Carbon Credits

“Carbon Credit Trading”

A project report submitted in partial fulfillment of the degree of

Master of Finance and control

Submitted by Under the guidance of

Sikha Jain (09MFC033) Prof. Anil Swain
Binita Sunadhar (09MFC013) P.G. Dept. of Commerce
P.G. Dept. of Commerce Utkal University, Bhubaneswar
Utkal University, Bhubaneswar

MASTER OF FINANCE AND CONTROL

P.G. DEPARTMENT OF COMMERCE

UTKAL UNIVERSITY, VANIVIHAR BHUBANESWAR - 751004

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CARBON CREDITS – A MARKET OF THE 21st CENTURY

Amidst growing concern and increasing awareness on the need for pollution control, the
concept of carbon credit came into vogue as part of an international agreement, popularly
known as the Kyoto Protocol. And, with the increasing ratification of Kyoto Protocol (KP) by
countries and rising social accountability of polluting industries in the developed nations, the
carbon emissions trading is likely to emerge as a multibillion-dollar market in global emissions
trading. The recent surge in carbon credits trading activities in Europe is an indication of how
the emissions trading industry is going to pan out in the years to come. It is estimated that 60-
70% of GHG emission is through fuel combustion in industries like cement, steel, textiles and
fertilizers. Some GHG gases like hydro fluorocarbons, methane and nitrous oxide are released
as by-products of certain industrial process, which adversely affect the ozone layer, leading to
global warming. The Concept of Carbon credit came into existence as a result of increasing
awareness on the need for pollution control.

Kyoto Protocol

The Kyoto Protocol is an international treaty to reduce greenhouse gas (GHG) emissions blamed
for global warming. The Protocol, in force as of 16 February 2005 following its ratification in late
2004 by Russia, provides the means to monetize the environmental benefits of reducing GHGs.
Kyoto Protocol is a voluntary treaty signed by 141 countries, including the European Union,
Japan and Canada for reducing GHG emission by 5.2% below 1990 levels by 2012. However, the
US, which accounts for one-third of the total GHG emission, is yet to sign this treaty. The
preliminary phase of the Kyoto Protocol is to start in 2007 while the second phase starts from
2008. The penalty for non-compliance in the first phase is E40 per tonne of carbon dioxide
(CO2) equivalent. In the second phase, the penalty will be hiked to E100 per tonne of CO2. The
Protocol and new European Union emissions rules have created a market in which companies
and governments that reduce GHG gas levels can sell the ensuing emissions ‘credits’. These are
purchased by businesses and governments in developed countries – such as the Netherlands –
that are close to exceeding their GHG emission quotas. Major contributors of Greenhouse Gas
emissions are cement, steel, textiles, and fertilizer manufacturers. The major gases emitted by
these industries are methane, nitrous oxide, hydro fluro carbons, etc. which directly deplete the
ozone layer. For trading purposes, one credit is considered equivalent to one tonne of CO2
emission reduced. Such a credit can be sold in the international market at a prevailing market
rate. The trading can take place in open market. However there are two exchanges for carbon
credit viz Chicago Climate Exchange and the European Climate Exchange.

The Kyoto Protocol provides for three mechanisms that enable developed countries with
quantified emission limitation and reduction commitments to acquire greenhouse gas
reduction credits. These mechanisms are Joint Implementation (JI), Clean Development
Mechanism (CDM) and International Emission Trading (IET). Under JI, a developed country with
relatively higher costs of domestic greenhouse reduction would set up a project in another
developed country, which has a relatively low cost. Under CDM, a developed country can take

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up a greenhouse gas reduction project activity in a developing country where the cost of GHG
reduction project activities is usually much lower. The developed country would be given
credits for meeting its emission reduction targets, while the developing country would receive
the capital and clean technology to implement the project. Under IET mechanism, countries can
trade in the international carbon credit market. Countries with surplus credits can sell the same
to countries with quantified emission limitation and reduction commitments under the Kyoto
Protocol. The EBRD region – former centrally planned economies of central and Eastern Europe,
Russia, the Caucasus and central Asia – is rich in possibilities for using the Protocol to reduce
emissions and energy waste and costs. Such economies are highly energy inefficient: it takes
twice as much energy to produce a unit of GDP in Hungary and Czech Republic as it does in
Western Europe and 10 times as much in Russia and Ukraine.

Understanding Carbon Credit

Carbon credits are measured in units of certified emission reductions (CERs). Each CER is
equivalent to one ton of carbon dioxide reduction. India has emerged as a world leader in
reduction of greenhouse gases by adopting Clean Development Mechanisms (CDMs) in the past
two years. Developed countries that have exceeded the levels can either cut down emissions,
or borrow or buy carbon credits from developing countries.

Trading in Carbon Credit (CC)

The concept of carbon credit trading seeks to encourage countries to reduce their GHG
emissions, as it rewards those countries which meet their targets and provides financial
incentives to others to do so as quickly as possible. Surplus credits (collected by overshooting
the emission reduction target) can be sold in the global market. One credit is equivalent to one
tonne of CO2 emission reduced. CCs are available for companies engaged in developing
renewable energy projects that offset the use of fossil fuels. Developed countries have to spend
nearly $300-500 for every tonne reduction in CO2, against $10-$25 to be spent by developing
countries. In countries like India, GHG emission is much below the target fixed by Kyoto
Protocol and so, they are excluded from reduction of GHG emission. On the contrary, they are
entitled to sell surplus credits to developed countries. It is here that trading takes place. Foreign
companies who cannot fulfill the protocol norms can buy the surplus credit from companies in
other countries through trading. Thus, the stage is set for Credit Emission Reduction (CER) trade
to flourish. India is considered as the largest beneficiary, claiming about 31% of the total world
carbon trade through the Clean Development Mechanism (CDM), which is expected to rake in
at least $5-10bn over a period of time.

