Carbon 2006 -- Towards a Truly Global Market

8/14/2019 Carbon 2006 -- Towards a Truly Global Market

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All rights reserved 2006 Point Carbon

Carbon 2006Towards a truly global market

TO THE POINT

This report was published at Point Carbons 3rd annual conference, Carbon Market Insights 2006 in

Copenhagen 28 February - 2 March 2006. For more information, see www.pointcarbon.com

28 February 2006

The worlds largest ever carbon market survey More than 800 participants in our web-survey and 67 in-depth

interviews, combined with Point Carbons proprietary databases and market intelligence services, makes

this the most comprehensive carbon market report to date.

Global carbon market transactions worth 9.4 billion in 2005. The EU ETS did an estimated 362 Mt CO2, at an

estimated financial value of 7.2 billion. 93% of the volumes in the project market came through CDM, at

397 Mt CO2e, 1.9 billion. JI did 28 Mt, 95 million.

China is largest CDM seller. More than 70% of CDM volumes came from a few large HFC-23 reduction

projects in China. There are also several projects in India and Brazil.

CDM buy side is dominated by private sector. riven by high EU ETS prices together with an increasing

number of carbon funds.

Japan enters market in earnest. The European private sector activity will continue to dominate the market,

but Japanese public and private sector will add further to demand for project credits in 2006. Canada is

conspicuous by its absence from the market.

The EU ETS is a qualified success. The weekly turnover in EU ETS has been increasing steadily. The market

is reacting to fundamentals, although policy (non-)decisions also still constitute a price driver. 45% of

survey respondents found the EU ETS to be a success.

CDM/JI still has some way to go. Only 7% of survey respondents find the project market to be mature, and

only 22% find them to be a success.

The cost of carbon cannot fully explain the increase in power prices. Increasing fuel prices, increased

demand, as well as generators strategies have also contributed to power price increases. The impact of

carbon costs on power prices, and vice versa, has created new interplays between energy commodities

nd strengthened energy market interactions.

Market is still best option for world to make transition to low-carbon economy. Unlike technology-based

lternatives, the carbon market places a cost on emissions and a value on reductions, and leads to large

scale reductions in the near term.


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All rights reserved 2006 Point Carbonii

Carbon 2006

All rights reserved 2006 Point Carbonii

Carbon 2006

About the report:This report was written and edited by Henrik Hasselknippe and Kjetil Rine.

For citations, please refer to: Point Carbon (2006): Carbon 2006. Hasselknippe, H. and K. Rine eds.

60 pages.

About Point Carbon:Point Carbon is the leading provider of independent analysis, forecasting, market intelligence

and news for the power, gas and carbon emissions markets. Point Carbon has more than

14 000 subscribers in over 150 countries. Our reports are translated into Japanese, Chinese,

Portuguese, German, French, Spanish and Russian. Among our clients are BP, Dupont, Norsk

Hydro, RWE, Shell and Vattenfall. Point Carbon has offices in Oslo (HQ), London, Kiev, Brussels,

Hamburg and Tokyo.

The company has expanded rapidly in recent years and now has an international team of more

than 60 employees. The competencies of our staff include international and regional climate

policy; mathematical and economic modelling; forecasting methodologies; methods for expert

evaluation and energy industries analysis.

The in-depth knowledge of power, gas and CO2 emissions market dynamics positions Point

Carbon as the number-one supplier of analysis on price-driving fundamentals for European

energy and environmental markets.


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All rights reserved 2006 Point Carboniii

28 February 2006

xecutive Summary

his report has been based on a number of different sources. First, Point Carbons proprietary databases

give an overview of the number of projects and their volumes. Our carbon project database contains at total

of 2,769 projects, and is to our knowledge the worlds largest. In addition, our web-based survey attracted

800 respondents, and we have further conducted in-depth interviews with 67 selected key market players.

oint Carbon estimates that the international carbon market in 2005 transacted a total of 799 Mt CO2-

equivalents worth approximately 9,400 million. In comparison, the market in 2004 saw an estimated 94 Mt

CO2e, worth 377 million.

he EU Emissions Trading Scheme saw the largest financial values in the previous year. In total, the brokered

nd exchanged market did 262 Mt CO2, corresponding to 5.4 billion. Brokers did 79% of this volume,

hereas the ECX was by far the largest exchange, with 63.4% of the exchanged volume. Point Carbon

urther estimates that the direct bilateral market (company-to-company, not through brokers or exchanges)

did 100 Mt, 1.8 billion in 2005. Annualised turnover increased to over 12% (OTC and exchange volumes

only).

he Clean Development Mechanism (CDM) remains the largest market segment in terms of volume. Point

Carbon estimates that emission reduction purchase agreements (ERPAs) corresponding to 397 Mt CO2e

ere entered into in 2005. Assuming payment on delivery and a 7% discount rate, this is valued at 1.9billion. The other project based mechanism, Joint Implementation (JI) did 28 Mt, 96 million. There is also

small market for secondary CDM trading, this is expected to increase in the future, but is currently held

back by transaction log delays.

Other market remain insignificant in the larger picture, at 7.8 Mt, 52 million. The largest of these is the

SW scheme in Australia, accounting for 93% of the financial value in this segment.

Table 1: Reported volumes and values 2004 and 2005Reported and estimated volumes 2004 and 2005 , in million tonnes of carbon dioxide equivalents and . BilateralETS for 2005 estimated as 27% of total EU ETS volume at average EUA price through the year.

2004 2005

[Mt] [ million] [Mt] [ million]

U ETS total

OTC + exch.

Bilateral

CDM

CDM 2nd

I

Other

17

.7

7.3

60

0

9

7.9

27

n.a.

n.a.

88

0

27

34

362

262

100

397

4

28

7.8

7,218

5,400

1,818

,985

50

96

52

Sum 94 377 799 9,401


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All rights reserved 2006 Point Carboniv

Carbon 2006

ut does the system work? We have seen very little evidence of actual fuel-switching or internal abatement

aking place. On the other hand, the market is working effectively, with reliable price discovery and increasing

olatility. Furthermore, the EU ETS is leading to substantial private sector investments in CDM, and to some

extent JI. In balance, we find that the EU ETS is a qualified success after its first year of operation. Survey

participants agree with us on this, at least to some extent. 45% of the respondents find that the EU ETS is

lready a success. Only 22% think the same of the CDM/JI markets. However, only a handful of people find

he markets to be mature, 10% for EU ETS and 7% for CDM/JI.

One of the shortcomings of the EU ETS relates to the way the EC and Member States release information

o the market. With carbon now acting as hard currency, it would be wise to look to financial markets to

see how information is distributed. The European Commission has shown that it has a more important

role in emissions trading than other parts of EUs environmental policy, and can be expected to meet this

challenge. Nevertheless, the market has shown that it can work even with asymmetric information

he introduction of carbon costs on power producers operation has also created new complexities with

other energy commodities, in particular power prices. The cross commodity impacts have also strengthened

interactions energy markets. We expect the debate on carbons impact on power prices to continue in 2006.

owever, carbon costs cannot fully explain the increases in power prices. Increasing fuel prices, in particular

or gas, through 2005 have also contributed significantly. Also, increasing demand for power has an impact,

s well as generators trading strategies.

he survey respondents are bullish on prices. Only 20% expect the EUA price in one year to be lower than

it was in December 2005. More than 70% expect the price of an issued CER to increase over the same

ime period. The market expects tighter allocations for EU ETS phase 2. Only 8% expect the allocation

or the next round to be looser than in the current phase. 25% expect it to be much tighter. Furthermore,

24% expect there to be more internal abatement in the next phase. It is also evident that carbon costs are

now taken into account for new investments. More than 40% see carbon costs as very important for new

investments in their industry.

