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What are Carbon Credits? And Why They are Not a Retail Investment Product

Investing in Carbon Credits is Probably a Choice that the Majority of Active Investors Have Been Presented With. The Market Explained and Why One of iNVEZZ’s Experts Would Steer Clear

by Tsveta Zikolova

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While fighting global warming and making the rich nations pay for polluting the planet by boosting green investment in poorer countries is a good concept in principle, it would seem that something went wrong along the way. Recently, the United Nations reported that the Clean Development Mechanism – one of the Kyoto Protocol’s fundamental instruments – had essentially collapsed. This in turn prompts the question whether the carbon credit trading system devised to facilitate the protocol’s targets still makes any sense.

This is of particular pertinence to anyone who has been conviinced to or is considering investing in carbon credits as an 'up-and-coming-sure-thing-fifty-percent-returns-in-six-months', investment product by some bloke on the blower calling up from Green Investments Inc. For the past couple of years carbon investment has been the in-vogue ‘alternative investment’ being pushed by every man and his dog with a short-term-contract office somewhere between Bank and Chancery Lane. Shades of ponzi and a certain lack of scruples concerning truthful and transparent representation of carbon credits as an investment product where most of these sales operators are concerned aside, the carbon trading system is something that the international community has poured massive amounts of effort, time and money into. Let’s take a closer look as to whether carbon credits can or should be termed an ‘investment’.

Carbon Credits in a Nutshell

So, what exactly is carbon investment and what are carbon credits? Although they have been around for a while now, they have proven to be a tricky concept to grasp. In short, a carbon credit or a carbon offset is a financial instrument representing one metric tonne of CO2 or carbon dioxide equivalent in another greenhouse gas. Carbon credits were introduced with the Kyoto Protocol in 1997 as a way of commoditising carbon emissions and creating a financial incentive for nations and companies to reduce their greenhouse gas emissions. Carbon offsets are traded on compliance and voluntary carbon markets.

The Clean Development Mechanism

The concept of carbon offsetting and carbon credits is perhaps most visible in the Clean Development Mechanism (CDM) which allows industrialised nations and companies to offset the impact of their carbon emissions by paying for projects aimed at avoiding greenhouse gas emissions in developing counties.

The projects in question produce carbon credits called Certified Emissions Reduction (CERs), with the UN recently announcing that the one-billionth CER has been issued. Polluters buy these carbon credits to offset their own emissions. Yet, despite the CDM’s role in lowering global carbon emissions, the carbon market is currently in a grim state. In its September 2012 report, aptly entitled “Call to Action”, the High Level Panel on the CDM Policy Dialogue stated that carbon prices in the CDM market had declined by as much as 70 percent in the past year alone, and were projected to fall further. The Panel attributes the falling prices of CERs to modest mitigation targets which in turn create no incentives for private international carbon investment and local action in developing nations.

The Financial Times recently quoted the UBS (NYSE:UBS) carbon analyst Per Lekander as saying that the UN-backed carbon market had turned into “a complete joke,” adding that the system would never have survived “if it hadn’t been for such a noble cause.” And while the cause is indeed noble, the execution seems to be flawed, with the CDM High Panel reporting that governments, private investors and financial institutions were increasingly losing confidence in the CDM market and the trend was likely to accelerate in the absence of new solutions.

The EU Emissions Trading System

Among the reasons cited for the CDM market’s downfall is the exclusion of a certain type of CERs from the world’s most developed carbon credit market up to date – the EU Emissions Trading System (EU ETS). The EU ETS, often referred to as a “cap-and-trade” system, imposes limits on the total amount of greenhouse gases which can be emitted by factories, power plants and other installations covered by the system. Within this cap, companies receive emission allowances which they can trade between one another as needed.

Effective in 2013, the EU ETS will ban the use of CERs generated from the destruction of waste industrial gases due to concerns about the environmental integrity of those credits. The EU ETS, however, has oversupply problems of its own, with the Eurozone turmoil further weakening carbon credit demand within the EU ETS. With output having fallen many EU countries are either within their emissions allowance or much less in deficit meaning less carbon credits need to be purchased by them. In its report “State and Trends of the Carbon Market 2012”, the World Bank notes that the oversupply of EU allowances (EUAs) is likely to remain for several more years, despite the upcoming more rigid Phase III of the EU ETS, when fewer allowances will be allocated for free. The World Bank also notes that “a considerable portion of the trades is primarily motivated by hedging, portfolio adjustments, profit taking, and arbitrage”.

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