To implement the Kyoto Protocol, the EU and other countries have set up ‘Cap and Trade’
systems. Under these systems, companies are obliged to match their greenhouse gas emissions
with equal volumes of emission allowances. The Government initially allocates a number of
allowances to each company. Any company that exceeds its emissions beyond its allocated
allowances will either have to either buy allowances or pay penalties. A company that emits
less than expected can sell its surplus allowances to those with shortfalls. Companies or

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countries will buy these allowances as long as the price is lower than the cost of achieving
emission reductions by themselves. Currently, project participants, public utilities,
manufacturing entities, brokers, banks, and others actively participate in futures trading in
environment-related instruments.

Sources of demand & supply

Emerging carbon credit markets offer enormous opportunities for the upcoming
manufacturing/public utility projects to employ a range of energy saving devices or any other
mechanisms or technology to reduce GHG emissions and earn carbon credits to be sold at a
price. The carbon credits can be either generated by project participants who acquire carbon
credits through implementation of CDM in Non Annexure I countries or through Joint
Implementation (JI) in Annexure I countries or supplied into the market by those who got
surplus allowances with them. The buyers of carbon credits are principally from Annexure I
countries. They are:

 Especially European nations, as currently European Union Emission Trading Scheme (EU
ETS) is the most active market;
 Other markets include Japan, Canada, New Zealand, etc.

The major sources of supply are Non-Annexure I countries such as India, China, and Brazil.

Price influencing factors

In Non-Annexure B countries (the developing countries) across the world, CER prices are
influenced by various factors including EUA prices, crude oil prices, electricity, coal, natural gas,
the level of economic activities across Annexure I countries, among others
 
Some of the major price influencing factors :

 Supply-demand mismatch
 Policy issues
 Crude oil prices
 Coal prices
 CO2 emissions
 Weather/Fuel prices
 European Union Allowances (EUAs) prices
 Foreign exchange fluctuations
 Global economic growth

Economic Parameters impacting Carbon prices

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Economic Indiacators 2008 2007 2006 2005 2004

Real GDP (% change)

US 1.1 2 2.9 3.1 3.6

Japan -0.3 1.9 2.8 2.4 4
Euro zone 1 2.3 2.6 1.4 2
China 9 11.5 11.1 10.4 10.1
India 7.3 8.9 9.7 9 7.9
OECD 1 2.6 3.2 2.7 3.6
Consumer Price inflation (% change)

US 1 2.5 2.7 3.4 2.7

Japan 0.5 1.4 0.3 0.3 2.3
Euro zone 1 3 2.2 2.2 2.1
China 3 5.9 2 1.4 3.2
India 5 7 6.7 5.3
4.6
OECD 1 3 2.2 2.1 1.8

Industrial Output (YoY % change)

US -8.9 1.7 1.5 2.9 3.3

Japan -20.7 1.5 5.4 3.4 1.7
Euro zone -12.2 1.4 5.3 2.5 0.8
China 5.7 17.4 14.7 16.5 14.4
India -0.2 8 13.4 5.7
8.9

Interest rates (%)

US ( Fed Funds Target) 0.25 4.25 5.25 4.25 2.25

Japan (12 month T-Bills) 0.249 0.581 0.618 0.066 0.003
Euro zone ( Refinance rates ) 2.5 4 3.5 2.25 2
China ( Lending Rate ) 5.31 7.47 6.12 5.58 5.58
India ( Repo rate ) 6.5 7.75 7.25 6.25 6

Money Supply ( YoY % change)

US 9.6 5.6 5.4 4.1 5.7

Japan 0.7 0.7 -0.6 0.3 1
Euro zone 7.5 11.6 9.9 7.4 6.6
China 17.82 16.72 16.9 17.6 14.63
India 19.6 22.84 19.33 17.79
13.49

Equity Index (points)

US (DOW JONES) 8,776 13,265 12,463 10,718 10,783

India (SENSEX) 9,647 20,287 13,787 9,398
6,603

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OECD Indicators

OECD Total Monetary Aggr. & Comp.

Broad Money Index 127.3 116.9 107.6 100 93.9
OECD Total Purchasing power
Index Manufacturing 113.83 106.9 103.7 100 96.16

OECD Total CPI OECD

Groups Total Energy IPB 127.8 113.7 109.3 100 89.4

Source: OECD, IMF, CPM gold yearbook, World Bank

How Trading Carbon Credit is Done

But how is the trading done? Take an industrialized country like Germany and a developing
country like Kenya as an example. Both countries have enacted law to limit the emissions that
businesses can produce as per Kyoto Protocol.
1. Germany has allocated a quota of 50,000 tonnes of greenhouse gas emissions per year to
factory A GmbH. But factory A GmbH is putting out 75,000 tonnes of greenhouse gas emissions
per year for its operations. Factory A GmbH will either have to reduce production to meet
50,000 tonnes of greenhouse gas emissions per year limit or it has to purchase the deficit of
25,000 tonnes of greenhouse gas emissions per year from the open market.
2. In the neighboring industrial area there is factory B GmbH. Factory B GmbH has been
allocated a quota of 100,000 tonnes of greenhouse gas emissions per year. Factory B GmbH has
invested in new and efficient machineries and CO2 emission has dropped to 60,000 tonnes of
greenhouse gas emissions per year. Factory B GmbH has a credit of 40,000 tonnes of
greenhouse gas emissions per year of which they can sell 25,000 tonnes to factory A GmbH. But
at what price? And what if they are not in the same area, how would they have known each
other? This is why Carbon Credit Commodity exchanges Market is coming about.
3. Project C Kenya Limited is a fossil fuel power generating company in Kenya. The cost of
greenhouse gas reduction is far much lower in Kenya as a developing country but the
atmospheric effect is globally the same. And because every game has its tricks, Factory A GmbH
may find it economical to sponsor Project C Kenya Limited recover methane from sewerage
waste to feed the power station that previously would have used fossil fuel. This way, Factory A
GmbH will recover 25,000 carbon deficits and even generate extra carbon credit which they can
sell in the open market.
Carbon Finance