CDM is set to be the project mechanism of choice, also in the future. Developing countries are indeed

aking their participation in the market seriously, and are years ahead of large JI sellers when it comes

o project approval frameworks. It also seems clear that the CDM will survive even without a successor

greement to the Kyoto Protocol.

echnology based alternatives to the Kyoto Protocol are expected to be pushed forwards as viable options

or the future international climate cooperation. However, we do not find there to be much substance

in these plans. For an agreement to work it is essential that there is a price on carbon, and a value on

reductions, thus incentivising private sector investments in new technologies. Currently, the carbon

market remains the best option for enabling the transfer to a less carbon-intensive global economy.

xecutive Summary


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28 February 2006

In many ways, the year 2005 marks the birth of a

global carbon market. The unexpected high price

of allowances in Europe caught most players bysurprise. During a period of a few months, carbon

trading suddenly came on the agenda in boardrooms

across Europe. This report attempts to document

how the sudden emergence of a global carbon

market has unfolded, and how it has affectedemitters of greenhouse gases and their markets

in ways that few anticipated one year ago.

It has been a massive effort making this report. More

than 800 readers responded to Point Carbons web-

poll carried out in November-December 2005. Theweb-poll was complimented by in-depth interviews

with more than 60 key players: traders, industry

representatives and service providers. Also, our daily

recording of carbon transactions has been invaluable

for documenting how the market has developed.

When analysing the results from the survey and

the transaction data, three important conclusions

spring to light. Firstly, although the value of thecarbon market increased by 2500% from 2004 to

9.4bn in 2005, and now involves players in closeto 150 countries, it is still early days. Traded volumes

compared to the underlying volume are still far below

what we can observe in other markets.

Moreover, among the participants there is a

widespread feeling of the market being immature,e.g. only approximately 10 per cent of the respondents

agreed to our polls statement of the EU ETS being

a mature market. Through the involvement of more

players and an increasing internationalisation of the

market volumes can be expected to grow rapidly

also in the years to come.

Secondly, strong links to the energy markets

are evident. The carbon market has significantly

increased power prices, and the development of the

power markets strongly impact carbon prices. Thisshould come as no surprise as power production is

major source of greenhouse gases emissions.

But there is more to it than that. Most of the active

carbon traders have a background in power or fuel

trading, and they have brought with them thisknowledge and experience into the carbon market.

One consequence is that prices across commodities

and markets have become correlated in ways they

have never been before driven by the carbon

market requiring a broader spectre of factors tobe taken into account when assessing trading and

investment strategies.

Finally, evidence suggests that the carbon market

leads to large-scale emission reductions. Whilelimited abatement appears to have taken place in

Europe so far, there is no doubt that the unexpectedly

high European carbon price has been pivotal in

terms of generating investments in projects under

the Clean Development Mechanism.

Until six months ago, we in Point Carbon were

pessimistic about the reductions that would be

generated by such projects. But the explosive

growth lately has changed our minds. Credits

from abatement projects under CDM and JI today

have the prospect of becoming a major avenue forensuring compliance with the Kyoto Protocol.

Moreover, these projects often bring abouteconomic, social and environmental benefits for the

local communities: e.g. close to half of the 2,769JI and CDM projects registered in Point Carbons

database utilise renewable energy.

You will find more about these trends and a number

of others in the present report, which we plan to

provide as an annual publication.

A considerable amount of work has gone into making

it and we believe it represents the most thoroughly

researched overview of the global market. Hopefully,

it will provide you with a useful source of reference

and we hope you will enjoy reading it as much as wehave enjoyed making it.

Kristian Tangen

Director Research & Advisory

Point Carbon


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Carbon 2006

From the editors

This report had not been possible without the contribution of numerous people.

First and foremost, we would like to thank the 800 persons who participated

in our web-survey, as well as the 67 key market players who took the time to beinterviewed on the phone. As you will see, your inputs have been invaluable in

the making of this report.

Thanks also go to everyone at Point Carbon, for their tireless efforts in maintaining

our proprietary databases and models. It is only due to your combined effortsthat we have been able to put this report together. Our CDM and JI team have

contributed through the development of the Carbon Project Manager, which has

been used frequently throughout during the making of this report. Our EU ETS

team has contributed through the Carbon Market Trader. And the Power & Gas

team has contributed analysis and thinking on the chapter focusing on carbon-

power complexities.

Some of our colleagues deserve special thanks and attention for their contribution

to this report: Kristian Tangen for guidance and overall coordination. Anders

Skogen for setting up the web-survey. Miles Austin and Therese Karlseng for

calling around to more than one hundred people in the carbon market. Anne

Katrin Brevik for sparring and comments on the power/carbon debacle. LizaBaeza for giving a helping hand with the layout and design. And finally, Kevin

Gould and Kjell Olav Kristiansen for providing valuable comments in the final

stages.

We hope that you find this report interesting and that it is useful for yourcontinued work in the carbon market. As this is the first annual report of this

kind, we encourage you to give us comments and feedback through the regular

channels (see Colophone). We look forward to meeting you all at our conference,

and look forward to producing another version of this report in 2007.

Henrik Hasselknippe and Kjetil Rine

Editors


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28 February 2006

1 Introduction

2 What is the carbon market?

3 How does it work?

.1 EU ETS

.2 CDM & JI

4 Market activity in 2005

4.1 EU ETS

4.2 CDM and JI

4.3 Other markets

Does it really work?

6 Carbon Market Insight: The power of

carbon

.1 igher spot prices

.2 Explaining increasing spot prices

.3 New complexities arising

What does the future hold?

.1 Globally - still political uncertainties

.2 Where to now for EU ETS

.1 CDM and JI - long term investments?

.1 Towards a truly global market

Colophone

1

4

9

9

11

15

15

2

6

28

33

3

4

8

40

40

41

44

45

51

Table of contents


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1. IntroductionThe rumours of the Kyoto Protocols death were truly

exaggerated. As the Protocol entered into force on 16February 2005, the international carbon market the

cornerstone of the Kyoto agreement was already

showing healthy signs of increasing volumes. While

the market for greenhouse gas (GHG) allowances

and reduction credits had been in operation for someyears already, the market had only recently moved

beyond the embryonic stage. However, growth has

since continued in all segments of the market, and

2005 has proved that the carbon market is indeed

alive and well, although it has probably only reachedthe toddler stage.

This report, Carbon 2006, provides a detailed

overview of the global carbon market, with special

attention to volumes and price trends in 2005. We

also include a brief introduction to the market for

those of you who might not be familiar with thedetailed and often highly complex structure of

this new commodity market.

Particular attention is given to the EU Emissions

Trading Scheme (ETS) and the project basedClean Development Mechanism (CDM) and Joint

Implementation (JI). These market segments are byfar the most advanced of the Kyoto related market

mechanisms, although, as we shall see, they are at

very different stages of maturity.

We also provide a special feature on carbon and

power, discussing some of the impacts that carbon

trading has had on the European power market.

Finally, we look to the future and try to give some

indications on where the market will move in the

years ahead.

