Emissions Exchanges Ready Contracts as EU Weighs Ban on Some CO2 Offsets

The European Union proposed a ban from the start of 2013 on tradable credits linked to certain industrial gases, prompting exchanges to begin creating new futures contracts to reflect a change in emissions regulation.

The regulatory arm of the 27-nation EU is taking aim against projects that may create “excessive” profits for investors and undermine the market’s integrity. The EU said yesterday it wants to prohibit United Nations credits related to hydrofluorocarbon-23 and some nitrous oxide credits. The news widened the price gap between UN Certified Emission Reductions and EU allowances for 2012 to the most since May 20, 2009.

“We expect to launch new contracts early next year for CERs eligible for the EU in the post-2012 period,” said Henrik Hasselknippe, a managing director at The Green Exchange, a group including Chicago-based CME Group Inc. “The discussion among regulators will continue for several months. We are not going to sit back and wait for that to conclude.”

More than 11,000 facilities in the EU system, the world’s largest cap-and-trade program, are allowed to use UN credits as a cheaper way to comply with pollution quotas. Regulators around the world are clamping down on HFC-23, whose warming potential is 11,700 times more powerful than carbon dioxide. Officials at the UN carbon market called for a revision of its procedures.

Clean Development Mechanism

The commission proposed banning the use in the EU system of UN credits linked to HFC-23 and nitrous oxide from adipic acid production from the Clean Development Mechanism, the world’s second-biggest CO2 market, and the Joint Implementation program.

The ICE Futures Europe exchange, the biggest platform for trading emission rights, said it has the right to determine the type of offset credits that can be used to settle CERs futures contracts. It will make a further statement on the EU proposal by Dec. 11, ICE said in an e-mailed statement dated yesterday.

While the UN CDM issues CERs to pollution-cutting projects in developing nations, the Joint Implementation program generates tradable Emission Reduction Units. Installations in the EU program can now swap as many as 1.6 billion UN credits with EU permits on a one-for-one basis. The EU average annual emissions cap for that period is 2.04 billion tons of carbon dioxide, valued at about 31 billion euros ($41 billion) at today’s prices. One permit represents one ton of CO2.

CERs for delivery in 2012 dropped 0.5 percent to 11.40 euros on ICE today, taking their loss to 2.6 percent in the past two days. Given the uncertainty about the UN market after 2012, exchanges don’t offer benchmark futures for 2013 or later. ICE Futures’s CER contract for delivery in March 2013 dropped 5.5 percent at yesterday’s close to 10.56 euros, a record low.

“As for futures traded on exchanges, it’s really up to exchanges to decide how they are going to deal with it, although you have to expect some kind of a discount,” Guy Turner, director for carbon markets at Bloomberg New Energy Finance, told a panel at the EMART conference in Amsterdam. “ICE may be reluctant to add technology-specific contracts because it would reduce liquidity,” he said today by e-mail.

‘Material’ Impact

The impact of the proposed EU regulation on the price of offsets traded on the over-the-counter market will be “material” because investors will be able to differentiate credits related to HFC-23 and nitrous oxide from credits from other types of projects, according to Turner. The effect on EU carbon allowances will be “very slight,” he said.

EU allowances for 2012 fell 0.8 percent to 15.70 euros today. The spread between the EU permits and UN offsets for that year, traded as a separate contract, widened to 4.36 euros, constituting the biggest discount on UN credits in 18 months.

The EU regulator’s operational objective is to restrict the use of credits linked to HFC-23 and adipic acid projects from being used within the bloc’s emissions-trading system “as soon as legally possible,” the commission said.

Financial Losses

As some project developers, financial intermediaries and compliance buyers have signed some contracts for the delivery of credits by March 2013, curbs imposed as of January 2013 would require “adjustments by market participants which could entail some financial losses,” according to the commission.

“Due to commercial interests of individual market participants it was not possible to collect factual information on the importance of these delivery contracts,” it said. “But in particular to the extent that they were agreed after the date of adoption of the revised EU ETS, these contracts may contain provisions in the event use restrictions are introduced.”

The future of the UN carbon market and other proposals to cut greenhouse gases will be on the agenda when envoys worldwide meet Nov. 29 in Cancun, Mexico, for climate talks. They will discuss a climate-protection framework for when limits in the 1997 Kyoto Protocol expire at the end of 2012.

Continuing to pay “high rents” for HFC-23 and N2O abatement under the CDM would not be in line with the EU negotiating position for Cancun that advanced developing countries should contribute to global emission-reduction efforts, the commission said.

Short Payback Time

“The payback time of the capital and operational costs of HFC-23 and adipic acid plant N2O destruction is less than a year, even with a yearly weighted average cost of capital of 30 percent, while projects can earn revenues up to 21 years in the future,” the commission said. “Within the first year they even generate sufficient profits to also compensate all operating costs for the remainder of the lifetime of the project. This results in extremely high returns on investment.”

While HFC-23 projects represent less than 1 percent of all registered UN offset projects, their credits account for 69 percent of about 465 million offsets issued so far. The 19 projects cutting the gas under the CDM program are located mainly in China and India, according to UN data.

CDM projects cutting nitrous oxide in adipic acid plants are present in Brazil, China and South Korea. In Europe, three adipic acid plants participate in the Joint Implementation program: one in France and two in Germany, according to the commission.

In 2009, EU emitters used 82 million CERs or ERUs for compliance in the bloc’s cap-and-trade, according to the commission data. Operators from Germany, Poland, Italy, Spain, UK and France used the highest number of HFC23 and nitrous oxide CERs, the commission said.

To contact the reporter on this story: Ewa Krukowska in Brussels at ekrukowska@bloomberg.net;

To contact the editor responsible for this story: Stephen Voss at sev@bloomberg.net

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