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Making money from emissions trading in Australia

October 15, 2009

It seems that there’s not a lot of interest in the Australian Government plans for an emissions trading scheme (Carbon Pollution Reduction Scheme – or CPRS) right now among bankers.  They just don’t think that there are great opportunities to be created from participating in carbon trading in the near future. 

Otherwise, they might actually be employing some people to work on it.  They’re not.

That should make many people happy.  The last thing that most would want to hear right now is a story of bankers making a fortune from a mechanism designed to contribute to an equitable defence of environmental and social vulnerabilities.

That isn’t to say that there isn’t strong interest in the CPRS among analysts in terms of its impact on relative company and asset performance, however.  With the ALP and Liberals seemingly edging ever-closer to total industry compensation measures, already in the context of a modest target, it is likely that the influence of tangential macro-economic issues such as energy and minerals commodity prices and volatility, interest, inflation, and exchange rate conditions will continue to have a much more significant influence on corporate activity than emissions trading will – irrespective of what the doomsayers would have you believe.  There are no level playing fields in this world – perhaps barring the existence of some very flat football fields in the Netherlands.

Remember, also, that ‘compensation’ provided to industry might just imply that the obligation to pay for emissions abatement has to come from elsewhere.

But what is the cause of the lack of interest?

It can be put down to four factors:

  1. The endless delays.  How long have we been anticipating the imminent arriving of carbon pricing in Australia?  There are still many industry players sitting on the sidelines waiting until legislation is signed before they are prepared to do anything.
  2. The obvious low carbon price cap which will be applied in Australia – likely below the floor price set in the United States in the first instance.  This means that absolute risk for compliance market participants is low.
  3. The establishment of price caps – the proposals currently conceive of a fixed permit price of $10 in the first instance, $40 for a few years thereafter (to end 2013) – importantly provides for a predictable exposure, with little worry about having to manage volatility.
  4. Efforts to enable market clarity and industry participation in Government auctions obviate need for market intermediaries

The effect is likely to strip any interest from the market in participating in potentially lucrative structured hedging contracts – contrary to the fears (sometimes expressed in colourful and evocative language) of some and however tempting it is to associate carbon markets with the bogey of Lehmans (whose carbon market desk staff liked to frequently remind conference participants about the importance of counterparty risk, as though that particular attribute represented a competitive advantage to them – what irony!)

Indeed, it is likely to also significantly diminish interest among market participants in participating in the international carbon markets.  It is quite likely that primary Certified Emissions Reduction (CER) carbon credits from international Clean Development Mechanism (CDM) projects will initially be more expensive than domestic credits.  The international carbon credit project developers have recognised this, and have voted with their feet by postponing the setting up of shop here for the most part.

There are further interesting questions that the desire to cap prices for industry under the CPRS kicks up:

If the Australian Government is prepared to intervene in the domestic carbon credit market, through allocation or release of additional carbon credits in order to maintain a given market price, then compliance risk with a national target is shifted from private sector treasuries to the public purse.  In other words, if the price rises above the cap price, then the government takes the heat off the price presumably by increasing supply through issuance of new permits, which come from the national carbon budget obligations (tracked at the UNFCCC).  The Government then has to go shopping for Kyoto-compliant carbon credits.

Frank Jotzo at Australian National University presented an interesting paper on this subject earlier in the year at the 2009 Australian Agricultural and Resource Economics Society Conference.  In a stochastic model, for the target and price scenarios, he estimates the likelihood of Australia being over its carbon cap in 2015 at over 50%, with a likelihood of a cost to the public purse of over AUD$1bn being between 0.4% to 7% – with some variables in the model being the national target in place, emissions abatement undertaken, price cap levels, and international permit prices.

In the United States, within the Kerry-Boxer ‘The Clean Energy Jobs and American Power Act’, as well as within the American Climate and Energy Security bill, the Market Stabilization Reserve is the entity which will be responsible for managing price bands and volatility within a proposed emissions trading scheme.  The former bill is currently in front of the Environment and Public Works Committee, and contains some very constructive propositions that would enable a carbon price collar.  For good analysis of this, see Andy Stevenson’s blog at NRDC’s Switchboard

In Australia, while there has been a little discussion of this aspect, there has not been extensive debate as to its functionality under the proposed CPRS construct.  I would be interested in information and views. 

A regulatory authority named ‘The Australian Climate Change Regulatory Authority’ has been charged with the release of information on AEU and market demand.  It is not clear to me, however, whether it will be the same entity that analyses this information, and issues the ‘order’ for the easing of the carbon supply (and/or for intervening in the international carbon markets to make up for the short).

The construct proposed for price capping has, however, come in for criticism.  Some commentators have suggested that it would effectively then operate as a tax, yet be far more complex to administer – so best to drop emissions trading all together. 

The trick with a trading scheme is that, while the price may vary, the aggregate environmental outcome is fixed by the scheme emissions cap.  For a tax, the price is set, but there is no certain environmental outcome as a target.

If the emissions cap is effectively made flexible for those covered sectors of an emissions trading scheme through application of a price cap, then neither is the price set, nor the environmental outcome assured. 

And so the sectors not covered by the trading scheme pick up the bill.  That means you, me, and everyone we know – whether through additional direct imposed costs on us to alter our emissions, or indirectly through use of public funds for the Government to buy international permits.

While I am certainly not saying what course of action is right or wrong, the fact is that industry sectors are better informed, more concentrated, have more resources, and are better represented in Canberra than the average tax-payer. 

So you want to know how to make money from the Australian emissions trading scheme? : 

 – you can bet on industry compensation and price caps – if the bookies will give you the odds.  For a hedge, try also going long on ‘no emissions trading’, just in case.

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