Point Carbon regularly publishes in-depth analyses on

international climate policy and the carbon market in

our publication series Carbon Market Analyst (CMA)

and Carbon Market Monitor (CMM). The analyses

that have gone into the CMAs are to some extentreflected in this report, although the level of detailed

is lower here.

In addition to our regular reports, the web- and phone

surveys have provided new data and a different

perspective. A total of 800 individuals responded

to our web-survey. Furthermore, 67 people were

contacted by phone, giving detailed answers toa range of questions not asked in the web-based

version. The in-depth interviews covered different

sectors, and we got answers from 38 players from

the Power & Heat sector, 21 from industry, and 8from the financial sector.

Figures 1.1-1.4 show the distribution of therespondents to the web-survey. Half of the

0 %

10 %

20 %

30 %

40 %

50 %

60 %

No

emissions

0-0.5 Mt/yr 0.5-1Mt/yr 1-5 Mt/yr 5-10 Mt/yr +10Mt/yr

Share

ofrespondents

Source: Point Carbon

Figure 1.1 Some big, many smallRespondents to the survey, broken down on their companys annual emissions level.

800 participants in our web-survey

28 February 2006


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Carbon 2006

respondents did not represent GHG emitting

industries, while about 25% represented only small

emission levels, i.e. below 0.5 Mt per year. 7.5% ofthe respondents represented major emitters, with

more than 10Mt per year.

The share of non-emitters is also reflected in the

break-down of respondents on sectors, where

as many as 31% were said to represent service

providers, and 27% defined themselves as belonging

in the Other category. 19% of the respondents camefrom the Power & Heat sector, 9% from industry

and about 5% from oil/gas.

As many as 55% of the respondents were from

the EU, 36% from Northwestern Europe, 10% from

Central and Eastern Europe, and 9% from SouthernEurope. In addition, 5% were from European

countries not in the EU. Of the remaining respondents

20% were from industrialised countries, whereas

another 20% were from developing countries, i.e.

non-Annex I countries.

28% of the respondents answered that they weretrading one or more carbon commodities. As many

as 23% claimed that they would be engaging in

trading soon, but as many as 47% said they were

not trading at all. Of the ones who were trading, 9%were active in the EU ETS and 8% in both EUAs and

CDM/JI. 11% said they did CDM/JI trading only.

This breakdown on respondents provides a backdrop

for the further analysis in this report. Where

appropriate, we will present answers based on

limited responses. For instance, for certain answerswe will not include the responses from non-emitting

players or companies which have not yet initiated

carbon trading internally. Where this is done it is

clearly noted.

Additional sources used in this report includes all ofPoint Carbons proprietary databases. Our project

database contains 2,256 CDM projects and 513 JI

projects, at all stages. We also maintain a transaction

database, where we register all transactions that we

learn of through our market intelligence services. In

addition, we draw extensively on our forecastingservices for the carbon, power and gas markets.

0 %

5 %10 %

15 %

20 %

25 %

30 %

35 %

Service

prov.

Other Power &

Heat

Industry Gov.mnt Oil/gas

Share

ofrespondents


Figure 1.2 Mostly outside trading sectorsRespondents to the survey, broken down on sectors.

19% of respondents from Power &Heat sector

55% from EU, 20% from developingcountries

28% trade one or more carboncommodities


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28 February 2006

0 %

5 %

10 %

15 %

20 %

25 %

30 %

35 %

40 %

EU:

Northwest

Other

Annex-1

Non-Annex-

1

EU: CEE EU: South Europe:

Non-EU

Share

ofrespo

ndents


Figure 1.3 European responsesRespondents to the survey, broken down on geographic location. Annex 1 refers to industrialised

countries as defined under UNFCCC. CEE: Central and Eastern Europe

0 %

10 %

20 %

30 %

40 %

50 %

No Will be soon CDM/JI EUA Both EUA

and CDM/JI

Share

ofresponses


Figure 1.4 Only some trading activelyRespondents to the survey, broken down on trading activity.


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Carbon 2006

2. What is the carbon market?In brief,the carbon market can be explained as

the market resulting from buying and selling ofemission allowances and reduction credits in order

to enable countries and companies meet their GHG

emission targets. Another way of looking at it is that

it introduces a price for carbon - placing a cost on

emissions and a value on reductions. This chaptergives a brief introduction to the concepts underlying

the carbon market, focusing on countries Kyoto

targets and the structure of the market mechanisms

that can help achieve them.

When the Kyoto Protocol was agreed in 1997, atotal of 39 industrialised countries (referred to in

treaty terminology as Annex B countries) were given

specific emission limitations for the 2008 to 2012

period. It did, however, take a number of years and

subsequent multilateral climate negotiations under

the UN umbrella before all the technicalities of theagreement were in place.

Table 2.1 shows a selection of countries with

significant GHG emissions and their respective

Kyoto targets. As of 14 February 2006, 161 statesand regional economic integration organizations

had ratified the Protocol, corresponding to 61.6%

of total Annex I parties 1990 emissions. USA and

Australia are noteworthy for being the only major

industrialised countries not to ratify Kyoto.

While the Kyoto Protocol does not imposeemission reduction commitments on developing

countries, they play a crucial role in the international

carbon market. Countries, and also companies, can

invest in emission reduction projects in non-Annex

I countries and receive carbon credits in return for

the resulting reductions. As we will show later inthis report, developing countries are indeed already

participating in a meaningful way contrary to what

has been argued by some opponents of the Kyoto

Protocol.

In an issue of CMA Kyoto progress: Will countries

meet their targets? (12 September 2005), weanalysed how various countries were approaching

their international climate commitment. The analysis

was based on the latest available national reports

on GHG emissions, reported figures for historic

Table 2.1 The Premier LeagueSelected countries commitments under the Kyoto Protocol for the period 2008-12. Targets for individualGermany, UK, Italy and Spain under the EU 15s burden sharing agreement.

Country GHG emissions in

1990 as share of

Annex 1

yoto target, in %

of 1990 emissions

Canada

Japan

EU 15

Germany

UK

France

Italy

Spain

EU 25

Poland

Russia

Ukraine

USA

Australia

3.3%

8.5%

24.2%

7.4%

4.3%

2.7%

3.1%

1.9%

29.8%

3.0%

7%

not available

36.1%

2.1%

6%

6%

8%

-21%

-12.5%

0%

-6,5%

+15%

n.a

6%

0%

0%

7%

+8%

How are countries meeting theKyoto challenge?


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28 February 2006

emissions growth, and projections on countries

future emission growth. Using 2010 as the reference

year for the Kyoto period we estimated what the

countries full five year shortfall would be without any

new policies, domestic trading systems, or carbon

procurement funds, denoting this as the business-as-usual (BAU) scenario. Figure 2.1 illustrates the

BAU short positions for the most significant buyer

countries/regions aggregated for the whole Kyoto

period (2008-12).

In terms of BAU emissions, the EU15 bubble hasby far the largest gap to fill in terms of tonnage.

However, this should be viewed cautiously as it

is merely 12.5% above the EU15s Kyoto target,

while Canada and Japan are projected to have BAU

emissions of 46% and 29% above their targetsrespectively. Overall BAU gap leaves countries 5,540

Mt short in the first Kyoto period.

Within the EU15 the Member States with the

biggest BAU gaps are Spain and Italy, at 660Mt and620Mt, respectively. Spain has seen rapid economic

growth coupled with rising emissions far beyond itsprovision to expand under the EU15 burden sharing

agreement. Italian emissions have also soared

lately, with a 15 Mt increase from the previous year

reported for 2003.

