

Sikorski and his research team see plenty of support to hold CER prices at an €11 to €12 per ton range. Compliance purchases by companies in Europe will help firms hedge their supplies in anticipation of future shortages, and new trading in New Zealand should keep the market buoyant, he said.

And the sudden explosion of new offsets supply shouldn't be a drag on EUA prices, either, experts say.

"The European market has a lot of other fundamental drivers that impact the carbon price there," said Sjardin at Bloomberg New Energy Finance. "And if you look at the longer term, longer-term, the prospects are still strong."

One analyst with a major Wall Street bank, speaking on background, even argued that the faster tempo at the CDM will actually hurt the system in the longer term. The European Union's plans to ban HFC-23 and some N20-derived CERs from its system beginning in 2013 could cause some players to raise concerns about the quality of other offset projects.

The analyst worries in particular about the large hydroelectric projects being awarded CERs. A seeming push to please developing nation governments and project developers may lead some to turn away from CERs if they conclude that the CDM has given up on assuring "additionality," the industry term for verifying that a carbon abatement project would not have existed were it not for the offsets trading system.

Abbass at the CDM headquarters in Bonn says the Executive Board is well aware of this perception problem and is carefully managing it. Reforms at the CDM have been carefully tailored "to the need for changes to the way requests for registration and issuance are assessed, to make the process quicker without compromising environmental integrity," he said.

But Fages at Société Générale also expressed concern that the CDM has seem to have undergone a fundamental change in culture -- from one focused on stringency and quality assurance toward a heavier emphasis on getting projects approved quickly and feeding as many CERs into the system as possible.

"Why I'm surprised is that now they're shifting to accelerated issuances, as if they have changed their stance more than they're staff," said Fages.

"I'm a bit hesitant to change my [CER supply] forecast just now because I'm not completely sure yet that they have changed their attitude," he added. "But if they are considering the projects differently from now on, then yes, I will have to increase my supply forecast."