Carbon finance is the term used for carbon credits to help finance GHG reduction projects such
as the recent biomass conversion at Bulgaria’s PFS paper mill. The switch from hydrocarbon to
biomass will reduce the mill’s GHG emissions, generating carbon credits being purchased for
the account of the Netherlands government.
There are two categories of countries involved in carbon credit trading and finance: One being
Developing countries which do not have to meet any targets for GHG reductions. However they
may develop such projects because they can sell the ensuing credits to countries that do have

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Kyoto targets. In the EBRD region these include Armenia, Azerbaijan, Georgia, Kyrgyz Republic,
FYR Macedonia, Moldova, Turkmenistan and Uzbekistan. These countries are covered by the
Protocol’s Clean Development Mechanism (CDM). The other, industrialized countries which
include OECD countries (the richest nations of the world) and countries in transition from
centrally planned to open market economies. The latter include 13 of the EBRD’s countries of
operation where the industrial base and other infrastructure are highly energy inefficient:
Russia, Ukraine, Bulgaria, Czech Republic, Croatia, Estonia, Hungary, Latvia, Lithuania, Poland,
Romania, Slovakia and Slovenia. They are part of the Protocol’s Joint Implementation (JI)
mechanism.

Exchanges Trading In Carbon Credit

Like the way the stock market evolved, there currently are five exchanges trading in carbon
credit. These exchanges are providing spot market in carbon credit allowances as well as
futures and futures' options to help discover market prices and maintain liquidity. The carbon
credit exchanges are:
1. Chicago Climate Exchange
2. Nord Pool
3. European Climate Exchange
4. Power Next
5. European Energy Exchange
Potential participants in carbon credits trading are as below
Hedgers

 Producers
 Intermediaries in spot markets
 Ultimate buyers

Investors

 Arbitragers
 Portfolio managers

Diverse participants with wide participation objectives

 Commodity financers
 Funding agencies
 Corporate having risk exposure in energy products

Various industries that have scope of generation of CERs:

 Agriculture
 Energy ( renewable & non-renewable sources)

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 Manufacturing
 Fugitive emissions from fuels (solid, oil and gas)
 Metal production
 Mining and mineral production
 Chemicals
 Afforestation & reforestation

Emergent Issues

Carbon Credit: RS 15,000-Crore investments likely

The unfolding opportunity of carbon credits has caught the imagination of Indian
entrepreneurs. The number of Indian projects, in the fields of biomass, cogeneration,
hydropower and wind power, eligible for getting carbon credits, now stands at 225 with a
potential of 225 million CERs (certified emission reductions). This is just the tip of the iceberg. If
there is no uncertainty as to what will happen beyond 2012, the number could easily cross the
2,000-mark. The Kyoto Protocol required the developed nations to reduce greenhouse-gas
emissions at least five percent from 1990 levels during the commitment period of 2008-2012.
On 93rd Indian Science Congress it was estimated that the new opportunity could trigger flow
of investments to the tune of Rs.15,000 crore. Projects approved by designated CDM (Clean
Development Mechanism) in the developing countries could earn carbon credits and sell them
to the countries that required reducing the greenhouse gas emissions under the international
agreement. It was also pointed out that India is not at all under any pressure. Going for cleaner
production was good for our own interest. In that process Indian companies can benefit by
selling the credits. Any projects that are set up after January 1, 2000, will be eligible for CDM
recognition. The Ministry had already started a project to sensitize and encourage States to
take a lead in this regard. Initially five States — Andhra Pradesh, Rajasthan, Karnataka, Punjab
and Maharashtra were given seed funding to set up their own CDM facilities and spread the
word. Now it had been extended to 15 States. It is likely that the whole country will be covered
up by the year-end.

Demand for Carbon Credits will grow

Because of projected shortfalls and higher relative carbon abatement costs, it is anticipated
that OECD countries will fail to meet their Kyoto target by 2012. The higher relative emissions
abatement costs in these countries mean that they will find it attractive to buy carbon credits
generated elsewhere. Private companies in industrialized countries will increasingly be subject
to ‘Cap and Trade’ mechanisms, such as the EU Emission Trading Scheme which started on 1st
January 2005 (although this will initially cover only 50% of emissions). The EU scheme is
separate from the Kyoto Protocol but the ‘Linking Directive’ of 2004 allows a European
company to buy Kyoto Protocol Carbon Credits to comply with their obligations under the EU
Emission Trading Scheme. Governments will also have to buy Carbon Credits because the ‘cap
and trade’ mechanisms will initially only apply to a fraction of each state’s economy and
Governments are responsible under the Kyoto Protocol for meeting their country targets. OECD

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Governments and European companies subject to the EU Emission Trading Scheme will
therefore be the main buyers of Carbon Credits.
Low-cost Carbon Credits available in the EBRD’s countries of operations
The reference year used by the Kyoto Protocol for targets in emission reductions is 1990. Since
then, emissions have dropped sharply in countries such as Russia and Ukraine, as a result of
substantial real contraction of GDP. It is expected that the 13 countries of operation with Kyoto
Protocol targets will remain below their agreed maximum greenhouse emissions. These
countries will therefore be likely sellers of carbon credits. High carbon and energy intensities
mean high potential for low-cost emissions reductions (low relative investment cost per tonne
of GHGs avoided).

India as a potential supplier

India, being one of the leading generators of CERs through CDM, has a large scope in emissions
trading. Currently, the total registered CDM projects are more than 300, almost 1/3rd of the
total CDM projects registered with the UNFCCC. The total issued CERs with India as a host
country till now stand at 34,101,315 (around 34 million), again around 1/3rd of the total CERs
issued by the UNFCCC. In value terms (INR), it could be running into thousands of crores. 
Further, there has been a surge in number of registered projects in India. In 2007, a total of 160
new projects were registered with the UNFCCC indicating that more than half of all registered
projects in India happened last year. It is expected that with increasing awareness this would go
further up in the future. The number of expected annual CERs in India is hovering around 28
million and considering that each of these CERs is sold for around 15 euros, on an average, the
expected value is going to be around Rs 2,500 crore.