Given these short positions, we might ask: How

can countries with such significant short positions

meet their targets? From the governmental pointof view, there are essentially three categories of

options: (1) Establish domestic emission trading

systems, (2) implement domestic non-market based

policies, and (3) establish procurement programmes

for purchases of allowances or credits from other

countries. See also Table 2.2.

The emission trading systems aims to stimulate the

private sector to reduce emissions through internal

abatement, external procurement, and trading. What

is common for the governmental and corporate

strategies is that they can both utilise credits from

CDM and JI projects to meet their commitments.

To date, only EU has a comprehensive emission

trading system, while Japan, Canada and New

Zealand are all considering whether, and how, to putup such systems. Obviously, all sectors contributing

to emissions of GHGs are not included in theemission trading system, and consequently the

governments themselves need additional policies

0 500 1 000 1 500 2 000 2 500

Other

Canada

Japan

EU 15

Mt CO2eSource: Point Carbon

Figure 2.1 Strong growth if uncheckedBusiness-as-usual emissions for world regions, i.e. no additional policies or measures

implemented, for the aggregate 5-year Kyoto period 2008-2012, in Mt CO2e. Source: Carbon Market

Analyst 12 September 2005.

Emissions trading stimulates privatesector reductions

Countries BAU gap is 5,540 Mt forfive-year Kyoto period


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Carbon 2006

for being in compliance with the Kyoto targets. For

instance, approximately 44 % of GHG emissions

within the EU are covered by the EU ETS.

Thus, it will be essential for countries to alsoengage policies in other sectors. Non-market

policies are typical domestic measures that will

primarily impact sectors not subject to trading

system and requirements, e.g. different renewableenergy policies, environmental taxes and subsidies,

and various voluntary programs. For instance inJapan, the Kyoto Protocol Target Achievement Plan

contains a raft of new schemes and measures,

nearly all of which are voluntary. Mandatory

measures are limited to reporting emissions and

efficiency rates, not actually reducing them. In1997 the Japanese business federation, the Nippon

Keidanren implemented its voluntary action plan on

the environment. The plan currently covers 82% of

industrial emissions embracing 34 industries.

The third pillar of the governmental climate strategy,

the procurement programmes, primarily aim atpurchasing Certified Emission Reductions (CERs,

from CDM projects) and Emission Reduction

Units (ERUs, from JI projects), as well as Assigned

Amount Units (AAUs, the country allocation under

Kyoto). There are several countries with operationalprocurement programs, e.g. the Netherlands and

Denmark, as well as a number of countries that

have invested in funds for procurement, e.g. the

different World Bank funds. Figure 2.2 further shows

how these different strategies all add up to form thecarbon market. In this respect, national policies -

such as the allocation of allowances to companies

under EU ETS or implementation of non-market

policies for domestic abatement constitute the

political framing conditions that are decisive for how

the market mechanisms actually work.

To what extent have countries employed these

strategies? And to what extent are they actuallyreducing emissions? Our analysis from 12

September 2005 looked at the full range of policies

and mechanisms employed by all countries expected

to be short in the Kyoto period. All governmental

procurement programs were examined closely,

considering actual and planned budgets in light ofprices in the carbon market. We further investigated

whether non-market policies already in place actuallyhad any impacts, and estimated how much existing

climate policy plans would contribute to the required

reductions. Finally, we looked at allocations under

existing or planned emissions trading systemsand estimated how much these schemes would

reduce.

Figure 2.3 shows the final results, and that several

countries still have a long way to go before theywill meet their Kyoto targets. It should be noted

that some countries, Japan in particular, have

announced governmental procurement plans since

the analysis was undertaken, and that the analysis

simply applied the caps in the EU ETS phase 1 to

phase 2. The recent guidance from the EuropeanCommission has made it clear that several countries

will have to reduce their caps for the second phase.

Nevertheless, the figure gives a good indication on

which countries that look set to meet their targets

comfortably and which that will have to make some

sacrifices.

Table 2.2 Governmental and corporate strategies for meeting Kyoto targets

Governmental

strategies

stablishing emission

rading systems (ie EU

TS)

rocurement

programmes

(CDM/JI/AAU)

on-market policies

(tech. dev, CO2-tax)

Corporate strategies nternal trading (ie

within EU ETS)

xternal

procurement and

rading (ie CER/

RU)

nternal abatement

strategies

Several countries with operationalprocurement programs

Spain, Italy and Canada at bottom ofleague


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28 February 2006

CDM/JI

Gov. AAU sales

EU ETS

Internal trading,

abatement

JPN/CAN/NZ

Gov. Purchase

programmes Governments Private sector

= Supply

= Demand

Forwarding

compliance

Political framing decisions

Political framing decisions

Figure 2.2 How it works, at least in theoryThe interplay of flexible mechanisms, purchasing programmes and trading schemes. Non-market

policies and overall allocations set the frame.

Spain

Italy

Canada

Japan

Norway

Portugal

Ireland

Austria

New Zealand

Finland

Greece

Belgium

Denmark

Germany

Netherlands

UK

Sweden

Switzerland

France

-10 % -5 % 0 % 5 % 10 % 15 % 20 % 25 %


Figure 2.3 Winners and sinnersRelative distance to the Kyoto target for countries covered in the study after all policies and programs have been

accounted for. Assumes that current allocation in EU ETS continues in phase 2.


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Carbon 2006

Bottom of the league are Spain, Italy, Canada and

Japan who all, it seems, will miss their targets by 20

per cent or more unless drastic action is taken. Still,

there is little reason for other countries to be smug,

almost all of the countries covered in the study have

yet to develop credible policies and measures thatwill help them meet their Kyoto targets.

Overall, our analysis finds that these measures

might potentially reduce the Kyoto gap with some

50 % from the shortfall presented in figure 1.

Still, major buyer countries experience a 2,740 Mtshortfall for the five-year period, or 548 Mt per year

in the Kyoto period even when taking measures into

account, leaving them 9.5% above their collective

Kyoto target.

An updated analysis on countries Kyoto progress

will be presented in a forthcoming issue of Carbon

Market Analyst, set for publication in early April 2006.

Moreover, the carbon policies in non-EU countries

will be further analysed in the CMA Carbon around

the world, scheduled for March 2006

The above analysis clearly shows that the demand

for allowances or credits is real. What then about

supply? Several of the countries with Kyoto targetsexperienced economic downturn in the 1990s,

leaving them with substantial emission allowance

(AAUs) to sell. These countries, located in Central

and Eastern Europe, are also prime candidates for

JI projects, as it is less costly to reduce emissions

here than in Western Europe, Canada or Japan.

Finally, there are about 100 non-Annex I countrieswhich can qualify as hosts for CDM projects, and

which could produce substantial reduction volumes

that could be sold to emission-craving industrialised

countries.

Without going into too much detail on the analysis, itis clear that the potential supply in the carbon market

is considerably larger than the aggregated demand.

Figure 2.4 shows the net supply and demand in the

5-year Kyoto period, as estimated by Point Carbon.

In particular, Russia has the potential to exportsignificant amounts of allowances, although it is far

from certain that they will do so. Our forecast for the

CDM market also shows that developing countries

will contribute substantial amounts, which could

grow even higher than what we indicate here. Point

Carbon monitors the situation in the major sellercountries on a continuous basis and will publish

several in-depth analyses on how their behaviour will

impact on volumes and prices in the global carbon

market.

