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ESG Focus: COP26 Unleashes Carbon Markets

ESG Focus | Dec 13 2021

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: COP26 Unleashes Carbon Markets

Global agreements on carbon markets are set to mobilise trillions of transition funds which will have major implications for Australia’s resources sector.

-Carbon markets to grow 15-fold this decade
-Agreement on carbon price to hit CBAM and Oz miners
-Voluntary bilateral arrangements to accelerate carbon trading
-Carbon pricing forecasts for voluntary markets
-Crypto and derivatives options for retail investors

By Sarah Mills

COP26 did throw a couple of good bones to investors, one being action on carbon trading markets.

The world’s nations reached an agreement on a framework for carbon markets under Article 6 of the Paris Agreement, which analysts expect will free transition capital and raise carbon prices.

“Global agreement on carbon mechanisms will unleash market forces, but also increase transition risk,” says Credit Suisse in its recent COP26 Watch.

Credit Suisse and Morgan Stanley provided Article 6 summaries in their recent COP26 updates; noting voluntary carbon markets could direct US$1trn a year of transition capital towards developing countries by 2050.

Credit Suisse estimates carbon markets could grow 15-fold through to 2030 and a maximum of 100-fold by 2050.

Likely beneficiaries include renewable energy facilities and forest protection, and other climate change-related projects.

The news has direct impacts for investors, project developers, credit buyers, carbon offset programs and schemes, carbon brokers, carbon exchanges and third party auditors global emissions.

Analysts say the COP carbon-market agreements enable countries to progress towards their emissions-reduction commitments by investing in projects elsewhere in the world.

Early biodiversity connection from global governments

They say the deal is a plus for the southern hemisphere, which is short of capital but boasts plentiful natural resources.

Bloomberg expects well-constructed carbon markets can slow deforestation, channeling investment into areas where cutting (and even burning trees) have been the only development options. 

Observers say the agreement means most developing countries will need carbon capture & storage capacity that will require foreign investment. Although this is interesting given the dubious nature of carbon capture & storage technology. 

Observers also say emerging countries can plant trees – a win-win for many the countries given they are fairly low cost and are environmentally beneficial, although the water trade-off is unclear.

Yet forest carbon offsets have proven rather risky in the light of recent fires, which can render them worthless. Theoretically, emerging economies could use fire as an economic weapon and definitely as a bargaining chip in a carbon-offset world. 

Brazil’s deforestation has been occurring at the fastest pace in 15 years, with fires proving a major contributor, and Brazil is said to be a major beneficiary from Article 6.

A map of the world’s most carbon-rich ecosystems was published in the journal Nature Sustainability. 

Half the world’s irrecoverable carbon is concentrated on 3.3% of the land equivalent of the size of India and Mexico. New protections for 5.4% of this land would keep 75% of carbon out of he atmosphere. 

The EU and US also agreed to a deal to abolish tariffs and restrict access to products that don’t meet carbon intensity levels.

No new carbon markets were announced. 

Key agreements for Article 6

-A minimum of 2% of the issued A6.4ER units will be cancelled to encourage emissions mitigation. This would result in a 51Mt carbon equivalent of extra abatement of global greenhouse gas emissions and EUR2.8bn revenue for adaption. This aims to reduce supply which should boost prices.

-A 5% levy will be applied to the crediting system, which will be transferred to an Adaption Fund, not including Certified Emissions Reductions issued since 2013.

-No double counting is permitted in internationally transferred mitigation outcomes (ITMO) – a mitigation transferred abroad must be uncounted by the country that agreed to transfer it.

Higher carbon prices and the CBAM connection

(CBAM: carbon border adjustment mechanism. See Carbon Markets To Reduce Chinese Iron Ore Demand

Observers consider one of the main achievements of COP to be the decision to price carbon high enough to incentivise a green transition.

“Agreement on the rule book should see strong growth in the coverage of emissions trading schemes and the voluntary market: in our view, the foundations of a global carbon price have been put in place,” says Credit Suisse.

Credit Suisse expects this will result in sharply higher carbon price and transition risk and estimates the resulting average Carbon Earnings at Risk (CEAR) for Australia’s miners will increase from 14% to 102%.

Bilateral trading arrangements to accelerate carbon trading

The main development was the introduction of voluntary bilateral arrangements from one country to another, allowing the recipients to count such purchases as nationally determined contributions (NDCs).

Article 6.2 allows for voluntary arrangement between countries, wherein overachieving countries (on climate pledges) can sell excess emissions savings to other countries.

These are called bilateral credits, or internationally transferred mitigation outcomes (ITMO).

Countries with vast forests were pushing the deal, and Brazil is set to become a big exporter of carbon credits under the new regime.

Another provision allows carry-forward carbon credits created under old Kyoto Protocal into the new offset market system. 

After much argy-bargy, nations agreed on a cut-off date of 2013 – countries can include offsets registered since 2013.

Critics say the 2013 date is not good and increases stock, weighing on the carbon price. They also feared double counting but this was banned.

The transition of certified emission reduction units (CERs) issued by the Clean Development Mechanism will lead to an increase in greenhouse gas emissions supply (for future offsets) corresponding directly to the number of CERs transitioned, according to Climate Analytics study.

But analysts expect the onus will fall on buyer countries not to take accept these credits, suggesting the existence of unspoken investment dynamics in play on the quality of credits.