Role of the EBRD

The main role of the Bank in the field of carbon finance is to act as financier of emission
reduction projects. However, in keeping with its principle of ‘additionality’ - supporting and
complementing the private sector rather than competing with it - the Bank can play a number
of additional roles viz;

(i) Carbon Funding: The EBRD is well positioned to purchase, for the account of third parties,
carbon credits from GHG emission reduction projects. The Bank’s added value in this area
stems from the size and quality of emission and reduction projects. The Bank is the largest
financier of private sector deals in the region, with preferred creditor status, a rigorous
appraisal process, and integrity and ‘good governance’ requirements. It also has lengthy
experience in energy efficiency and renewable energy projects. The Bank also closely
coordinates the project financing and carbon buying process. EBRD’s strong relationships with
host country’s Government and its ability to engage in policy dialogue to remove or alleviate
obstacles to carbon trading and mitigate the ‘political’ risks inherent to the JI and CDM project
cycles. Its experience in managing funds from its shareholders for a variety of purposes (e.g.
nuclear safety) has an added advantage. Banks ability to access donor funds to help develop
and implement projects makes them play a key role here. In October 2003, the EBRD
established its first carbon fund, the Netherlands Emissions Reductions Co-operation Fund, with

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the Dutch Government. The fund buys Joint Implementation Carbon Credits from its 13
countries of operations eligible for this mechanism. Its first transaction was the PFS biomass
conversion. The Multilateral Carbon Credit Fund will become operational in 2006. The fund will
buy carbon credits from investments under the European Union scheme as well as the
Protocol’s Joint Implementation and Clean Development Mechanism. It will also aim to
facilitate the direct trading of carbon credits between some of its shareholders (so-called Green
Investment Schemes).

(ii) Donor Funding: The Bank can help Governments and companies in its region of operations
overcome obstacles in emission trading by providing technical advice funded by donor
governments. For example, as part of the Bank’s Early Transition Countries Initiative for its
poorest countries of operation, donors have approved funding to help in development of
complex CDM projects.

(iii) Business Opportunities for the Private Sector: EBRD’s carbon finance activities create new
business opportunities for the private sector in this emerging market. The selling of carbon
credits increases the feasibility of emission reduction projects, which helps to attract new
private investors. By being the buyer of carbon credits in a transaction, the EBRD can provide
comfort to private sector buyers that would not otherwise consider these projects.
Outsourcing, to private firms who are expert in this area, the work of developing emission
reduction projects covered by the Protocol. This is contemplated under the Multilateral Carbon
Credit Fund.

The role of MCX

With MCX keen to play a major role on the emission front by extending its platform to add
carbon credits to its existing basket of commodities with regard to commodities futures trading,
the existing and potential suppliers of carbon credits in India have geared up to generate more
carbon credits from their existing and ongoing projects to be sold in the international markets.
With India supposed to be a major supplier of carbon credits, the tie-up between the two
exchanges is expected to ensure better price discovery of carbon credits, besides covering risks
associated with buying and selling.

Advantages of an MCX carbon contract

In India, currently only bilateral deals and trading through intermediaries are widely prevalent
leading to sellers being denied fair prices for their carbon credits. Advantages that the MCX
platform offers are:
 Sellers and intermediaries can hedge against price risk;
 Advance selling could help projects generate liquidity and thereby, reduce costs of
implementation;
 There is no counterparty risk as the Exchange guarantees the trade;
 The price discovery on the Exchange platform ensures a fair price for both the buyer and
the seller;
 Players are brought to a single platform, thus, eliminating the laborious process of
identifying either buyers or sellers with enough credibility; and

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 The MCX futures floor gives an immediate reference price. At present, there is no
transparency related to prices in the Indian carbon credit market, which has kept sellers
at the receiving end with no bargaining power.

MCX strives to reduce energy usage and wastage and have adopted safe recycling mechanisms.
The Exchange Square building, a new headquarter of MCX, is equipped with the best global
practices for conserving energy. Glass windows that are doubled vacuumed are put in place so
that they conserve energy. India’s First Green Exchange: Operations of MCX are almost
entirely electronic with zero carbon footprint. To further India’s role in the global combat
against greenhouse gas emissions, MCX — in January 2008 — launched carbon credit futures
trade. This has enabled Indian owners of Clean Development Mechanism (CDM) projects under
the Kyoto Protocol to sell the carbon credits they have earned, at the correct market prices
without having to negotiate or bargain. This has done away with many of the problems Indian
SMEs faced in the global carbon credits market. In recognition of the environment-friendliness
of its operations and the launch of carbon credit futures, MCX has been honored with the title
of India’s First Green Exchange. The honor was conferred on MCX by Dr. Michael Nobel,
executive chairman, Nobel Charitable Trust, on behalf of the well-known NGO, Priyadarshini
Academy. 

Risks associated with carbon credits

There are market- and policy-related risks for CER producers, including the supply-side risks
starting from the DNA approval risk to the CER issuance risk in a complete CDM approval cycle.
Apart from these risks there are a host of other risks from both the supply and demand sides
that the real market players confront with. Most CDM projects by their very nature take a long
time to generate the CERs and hence, face the aforesaid risks in large proportion, which if not
hedged would lead to reduced realization. Under such a situation, the realization of CER
generators at times may not even cover the investment put in to generate the CERs and thus,
has the potential of even making a CDM project unviable in the long term. Given the long
gestation period of CDM projects and the risks involved, it is rather inevitable that they pre-sell
their potential credits in the futures market (preferably a domestic futures market, to avoid
forex risk attached to participation in a foreign exchange) and thereby, cover their probable
downside in the physical market.