-5 -4 -3 -2 -1 0 1 2

Russia

Eastern Europe

Ukraine

Other

Canada

Japan

EU 15

Gt CO2e


Figure 2.4 Potential supply more than enoughNet short and long positions for countries and regions, i.e. when all policies and procurement plans have been

accounted for. Aggregated for the 5-year Kyoto period


16/60


28 February 2006

3. How does it work?While the previous chapter presented a general

overview of how countries fare in respect totheir Kyoto target, this chapter will focus on the

mechanisms that are being employed to meet

targets. We will give a brief introduction to the EU

ETS, what it is and how it works, as well as a quick

overview of CDM and JI. While the operation of thesemechanisms is much more complex than what can

be conveyed within these pages, this gives at least a

general introduction. For more detailed analyses we

refer to our regular report series.

.1 EU ETSThe European Union Emissions Trading Scheme (EUETS) works, simply put, by placing GHG emission

limitations on a number of installations within specific

sectors, and allowing the emission targets to be met

through trading of EU emission allowances (EUAs).

Thus, if the price of carbon is higher than the internal

abatement cost, companies will at least in theory reduce internally and sell any unused allowances

in the market. For installations that miss their target

the penalty is 40/t CO2 on the shortfall in the 2005-

2007 period, in addition to having to purchase the

deficit on the market.

The National Allocation Plans (NAPs), developed

by each member state and approved by the

Commission, set the overall structure of EU ETS by

outlining the upper level of allowances to be issued

(the caps) and how these are allocated to sectors

and individual installations within in each Member

State (MS). The EU Commission (EC) has approved

in total 6.3 billion allowances to be issued for the

period 05-07, excluding allowances set aside to newinstallations, resulting in an average of 2.1 billion

allowances to be distributed each year. However,

MS initial applications were for even more.

The EC ended up cutting almost 300 Mt of

allowances, or more than 4 % of the total volume,

from the initial volumes of allowances as submittedin the draft NAPs. Comparing this to 2003

emissions, we find that the EU ETS covers 44 % of

all greenhouse gas (GHG) emissions in the EU.

The annual average cap is distributed among the MSs

as shown in Figures 3.1 and 3.2. Germany is by farthe MS with highest number of allowances (488 Mt/

year), followed by Italy, Poland and the UK pending

around 250 Mt each for the first trading period, and

France and Spain around 150 Mt. Together, these sixcountries constitute 71 % of the total allowances in

the market.

0

100

200

300

400

500

600

DEU GBR POL ITA ESP FRA CZE NLD GRC BEL FIN PRT DNK

Mt

1990 2003 CAPSource: Point Carbon

Fig 3.1. The big emittersEU member states with more than 100 Mt in aggregated allocations for the 2005-2007 period. Emissions in

ETS sectors in 1990, 2003 and allocated in 2005, in Mt CO2.

EC cut 300 Mt, 4% from initialvolumes


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Carbon 2006

Figures 3.1-2 also show calculated CO2- emissions

for the years 1990 and 2003 in the sectors now

covered by the EU ETS. The majority of the countries

have had to reduce their emissions compared to

their 2003 level.

Within each MS the allowances are allocated to

existing installations in five main sectors. Figure 3.3

illustrates the distribution of allowances between

these. The power & heat sector is by far the largest

sector, accounting for 55 % of all allowances in thesystem, making the EU ETS primarily dependant on

activities and changes within this sector.

0

5

10

15

20

25

30

35

40

45

AUT HUN SVK SWE IRL EST LTU SVN CYP LVA LUX MAL

Mt

1990 2003 CAPSource: Point Carbon

Fig 3.2. ..and the smaller onesotal allocations to some of the smaller EU member states, aggregated for period 05-07. Emissions in ETS sectors

in 1990, 2003 and allocated in 2005, in Mt CO2.

0

500

1 000

1 500

2 000

2 500

3 000

3 500

4 000

Power &

heat

Metals Cement,

Lime &

Glass

Oil & gas Pulp and

paper

Others

Mt


Fig 3.3 Power & heat in drivers seatotal EU ETS allocations on sector level, aggregate for 2005-2007 period, in Mt CO2.


18/60


28 February 2006

Close to 10,000 installations now have

commitments within the EU ETS. Figure 8 illustratesthe distribution of allowances and installations

categorised relative to the size of the installations.

According to the currently available installation lists,

there are 92 large installations with an allocation

of more than 10 Mt CO2e in the 3-year period 05-07. Together these account for only 0.9 % of the

total number of installations but for a whopping

34% of the total allowances. At the other end of the

scale, we find that there are close to 9,000 small

installations emitting less than 1 Mt CO2e, totalling

only 19% of the allowances but more than 90% ofall installations. However, it is the medium sized

emitters, between 1 and 10 Mt, which have the

largest amounts of allowances, accounting for 47%

of the total amount.

In addition to allocating allowances to existing

installations, the MSs have in their NAPs set asidesome allowances for new installations, the so called

New Entrant Reserves (NER). Based on the current

version of MS NAPs, the total potential supply of

allowances from NERs for the 05-07 period is

between 120 180 Mt. Unused NERs might be

made available to the market later in the first tradingperiod. There are basically two options for how the

NER surplus is dealt with, either by sale or auction,

or cancellation. From a demand and supply point

of view, it does not make any difference whether

NERs are made available through new installations

or through auctions; they represent net supply tothe market in any case.

3.2 CDM and JIWhile the EU ETS is a consequence of countriestaking on their Kyoto commitments, the two project

based mechanisms are actually specified in theKyoto Protocol itself.

CDM is the only mechanism under the Kyoto Protocol

involving countries that are not subject to binding

greenhouse gas emission caps by the protocol so-

called non-Annex I countries, primarily consistingof developing nations. Under the CDM, investors

from Annex I states, i.e. industrialised countries,

receive Certified Emissions Reduction units (CERs)

for the actual amount of greenhouse gas emissions

reduction achieved through an emission reduction

project, subject to host country agreement. CERscan be produced from projects initiated after

2000, and although most current projects are only

contracted until 2012, there is no specific end date

for the mechanism itself.

A key component of the CDM is the requirement of

additionality. CER units generated under the CDMwill only be recognised when the reductions of

0

20

40

60

80

100

< 1 Mt 1 Mt < x < 10 Mt > 10 Mt

%

Allowances InstallationsSource: Point Carbon

Fig 3.4 When size mattersDistribution of allowances and number of installations according to size categories for installations; less than 1 Mt, between

1 and 10 Mt, and larger than 10 Mt.

Medium-sized emitters account for

47% of total allocation

Additionality is key component ofCDM


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Carbon 2006

greenhouse gas emissions are additional to any that

would occur in the absence of the certified project

activity.

JI is the sister mechanism of CDM, allowing for GHGemission reduction projects to be carried out jointly

between two or more developed Annex I countries,

where one will act as investor/buyer and the other

as host/seller. These projects will result in so-called

Emission Reduction Units (ERUs), which can then

be used for compliance by countries or companies.Although a test programme for JI has existed since

1999, the actual transfer of allowances will not begin

until 2008.