Brazil, China and India pushed to have lower quality carbon credits included under the Clean Development Mechanism.

To date, more than 2.11bn CERS have been issued, of which 1.15bn have been used – roughly 55% through retirement or voluntary cancellation, leaving 950m on global registries. Two thirds of CERs were registered prior to 2013 – or US$1.4bn.

Large players, China, India and Brazil would suffer strongly from a late cut off, with Brazil and India losing most from a 2008 cut off, and China being hit most by a 2013 cut-off.

Carbon pricing in the voluntary market

The Taskforce on Scaling Voluntary Carbon Markets provides scenarios ranging form US$5 a tonne to US$100 a tonne, which would equate to a US$5bn to US$180bn primary market a year by 2030.

According to Trove Research, the carbon price is roughly US$5-US$6 per tonne in the voluntary market and is forecast to rise to US$20-US$50 a tonne of CO2 by 2030, and could reach US$100.

Under Credit Suisse modelling, carbon prices ramp up sharply from here under most scenarios.

Under the most optimistic scenario arising from COP26 of 1.8 degrees Celsius, carbon prices start at US$12 in 2020 and rise to US$409 in 2030 and reach US$870 in 2050.

Under 2.1C, they start at US$12 and rise to US$44 in 2030 and US$135 in 2050.

Under 2.4C, they start at US$29 in 2020, US$27 in 2030 and US$41 in 2050.

Under 2.7C (current pricing), they start at US$24 in 2020, US$17 in 2030 and US$17 in 2050.

Credit Suisse has developed a toolkit to calculate pricing on portfolios.

Under a1.8C scenario, Energy would rise to 85%, compared with 12% at 2.1C; Materials to 55% compared with 8%; Metals and Mining 102% compared with 14%; and Utilities, 141% compared with 19%.

Credit Suisse says this signifies a massive carbon-price swing should governments follow through on net-zero, given under implied modelling, that would mean the carbon price could reach US$205 a tonne.

Critics say it’s business as usual

There are many observers who perceive the COP26 to signify lack of true climate intent on behalf of governments, suggesting the transition is in fact, truly about building the fourth industrial revolution on circular technology.

“The Paris deal contains omissions through which planet-heating emissions can still continue to seep, while giving the impression or illusion of progress on paper,” says Carbon Market Watch (CMW).

CMW says the 2% cancellation of each credit traded under the new centralised carbon market is too low to contribute to meaningful emissions reductions, and leaves markets wallowing in zombie credits.

“By and large, international carbon markets will be used to shift pollution from one place to another,” says CMW. 

Oxford Economics notes wealthy nations have already hit “peak carbon” and their emissions are falling, largely because carbon-intensive production has been offshored to developing countries as advanced economies shift to services.

Macquarie answers the critics

“Despite some mega-bullish predictions out there, there remains plenty of uncertainty on the demand trajectory…technology and ‘crowding out’ by compliance markets as more emissions trading schemes are launched around the world,” says Macquarie.

To the cynics who say we’ve been here before, there’s been an oversupply in the past, what’s different, Macquarie agrees that risk of a large supply response as prices soar does exist for voluntary carbon markets as well.

“However, the potential for demand growth is drastically different: the scale of climate targets announced in the private sector is nothing like we’ve seen before.”

Agreement on Article 6 has also carved a path for a broader global carbon market and the voluntary carbon market breached US$1bn this year.

Investors in carbon markets beware

All carbon markets are not the same, and investors need to be aware of the quality and variety of carbon credits, warn analysts. 

Renewables versus nature credits are one category, for example. 

Platts notes renewable prices rocketed 37% in one week in mid November.

“Prices remain opaque but transparency is on the rise,” says Macquarie. “Platts says offset prices range between US$7 and US$17 a tonne depending on credit type. Carbon capture storage offsets can trade in excess of US$100 a tonne, albeit in small volumes.”

Credit vintage is another.

Pre-2016 vintages are considered to be of lower quality, and account for about one third of the market, and undeliverable under some standards such as the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).

COP26 put the cut-off at 2013 to placate emerging countries (China would have been particularly hard hit).

However, CORSIA’s actions are just one of many indicators that the private sector will sort this out.

Avenues of carbon investment

While no new carbon markets were announced, financial markets are doing a jolly good job of creating their own markets.

Macquarie notes Klima Dao’s launch of carbon-backed crypto coins is emerging as a key driver of demand, offering retail investors exposure to voluntary offset markets. 

Since its launch on October 10, Klima has retired 11.5 megatonnes of carbon offsets.

Macquarie says investors can also gain exposures through two futures contracts: GEO and N-GEO, which clear against spot contracts trading on CBL-Xpansiv. GEO trades CORSIA-compliant, renewable and nature-based offsets.

Emissions Trading Schemes and Markets

Meanwhile, emissions trading schemes are gaining traction and Morgan Stanley expects investors will start to factor in the implications of national emissions trading schemes on corporation’s long-term financial and business models.

Morgan Stanley spies downside for EU carbon units risk towards the end of 2021 (prices having rallied 90% this year) but forecasts 50% upside by 2025.

China’s national emissions trading scheme went live on July 16 after 10 years of development. 

For now it is focused on power and heat generation, but Morgan Stanley expects cement and electrolytic aluminium producers might follow by 2022.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

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