Rise of Global Carbon Commodity

Global carbon markets have been growing at 100% a year, touching US$126 billion in 2008. The
EU ETS (European Union Emission Trading Scheme) saw 3.09 billion EUAs (European Union
Allowances) traded in 2008, exceeding the annual allocation for 2008 of 1.8 billion. Spot trading
in EUAs jumped significantly to 250 million out of total 2.7 billion exchange-traded EUAs in 2008
and further increased to 850 million out of total 3.2 billion exchange-traded EUAs in the first
half of 2009. The explosive growth in the EUA market and the significant increase in spot
trading imply a deepening of the EUA market, and if this growth continues, the year 2009 could
end up with the financial market. volume for carbon in excess of 6 billion or more than 3 times
the underlying physical market. Trade in primary CERs (Certified Emission Reductions), the
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developing world’s instrument of access to the global carbon markets, was below the 2007
level at 389 million in 2008, while that in secondary CERs (CERs traded among developed
economy banks, traders, and utilities) witnessed a significant jump in volumes at 1,072 million
in 2008. This is 5.3 times the underlying physical market of 275 million issued CERs up to 2008.
We should see greater volumes of EUA and CER trades as the carbon commodity markets
deepen and reach the level of other energy markets such as electricity and natural gas markets
where the total financial market is 10 to 20 times the underlying physical market or crude oil
where it is more than 30 times.

The linkage between the energy and the carbon emissions markets is obvious, but it is
interesting that some analysts predict that the emissions market may one day overtake the
energy market (electricity and gas). Estimates of the size of the global carbon market in 2020
are in the range of US$1 trillion to US$3 trillion. Bart Chilton, US Commissioner of the
Commodities Futures Trading Commission, opined that “the potential size and scope of a
structured carbon emissions market in the US is unequivocally vast. It is certainly possible that
the emissions markets could overtake all other commodity markets," while estimating emissions
futures to reach US$2 trillion in five years. Data on transactions in the UK, one of the largest
electricity, gas and emissions markets in the Euro Zone, can read as a first sign of rapid growth
of emissions trading with high volatility in other energy markets in the last three years.

Contracts transacted by UK brokers – notional value of markets in £ billion.

2005 2006 2007 2008

UK power 25 30 30 63
UK gas 54 108 134 176
Euro power 77 147 193 178
Euro gas 7 11 11 27
Coal 45 107 46 111
Emissions 1.5 5.5 8.8 36

Source: Financial Services Authority (FSA) survey of the energy derivatives market

The European Union has agreed to take a 30% reduction below 1990 by 2020, in the event of an
international agreement on emission reductions. In its absence, it will take a 20% reduction
below 1990 by 2020, which translates into a 21% reduction between 2005 and 2020 in the EU
ETS sectors. This implies allocation/auction of 2 billion EUAs for 2013 decreasing to 1.7 billion
EUAs for 2020 valuing the physical market at US$ 50 billion a year. The demand for CDM/JI
(Clean Development Mechanism/ Joint Implementation) credits is restricted, in the event no
international agreement takes place, to the allowances unused during the period 2008-2012. In
the event of an international agreement on emissions, the limit on use of CDM/JI credits will
automatically be increased up to half the additional reduction effort. Estimates put the total
limit of CDM/JI credits during the period 2008-2020 at 1.4 billion (without international
agreement) and an additional 300 million in the event of an international agreement being
secured.

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However, the CDM scheme is expected to change significantly from the one that exists
today — both internally, in terms of improving the existing mechanism, and externally, in scope
and coverage. There are calls for the existing (improved) CDM scheme to be applicable only to
‘least developed countries’ in future and making sectoral CDM applicable for major economies.
Calls for exclusion of industrial gases have also been raised. On the other hand, the developing
countries have been raising the issue of financing and technology transfer, the key parameters
set out in the Bali Action Plan. The US is not yet a significant player in the global carbon market.
However, the recent passage of the American Clean Energy & Security Act (ACES) through the
US House of Representatives is expected to change that dramatically and, at the very least, has
kept the momentum to Copenhagen summit (the 15 th Conference of Parties in December 2009).
The ACES proposes 17% emissions reduction between 2005 and 2020 (3% below 1990 levels)
and 80% by 2050. Projections by EPA show that this would require an emissions reduction
(against the business as usual) of 366 mtCO2e (million tons of carbon dioxide equivalent) per
annum during the period 2012-2020. The total US emissions in 2005 were at 7.2 billion. The
ACES does not automatically allow all CDM/JI credits but calls on the US EPA (Environment
Protection Agency) to develop its own process for approving offset projects. It provides for
allowable limits of two billion tons annually from domestic and international offsets, and
international allowance trading. A carbon market of US GHG emissions of this magnitude will
increase the global emissions market multiple times.

Huge investments in green technology in Asia and steps towards domestic emissions
trading are opening up the prospect of regional carbon trading. Many Asian nations are not
waiting for agreement on a broader UN climate pact and see good investment opportunities to
move ahead now to boost energy security and job growth. Countries such as China, Japan,
Korea and Australia were likely to press ahead with their own schemes to curb greenhouse
gases, Anthony Hobley, global head of climate change at law firm Norton Rose, said at a carbon
conference in Melbourne. “What’s happening is things are growing more organically, it’s a
bottom-up approach and that’s how international currencies trade evolved, that’s how
international trade in oil evolved and I think that will happen with carbon,” he said. “There
won’t be this global unified top-down carbon market but what will happen is bottom-up
development made possible by Kyoto Protocol and international agreements which unleashed
design principles for monitoring and setting up markets.” The Kyoto Protocol is the UN’s main
weapon in the fight against climate change and includes a scheme that rewards investors in
clean energy projects in poorer nations. Investors earn tradeable carbon offsets in a scheme
worth US $20.6 billion. But UN climate talks have got bogged down on whether to extend Kyoto
into a new phase from 2013 or to craft a new treaty. The United Nations says it doesn’t expect
nations to agree on a new legally binding treaty during major climate talks in Cancun, Mexico,
in less than two months. Agreement might come a year later during talks scheduled for end-
2011. “It could be in the future that there will be treaties that link China’s domestic market with
global markets, that, if not global, may be bilateral or regional market models,” Hu Tao, a
member of China’s Carbon Forum Advisory Board, said. Japan is already looking at bilateral
offset deals to help the government meet its pledged emissions cut of 25 per cent below 1990

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levels by 2020, fearing the UN talks could falter. What the regional carbon currency would be
remains unclear but could be based on Kyoto offsets called certified emission reductions that
are widely traded.