There are two broad categories under the JI, called

track 1 and track 2. Whereas track 2 is essentially

the same as the CDM (see above) with strongadditionality requirements, track 1 is a very simplified

procedure. The issuance of ERUs from a track 1

initiative can be done provided the following criteria

are fulfilled by both buyer and seller:

1) Both participants are parties of the Kyoto Protocol.

2) Both participants have a national system for

identification of GHG emissions from sources and

storage using sinks. 3) Both participants have a

computerised national registry compliant with

international requirements. 4) Both participantshave submitted a report for determining their initial

assigned amounts. 5) Both participants annually

submit a current inventory protocol fully compliant

with Kyoto requirements.

Hence, the track 1 system leaves much more upto the host nation than does track 2 and the CDM.

Track 1 JI projects are still, however, required to

substantiate additionality.

While the above describes the project market in verybroad terms, it is in fact a highly complicated market,

with several steps and bureaucratic processes to go

through before credits are issued and can be used

for compliance purposes. Figure 3.5 shows a very

simplified picture of the different steps needed for

a CDM project to produce credits, and some of therisks involved at different stages. In this context, the

process for JI track 2 can be assumed to be fairly

similar, although there will be different institutions

involved.

As expected, the increased regulatory certainty

following Kyoto ratification by Russia, andsubsequent entry into force of the Protocol, as well

as the registration of the first CDM project on 18

November 2004 has lead to a jump in CDM activity.

In addition to this come the improvements to the

processes of the CDM Executive Board and the

Methodology Panel.

This can be seen clearly from the number of

proposed CDM projects registered in Point Carbons

database, which more than doubled throughout the

year, from 980 to 1965 projects. Currently, there are

2,256 CDM projects in the database. A significantshare of the increased number of projects has come

in a few select countries. Figure 3.6 shows the

number of projects in the Point Carbon database for

selected countries at the end of 2004 compared to

mid-December 2005.

Project

development

Design docs.

methodology

Approval,

Executive Board

Implementation

Certification

CER

Risk factors

Methodology

rejected

Stages

Non-approval

Failure

Delay

Initial stage

failure

Uncertified

Fig 3.5 Step-by-stepThe different stages for a CDM project and some of the risk

factors that might arise at the different stages,

Increased regulatory certainty leadto jump in CDM/JI activity

Two broad categories under JI - Track1 is very simplified


20/60


28 February 2006

0

50

100

150

200

250

300

350

India

China

Brazil

Panama

Vietnam

Argentina

Indonesia

Chile

Philippines

Mexico

NumberofP

rojects

To year end 2004 To Dec 2005Source: Point Carbon

Fig 3.6 Project growthThe number of projects registered in Point Carbons project database, at the end of 2004 and in December 2005.

Table 3.1 CDM and JI host country ratingPoint Carbons assessment of major project hosts.

CDM Dec 05 Dec 04 JI Dec 05 ov 04

1. India

2. China

3. Chile

4. Mexico

5. Brazil

6. Korea

7. Peru

8. Morocco

9. South Africa

10. Argentina

11. Malaysia

12. Vietnam

13. Egypt

14. Indonesia

15. Thailand

-

BB

BB

B+

B+

B+

B+

CCC+

CCC

CCC

CCC

(1, BBB)

5, B)

(2, BBB)

(7, B)

(3, BB)

(4, BB)

6, B)

5, B)

(10, CCC)

(n.a.)

(n.a.)

(8, CCC)

(n.a.)

(11, CCC)

(9, CCC)

1. Bulgaria

2. Romania

3. Poland

4. Hungary

5. Estonia

6. New Zealand

7. Chzech. Rep

8. Slovakia

9. Russia

10 Ukraine

BBB+

BBB

BBB-

BB

BB

B-

B+

B

B

B-

(1, BBB)

(4, BB)

(5, BB)

(6, BB)

(7, BB)

(n.a.)

(2, BBB)

(3, BBB)

(9, CCC)

(8, B)


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Carbon 2006

We see that growth was significant throughout

the year, testifying to the increase of activity in the

carbon project market. India and China are particularly

noteworthy, having more than doubled the number

of projects through the year. Still, this is somewhat

misleading as the graph shows projects at all stagesof development. India and Brazil are the countries

with most projects at Project Design Document

(PDD) level or higher, 186 and 101 respectively,

while China currently has a modest 35 projects at

the same stages.

However, although counting the numbers of projects

in the different countries tells us something about

where the activity levels might be the greatest, it

does not tell us where the reduction potential will

be the highest.

Of the 10 host countries in our database with the

largest estimated volume by 2012, China, India

and Brazil are responsible for about 63% of the

total volume for all projects at PDD stage shown in

table 3.1. It must, however, be stressed that thesehave not been adjusted for the possibility that the

various projects might not be implemented after all,

that they might be implemented later than stated in

the PDD, or that they will deliver fewer reductionsthan aimed for. The risk factor is an essential part of

the CDM/JI market, and as we will see later in thisreport it is an important parameter for the price paid

for different projects.

Point Carbon monitors developments in all major

CDM and JI host countries, and rates them according

to their attractiveness as project hosts. Based on

an assessment of the countrys CDM- or JI-related

organisations and institutions, its investment climateand its CDM/JI project status, Point Carbon evaluates

whether the country in question is attractive for

CDM or JI investments. Table 3.1 shows the ratings

for the major host countries and how they ranked at

the end of 2005 in comparison to their standing atthe beginning of the year.

The following chapter will go into detail on the type of

projects that were contracted in different countries

in 2005. Later chapters will discuss whether the

CDM/JI mechanisms are functioning as intended,and how they might develop in the future.

China, India and Brazil dominate thesell side


22/60


28 February 2006

4. Market activity in 2005The volumes and values for the carbon market last

year are based on registrations in our proprietarydatabases, interviews with market participants, and

our assessment of policy developments and their

potential market impacts. The analysis of the size

of the CDM and JI market in 2005 is furthermore

based on interviews with around 60 of the majorplayers in the market, together with registrations

in Point Carbons transaction database, and Point

Carbons project database. See Box 4.1 for a further

description of the methodology and Box 4.2 for a

description of what is included in this analysis, andwhat is not. Table 4.1 presents the market activity in2004 and 2005.

We find that the global carbon market saw transactions

toalling 799 Mt CO2e in 2005, corresponding to a

financial value of 9.40 billion. See Figure 4.1 for an

overview of historic volumes in the carbon market.

In comparison, the market saw an estimated 94 Mt,377 million in 2004. The growth and speed in the

carbon market has been quite extraordinary, with aneight-fold increase in volume from 2004, and about

25 times larger financial values in 2005 compared to

the previous year.

The EU Emissions Trading Scheme (ETS) was the

largest market segment in financial value, although

not in terms of physical volumes. In total, 262

million EU allowances (EUAs), worth 5.4 billion

were transacted through brokers and exchanges

in 2005, 79% of this through brokers. In addition,

we estimate that the bilateral market (company-to-

company, not brokered or exchanged) did 100 Mt,1.8 billion.

CDM is by far the dominant of the two project-based

mechanisms, and we find that contracts for 397 Mt,

1.9 billion were entered into in 2005. JI saw 28 Mt,

95 million contracted in Central and Eastern Europe(CEE). Other carbon markets remain insignificant

in the larger picture, and did 7.8 Mt, 52 million in

2005. The New South Wales trading system remains

the largest of these, at an estimated 93% of the

financial value.

4.1 EU ETSThe past year saw significant growth in the

European emissions trading market. In total, the

market transacted 262 Mt CO2 through brokers and

exchanges, corresponding to a financial volume of

5.4 billion. In addition to this comes an unreported

direct bilateral market, which Point Carbon estimates

to be 100 Mt, 1.8 billion. In comparison, the EUETS did an estimated 17 Mt, 127 million in all

segments in 2004. Although growth slowed down

towards the end of the year, see Figure 4.2, each

quarter saw record volumes and value. This growthhas continued also in 2006, with the market trading

91 Mt, 2.3 billion year-to-date (10 February).

Table 4.1: Reported volumes and values 2004 and 2005Reported and estimated volumes 2004 and 2005 , in million tonnes of carbon dioxide equivalents and . BilateralETS for 2005 estimated as 27% of total EU ETS volume at average EUA price through the year.

2004 2005

[Mt] million] [Mt] [ million]

EU ETS total

- TC + exch.

- Bilateral

CDM

CDM 2nd

JI

Other

7

9.7

7.3

60

0

9

7.9

127

.a.

.a

188

0

27

34

362

262

100

397

4

28

7.8

7,218

5,400

1,818

,985

50

96

52

Sum 94 377 799 9,401

Carbon market did 799 Mt, 9.4billion in 2005


23/60


24/60


28 February 2006

Box 4.2 What is included, what is not?

The carbon market has historically been fragmented, and although the vast majority of trading activity now

takes place in the EU ETS, CDM and JI segments, there are still some deals involving greenhouse gas credits

that we do not include in our analysis and forecast. This might be the case if no actual contract has been signed

or transaction has taken place, or if there is no standardised tradable unit involved in a transaction.

Included

yoto markets: CDM, JI, AAU

andatory emissions trading: EU ETS, UK ETS, New South Wales (Australia)Voluntary emissions trading: CCX (USA)

For the EU ETS we report transactions in the brokered (OTC) market and the volumes on exchanges. However,

we do not include clearing (e.g. exchange for physical) of OTC contracts through exchanges. In addition, we

estimate the size of the pure bilateral market (outside brokers and exchanges).

For CDM and JI we include only emission reductions purchase agreements (ERPAs) signed by both Seller(s)

and Buyer(s). We furthermore only report contracts based on future delivery, as there will be no liquid spot

market until the International Transaction Log (ITL) is up and running in April 2007, at the earliest. We also

include forward sales of issued/approved and non-issued/approved CERs/ERUs in the secondary market. In

addition, we include auctions of CERs through the New Values platform, and transactions of Carbon Credit

Notes through the Johannesburg Stock Exchange.

Not included

omestic project tenders: Programs where companies can apply to their government in order to receive

emission credits or allowances based on specific projects, e.g. in the past this has applied to New Zealands

PRE Tender. Although these programs might result in the allocation of actual credits or al lowances that can

be traded on the market, the initial allocation of the credits from the government to the company or project

developer is not counted as a transaction. If the project volumes are sold on to a buyer we count the volumes

once that contract is registered.

There are also S stateswith caps on emissions and plans for trading, but as long as there is no activity in

these potential markets they will not be included.

Various voluntary programs Several voluntary programs exist where companies or organisations engage in

deals that include transfers of carbon credits, e.g the Oregon Climate Trust, which uses its funds to acquire

emission reductions from a number of sources. These credits are normally not transferable to operationaltrading systems. There is also a growing retail sector, selling various carbon credits to companies, organisations

and individuals. Typical retai l initiatives include e.g. programs for offsetting emissions from air travel.

Various stand-alone deals Some companies have undertaken carbon credits deals that are so far not related

to any program or system. Many of these are done for company internal emission requirements, or used for

Corporate Social Responsibility reporting purposes. If these credits are sold to any operational system they are

reported under that market segment.


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Carbon 2006

responses are spread somewhat evenly, there aresome indications that the majority see the bilateral

market as being somewhere between 10% and

50%.

Based on this response we estimate that thebilateral market in 2005 was 100 Mt, or 27.6% ofthe total volume. Although bilateral trading will have

occurred at different times throughout the year,

by applying the average price through the year we

find that the bilateral market in 2005 corresponds

to 1.8 billion. While we will certainly never know

exactly how much is traded bilaterally, this provides

at least some transparency on what the company-to-company market might look like.

4.1.1 What drives the EUA price?Prices increased significantly in the first half of2005, going from about 7/t in February to almost

30/t in July, before ranging from 20/t to 24/t for

the second half. Figure 4.6 shows the daily prices

as reported by Point Carbon together with daily

volumes in the OTC and exchanged markets.

What were the main drivers for the price development

over the year? As in any market, the price is set by

supply and demand. The supply is here determinedfirst by the caps set under the different NAPs,

together with the amount of reserve allowances

and CDM credits coming into the market. Demand

is set by the amount of emissions through the year

in relation to the overall allocation. Briefly put, theallowance demand can be measured by estimating

the emissions from the different sectors under the

EU ETS and subtracting the caps. This produces

what Point Carbon terms the emissions-to-cap (E-t-

C), our allowance demand indicator.

The E-t-C will change on a continuous basis due to

a number of factors, but in particular: weather, as

0

20

40

60

80

100

120

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

MtCO2

0

500

1 000

1 500

2 000

2 500

mill


46%

94%

14%

185

137%

7%

Figure 4.2. So good we had to show it twiceQuarterly volumes and values in the EU ETS in 2005, Mt and million.

0 %

20 %

40 %

60 %

80 %

100 %

3-Jan

3-Feb3-M

ar3-A

pr

3-May

3-Jun

3-Jul

3-Aug

3-Sep

3-Oct

3-Nov3-D

ec

OTC ExchangesSource: Point Carbon

Figure 4.3 More or lesshe relative shares of daily volumes for the brokered and

exchanged market in the EU ETS in 2005. Pure bilateral

trades not included.

Price changes based on fuel pricesand weather


26/60


28 February 2006

temperature determines power/heat demand and

precipitation the potential for hydropower production;

and fuel prices, as the relative price for coal and gaswill determine which of the fuels will be used for

power production. In other words, if the winter is

cold and the gas-to-coal price differential widens,emissions will increase as more power is consumed

and coal, which emits more GHGs per unit of output

than gas, is the preferred fuel source. Thus, carbonprices will also increase. A different situation would

occur in a mild and wet summer, where there is

less demand for power and the rainfall increases the

potential for hydropower production.

Have we seen evidence of the market reacting tothese fundamentals? In fact, the first year of the EU

ETS has shown that the market is indeed responding

to changes in fuel prices and weather. Nevertheless,

policy decisions still have the potential to shift prices.

See Point Carbons Carbon Market Analyst After theNAPs from 3 November 2005 for a full discussionon which policy events we anticipate to impact on

price development in the future.

Fig 4.7 shows the development of the EUA price

throughout 2005 in relation to the impact from

fuel and weather to the overall short position, i.e.

the impact on Point Carbons allowance demandindicator E-t-C from relative coal/gas prices and

temperature/precipitation. It is evident from thegraph that the market is to a large extent trading on

changes in the fundamentals. The correlation (R2)

between the EUA price and the combined effect

from fuel and weather was 0.92 over the year as awhole. The individual correlations to fuel prices and

weather were 0.89 and 0.48, respectively. This is

yet another signal of the market working effectively,

as participants and observers clearly see that the

market price is not arbitrary.