China’s next five-year plan from 2011 to 2015 is expected to include a commitment to
market-based emissions trading. South Korea is finalizing plans for carbon trading, while Japan
hopes to launch a scheme by 2013 or 2014 if the government’s climate bill passes parliament.
India aims to launch renewable energy and energy efficiency trading schemes, while an
Australian government panel is weighing whether to recommend a carbon price or a limited
emissions trading scheme with an initial fixed price for pollution permits. New Zealand already
has the world’s only national emissions trading scheme outside the European Union. These
steps have been buoyed by huge domestic stimulus plans, including China’s US $736 billion
clean energy investment pledge to 2020, India’s 20 Gw solar initiative by 2022 that is expected
to draw US $70 billion in investment as well as steps by South Korea and Japan.

Buyer countries Number of projects

Austria 80
Belgium 24
Canada 74
Czech Republic 3
Denmark 63
Finland 34
France 71
Germany 202
Greece -
Hungary -
Iceland -
Ireland 14
Italy 92
Japan 464
Latvia -
Luxembourg 24
Netherlands 433
New Zealand 1
Norway 36
Portugal 5
Spain 133
Sweden 220
Switzerland 560
United K. 1155
CDCF 4
WBCF 1
NEFCO -
IBRD 1
CCAC 16
n.a. 1479

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Total 5173

Note: In some project more than one investor country participate. Projects rejected by DOEs or
EB or withdrawn are not included.

Graph-1

Primary CERs Producers (2008)

CHINA
3%
4%2%
3%
4% INDIA

BRAZIL

REST OF ASIA

REST OF LATIN AMERICA

84% OTHERS

Source: State and Trends of the Carbon Market 2009 - World Bank report

Graph-2
Primary CDM and JI Buyers (2008)

OTHERS

AUSTRIA

39% 41% SPAIN & PORTUGAL

JAPAN

ITALY

9% 2% UK
5% 4%

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Source: State and Trends of the Carbon Market 2009 - World Bank report

Energy Markets in India

In India, electricity exchanges have been a recent entrant in the commodity market, with Indian
Energy Exchange Ltd (IEX) and the Power Exchange India Ltd (PXIL) becoming operational last
year. Recently, a third power exchange, National Power Exchange Ltd, has received approval
from CERC (Central Electricity Regulatory Commission). Currently a day ahead market, there are
indications that term capacity contracts and intraday contracts would be allowed to be traded
on the exchange. The power exchanges deepen the existing bilateral electricity trading by
embedding the transmission availability within the day-ahead contract in addition to the
standard benefits of a trading platform — access, risk mitigation, clearing and settlement
processes.

On an annualised basis, the electricity traded by the trading licensees stood at 21.9
TWh (terawatt hour or billion kWh) in 2008-09, approximately 3% of the total electricity
generation in India, valued at approximately US$3 billion (given the high traded prices in the
range of US$150/MWh). Around 2 TWh was traded on the power exchanges in FY09 (part year
operation of both the exchanges). If one were to use the 10-20 multiple benchmark of financial
markets to the underlying physical markets, this shows a huge growth potential in terms of
electricity trade volumes and the share of exchange-traded electricity. There are some issues
relating to the appropriate regulatory agency that has primary jurisdiction over the electricity
commodity market. While these issues are being deliberated, they have not come in the way of
developing the exchange traded electricity market. Multi Commodity Exchange of India Ltd
(MCX) inter alia trades in natural gas, which is one of the actively traded contracts, while
National Commodity & Derivatives Exchange Ltd (NCDEX) has recently introduced trading in
thermal coal. Crude oil and fuel oil are traded on both MCX and NCDEX. Emissions trading (see
section below) got underway at both the exchanges last year. That is, an entire suite of energy
and emission products is being traded on the two exchanges and is expected to grow
significantly in volumes. We anticipate that, as energy markets are further liberalised, new
products in the form of spark and dark spreads with and without embedded emissions will also
emerge as hedging tools.

Carbon Markets in India

Carbon instruments were launched in India in 2008 in anticipation of significant growth in the
global carbon markets and India’s position as the second-largest supplier of emission
reductions. MCX initially launched futures linked to EUA and later launched CER futures
contracts (expiry December 2008-2012). NCDEX launched CER futures contract with expiry
December 2008. Exchange-traded carbon instruments were aimed to infuse greater liquidity
and depth to a market that was being serviced by the over-the-counter (OTC) market, which
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largely comprised compliance buyers, international brokers, traders, banks etc. The exchange-
traded market’s role in price discovery and transparency was of particular relevance to Indian
sellers as there was a general perception of lack of transparency in the OTC market. OTC
transactions generally involve longer lead times and more complex and largely bespoke
emissions reduction purchase agreements with extensive provisions to deal with credit risk
issues. Exchange-traded carbon instruments were seen capable of addressing all these issues.
Importantly, exchange-traded carbon instruments were intended to give the treasuries of large
carbon sellers in India the ability and the flexibility to actively manage the company’s carbon
portfolio and price risks as commodity hedging on overseas carbon markets requires regulatory
approvals not many companies are willing to pursue. As with any trading scheme, primary CER
sellers were seen as an important segment of the market but the anticipation was that very
significant interest from speculators, traders and arbitrageurs would provide the needed
liquidity. The initial trades and growth in the volumes of exchange-traded carbon instruments
on MCX and NCDEX were encouraging, and there was a lot of interest. At times, the prices of
CER futures contracts on these exchanges were at a premium over those of the European
Climate Exchange (ECX), the world’s largest carbon exchange. However, it was generally
understood that the premium was on the account of speculation over the exchange price (Euro
Vs INR), which was expected to rise. However, as the global recession and economic slowdown
hit Europe in the latter half of 2008, the demand for the EUAs — and hence for CERs — began
to decrease. The price fall was further fuelled by companies in Europe selling surplus EUAs to
raise much needed finances. When CER prices began to decline, Indian sellers preferred to wait
and watch rather than transact at lower prices. In the absence of buyers and sellers in the
Indian market, speculators and arbitrators vanished. And this resulted in the drying up of trades
on the Indian exchanges.

The 2008 preliminary verified emissions data released in 2009 showed that EU ETS
was overall short in spite of the economic slowdown but this did not cause any significant
market movements as this was generally expected. Indian commodity exchanges do not allow
direct participation by foreign institutions. This may not impact price discovery for domestic
commodities but CERs are different as their primary use is by Annex 1 countries. As there are
no compliance buyers in India and foreign traders and institutions are not allowed to
participate on NCDEX and MCX, liquidity and trading volumes are likely to continue to be low
(affecting the price discovery process) until some elements of this equation are modified. Apart
from market participation regulations, the development of carbon markets in India will also
depend on the contours of global carbon markets post- 2012, agreed in Copenhagen summit.
Significant opportunities could emerge for compliance and voluntary carbon for commodity
exchanges if there is continued use of market mechanisms for reducing GHG emissions in the
global context post-2012.

Even as India is being heralded as the next carbon credit destination of the world,
with maximum growth in this front is happening in Maharashtra, Chhattisgarh and Andhra
Pradesh, Gujarat is slowly emerging as the dark horse of the country on the back of rapid
industrialization through its recent oil refineries and power projects. Between the end of 2005
and December 2006, 450 clean development mechanism (CDM) projects had been submitted to

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the ministry of environment and forests, of which around 420 CDM projects have received
government approval, which make up a total of 350 million carbon credits. Of the 420 projects,
around 20 are from Gujarat. Big corporates like Reliance and Essar are already present in the
state. And now, most carbon credit consultants, including a few international environment
players are planning to set up shop in the country, and are eyeing the Gujarat market. Of the
approved companies from Gujarat, Torrent Power has the maximum number of credits to its
name with 11 million credits followed by ONGC’s Hazira refinery with approximately two million
credits, Indian Farmers Fertilizer Cooperative Ltd (IFFCO) with 1.5 million credits, Essar Power
with 0.5 million credits, Reliance Industries’ approval for its base in Gujarat close to 2,40,000
credits, and Apollo Tyres with 1,00,000 credits. Others include United Phosphorus, Gadhia
Solar, Tata Chemicals, Rolex Rings, Alembic and Fairdeal Suppliers. Going by the current rates,
where carbon credits are measured in units of certified emission reductions (CERs) and each
CER is equivalent to one tonne of carbon dioxide reduction, the value of one carbon credit
could be anywhere between three Euros and six Euros, and with bank guarantee can go up to
eight or nine Euros.

The market is very big. It may be a clue to know that a recent analysis shows
that India will stand to gain $5 billion from carbon credit in seven years. After Chicago Climate
Exchange and the European Climate Exchange, MCX (Multi-Commodity Exchange of India) is
likely to be the third exchange in the world with a license to trade in carbon credits. Two
leading international players have already begun dialogue with the government to acquire
permission to set up liaison offices in India. Eco-securities is the only international developer
and trader of carbon credits to have a liaison office in India as on date. SRF Ltd and Shell Trading
International have entered into a deal for sale and purchase of 500,000 CERs (Certified Emission
Reductions) to be delivered on or before 2007. The move made a strong impact on the charts.
In March 2006, India had 310 ‘eco-friendly’ projects awaiting approval by the UN. Once cleared,
these projects can fetch about Rs. 29,000 crore in the next seven years. India’s carbon credit
market is growing, as many players (industries) are adopting the Clean Development
Mechanism (CDM). US accounts for 30 per cent of global emissions, while India makes for three
per cent. Now, India can transfer part of its allowed emissions to developed countries. For this,
India must first adopt CDM and accrue carbon credits. In India so far, 242 projects have been
identified for generating CERs while a total of 318 projects have received clearance by the
Ministry of Forestry and Environment. The Indian carbon market has the potential to supply 30-
50% of the projected global market of 700 million CERs by 2012. Harsh Pati Singhania, senior
vice president, FICCI highlighted the fact that the Indian CDM project portfolio has grown
exponentially, from 297 projects in April 2006 to 753 projects in September 2007 to 1,114
projects today, with over 536 million carbon credit potential up to 2012.

It has been recommended the need of reforms in the CDM framework

beyond 2012, which must address ways to support mitigation by public entities to a greater
extend through the CDM route. The carbon emission of India in 1990 was lower than the world
average. Since India has a lower emission compared to its developed counterparts, it does not
qualify for mandatory emission targets. The meeting also underlined the fact that India has a
very attractive CDM portfolio with a market share close to 12%. Indian revenues are expected

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to grow by $10 billion by 2012. Out of the 806 projects registered India bags nearly 35.7%. The
number of expected annual Certified Emission Reductions (CERs) in India is hovering around 28
million and considering that each of these CERs is sold for around 15 euros, on an average, the
expected value is going to be around Rs 2,500 crore. CDM can pave the way for around Rs
18,500 crore of investment by 2012.

Giving an introduction to the carbon market, Sarika Rachuri of FTKMC said that EU Emission
Trading Scheme EU-ETS is one of the biggest trading schemes dominating the carbon space
which was launched in 2005. Elaborating on the implications of Kyoto Protocol she said that it
offered cost reduction in Green House Gas (GHG) abetment and has increased the investment
opportunities in green and clean technologies by incentivizing it. The other person who spoke
on the occasion was Umamaheswaran of GTZ - a German company which is into bilateral
development. He narrated the different stages of carbon credit generation and said that carbon
credit is basically reduction in emission on GHG which is caused by a project. He said that CDM
Project activity cycle included validation and registration, implementation and monitoring,
verification and certification and trading & CER's delivery.

Carbon
Fundamentals (Million Metric tons)

Carbon Market 2008 2007 2006 2005

Vol Val Vol Val Vol Val Vol Val
(MtCO2e) (MUS$) (MtCO2e) (MUS$) (MtCO2e) (MUS$) (MtCO2e) (MUS$)

Project based transactions

Primary CDM 389 6519 552 7433 450 4,813 341 2,417
Secondary CDM 1072 26277 240 5451 25 444 10 221

Sub total
(including JI & voluntary
market) 1535 33487 876 13646 508 5477 382 2894

Allowances market
EU ETS 3093 91910 2060 49065 1101 24357 321 7908
New South Wales 31 183 25 224 20 225 6 59
Chicago Climate Exchange 69 309 23 72 10 38 1 3

Sub total (including others) 3276 92859 2108 49361 1131 24620 328 7971

Total carbon market 4811 126346 2984 63007 1639 30097 710 10865

Source: State and Trends of the Carbon Market 2008, 2007, 2006 by World Bank

Status of CDM projects Number

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At validation 2575
Request for registration 57
Request for review 57
Correction requested 66
Under review 13
Total in the process of registration 193
Withdrawn 30
Rejected by EB 112
Rejected by DOEs 480
Registered, no issuance of CERs 1174
Registered. CER issued 40.41636364
Total registered 1214.416364
Total number of projects (incl. rejected
& withdrawn) 4604.416364

Title Number of CERs

AIssued CERs 316,818,951
Total CERs Requested 324,998,220

Source: UNFCCC

Title Annual Average CERs* Expected CERs until

end of 2012**CDM
CDM project pipeline: > 4200 of which: N/A > 2,900,000,000
--- 1760 are registered 310,521,163 > 1,630,000,000
--- 104 are requesting registration 12,982,558 > 40,000,000

* Assumption: All activities deliver simultaneously their expected annual average emission
reductions
** Assumption: No renewal of crediting periods

Source: UNFCCC

Carbon Trading Activity

In lots MCX CER ICE-ECX CER

Volume Open Interest Volume Open Interest

Mar-09 2250 15 50315 110589

Feb-09 2556 0 79498 114383
Jan-09 1815 108 44013 111772
Dec-08 561 152 40079 103556
Nov-08 219 2 90272 112772

Oct-08 85 111 65675 104717

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Sep-08 129 106 61724 87541

Aug-08 1139 120 59537 71846
Jul-08 14293 161 84508 62298
Jun-08 18771 131 56597 48823
May-08 - - 23142 29672
Apr-08 - - 17656 16613
Mar-08 - - 8240 5259
Feb-08 - - - -
Jan-08 - - - -

Source: Exchanges' websites

Aggregate Volume in all Contracts during the month- Cumulative open interest in all contracts at end of
the month.

Carbon Prices

CER Spot prices ICE-ECX EUA spot RBI rate

( EUR/metric tonne)CER (EUR/metric tonne) USDNIR

MCX (Rs/tonne) Open High Low Close Monthly Average Monthly Average

Mar-09 695.16 10.75 11.20 9.50 10.46 11.9 51.23

Feb-09 561.63 10.25 10.25 7.75 8.96 9.95 49.22
Jan-09 770.63 13.10 13.10 10.05 10.66 11.93 48.83
Dec-08 874.17 14.25 14.40 12.90 13.64 15.95 48.64
Nov-08 928.63 14.95 16.39 13.25 13.91 15.55 49.00
Oct-08 1177.42 19.00 20.45 14.25 15.05 17.85 48.64
Sep-08 1309.23 21.10 21.10 17.30 18.45 22.4 45.56
Aug-08 1267.12 17.74 21.25 16.75 21.20 25.3 42.94
Jul-08 1437.83 21.60 23.38 17.20 17.72 21.85 42.84
Jun-08 1353.50 17.85 21.00 17.78 20.86 28.63 42.82
May-08 - - 17.95 16.85 17.85 26.05 42.13
Apr-08 - - 16.50 15.2 16.07 23.85 40.02
Mar-08 - - 16.61 15.31 15.43 22.15 40.36
Feb-08 - - - - - 21.57 39.73
Jan-08 - - - - - 19.3 39.37
Dec-07 - - - - - 21.9 39.44
Nov-07 - - - - - 0.02 39.44
Oct-07 - - - - - 0.08 39.51
Sep-07 - - - - - 0.08 40.34
Aug-07 - - - - - 0.1 40.82
Jul-07 - - - - - 0.1 40.42
Jun-07 - - - - - 0.13 40.77
May-07 - - - - - 0.26 40.78
Apr-07 - - - - - 0.53 42.15
Mar-07 - - - - - 1.33 44.03

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Feb-07 - - - - - 0.98 44.16

Jan-07 - - - - - 2.4 44.33

Source: Exchanges' websites, RBI

Conclusion
However, in spite of the global interest in India for the CERs market, there is still some way to
go before it catches up with the market leaders in the field. While China leads the pack with a
market share of 60 percent in the carbon credit trading, India lags behind with around 15
percent market share. Compounding to its woes is its high rejection rates from United Nations
Framework Convention on Climate Change (UNFCCC)’s Kyoto protocol. In spite of being
preferred by most companies in the UK, Germany, Japan and Denmark, the reason India is still
not counted among the top three carbon credit nations is because of its project rejection rate,
which is as high as 50 percent. Just because our government approves projects does not mean
that validators or the CDM executive board will do so. The projects do not get approval mostly
due to the consultants hired by Indian companies who if not well versed with the Kyoto
protocol will not be able to comply with the strict UNFCCC norms. However, buying credits that
are intangible in nature, is no substitute to domestic action to reduce emissions. The conclusion
we can draw is that there is significant trading potential for traditional energy and clean energy
in the Indian commodity market. However, it will be important to sort out jurisdictional and
market participation issues even as we consider market mechanisms for achieving strategic
clean energy objectives in India so that the commodity markets can perform the role of risk
mitigation in this important sector of the economy.

 
 
 
 
 

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