However, some would still argue that the current

price neglects fundamentals, in the sense that

0

2

4

6

8

10

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

MtCO2

ECX NordPool Powernext EEX EXAASource: Point Carbon

Volumes through 2005

ECX: 63.4%

Nord Pool: 24.0%

Powernext: 7.9%

EEX: 4.3%

EXAA: 0.3%

Figure 4.4: Exchanges grow tooMonthly volumes of EUA trades in 2005 at the different carbon exchanges, in Mt CO2.

0

10

20

30

40

50

60

70

8090

0-10% 10-25% 25-50% 50-75% 75-90% 90-100%

Numberofrespondents


Carbon Market Survey 2006Q: What is your best guess of

the bilateral market as

percentage of total volume in

EU ETS?

Figure 4.5 What the readers thinkOur subscribers best guess of the relative size of the

bilateral market.

Market is responding tofundamentals and policy events


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Carbon 2006

0

500

1000

1500

2000

2500

3000

3500

3-Jan-0

5

1-Feb-0

5

2-Mar-05

4-Apr-05

3-May-0

5

1-Jun-0

5

30-Jun-0

5

29-Jul-05

29-Aug-0

5

27-Sep-0

5

26-Oct-05

24-Nov-0

5

23-Dec-0

5

ktCO

2

6

8

10

12

14

16

18

20

22

24

26

28

30

/t

Volume PriceSource: Point Carbon's Carbon Market Trader

Figure 4.6 Volumes and pricesDaily closing prices and traded volumes in EU ETS in 2005

0

5

10

15

20

25

30

35

8-Feb

8-Mar

8-Apr

8-May

8-Jun

8-Jul

8-Aug

8-Sep

8-Oct

8-Nov

8-Dec

/t

-20

0

20

40

60

80

100

120

140

MtCO2

EUA 2006 Fuel + weather (accumulated)

R2

= 0,92


Figure 4.7 Driven by fuel pricesEUA prices from 8 Feb to end Nov 2005, left axis in /t, compared to the changes to Point Carbons allowance demand

indicator E-t-C from fuel prices and weather, accumulated throughout 2005, right axis in Mt CO2.


28/60


28 February 2006

switching prices in the UK are well above the

EUA prices. Hence, one would need higher EUA

prices and/or lower gas prices to trigger substantial

switching from coal to gas.

Not only does the price relation to fundamentals tell

us that the market has found reliable price indicators,

it also shows to some extent which sectors that areactive in the market. The Power & Heat sector, which

is where the overall shortage has been placed, is

used to trading on a daily basis, and importantly,

is used to trading based on weather and fuel price

changes. Although there are some (larger) industrialcompanies with their own trading departments, the

majority of trading activity - and price development

- in 2005 was due to power generators trading

strategies.

This dominance by the power sector has been usedby many to criticise the system, in particular in light

of the impact carbon costs have had on power

prices. As we will touch upon later in this report,

the increased spot prices in the German and Nordicpower markets can to a large extent be explained by

the introduction of emissions trading.

What do market participants see as the most

important factors for carbon price development?

Fig 4.8 shows the response from our survey, where

it is evident that fuel prices are seen as the most

important price determinant. Appoximately 45 % of

the respondents considered fuel prices as the mostimportant factor, while more than 20 % considered

it to be the second most important factor. It is also

interesting to note that political factors are seen to

be the second most important factor in the short

term. Many of the political factors should already

have been cleared at this stage, but it is evident thatthis politically created market still looks to policy for

announcements on supply, and to some extent also

demand.

It would clearly be a positive development if theimportance of politics was reduced and replaced by

a more predictable fundamental both as a risk and a

price driver. This will probably happen as the EU ETS

matures and confidence in its continuation accrues

and the outcome of legal and regulatory tussles

between the commission and MSs becomes morepredictable.

There are, however, political developments thatcannot be expected to be solved in the immediate

0 % 20 % 40 % 60 % 80 %

Other factors

Long-term prices

CDM/JI supply

Weather

Political factors

Fuel/other commodity prices

Share of responsesMost important factorSecond most important factorSource: Point Carbon

Figure 4.8 Short-term price drivers in the EU ETSBased on responses from our web-survey

Majority of trading due to powergenerators activities

Fuel prices most important in short-

term perspective


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Carbon 2006

future. In particular, this relates to the developments

towards an international climate agreement to

follow the Kyoto Protocol. Fig 4.9 shows what therespondents to our web-survey saw as the most

important price drivers in the long-term. Political

decisions are seen as by far the most important

factor, while it should also be mentioned that CDM/

JI supply is seen as more important in the long-

term than the short-term. This shows that marketparticipants are looking to international policy for

certainty on the future of the market, while at

the same time they expect developing countries

to participate in an active manner through CDM

investments. As we will show in the following

section, there is already evidence that this is takingplace.

4.2 CDM and JIVolumes in the project markets also increased

considerably in 2005. The lions share of transactions

still takes place in developing countries, whereCDM contracts (ERPAs) worth 397 Mt CO2e were

registered by Point Carbon, corresponding to an

estimated financial value of 1.9 billon (7% discount

rate). Thus, CDM accounted for 93% of the physical

volumes transacted in the project market and 95%

of the total financial value. The JI market is stillconsiderably smaller than CDM, but nevertheless

almost tripled in volume in 2005, growing to 28 Mt

CO2e, 95 million, worth of reported transactions.

Table 4.2 shows CDM and JI volumes in 2005 as

registered by Point Carbon, together with estimates

on the financial value.

In 2005, a total of 397 million certified emissionreductions (CERs), at volume weighted average

price of 6.7 /CER, were contracted for future

delivery. As for JI, the volume of emission reduction

units (ERUs) contracted more than doubled, to 28

Mt, while the average price increased slightly to 5.1/t As Figure 4.10 shows, the volume has increased

throughout with Q4 as by far the most hectic

contracting period in terms of volume signed. To

0 % 20 % 40 % 60 % 80 %

Other factors

Long-term prices

Weather

CDM/JI supply

Fuel/other commodity prices

Political factors

Share of responses

Most important factorSecond most important factorSource: Point Carbon

Figure 4.9 Long-term price drivers in the EU ETSBased on responses from our web-survey

Table 4.2 CDM still dominates the project marketCDM and JI volumes registered by Point Carbon in2005. For simplicity, all payment is assumed to bedone on delivery, and a 7% discount rate is applied.

Volume

(Mt)

Financial value

( million)

CDM 397 ,985

CDM 2nd 50

JI 28 96

CDM saw 397 Mt, 1.9 billion. JI did28 Mt, 95 million


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28 February 2006

some extent this might reflect when Point Carbon

registered the transactions, but it also supports thetrends seen in previous years when it comes to

timing of contracts.

There are several reasons for the substantial increase

in the volume transacted throughout 2005. The most

obvious reason is that the supply of potential projectshas increased. By the end of 2005 there were more

than 900 CDM and JI projects that had reached

the public validation stage. Several host countries

have shown increased support for the project base

mechanisms, in particular China and Brazil. Also,

large-scale projects are contributing significantly,

with four HFC-23 decomposition projects signed in

2005.

Some of the bottlenecks at the institutional level,

both in host countries and at the CDM Executive

Board, have been overcome, or are in the process of

being removed. The CDM EBs improved efficiency

in approving methodologies and projects, and the

positive signs in terms of establishment of the JISupervisory Committee have both added to the

increasing investment trend.

China, India and Brazil are the main seller countries

when it comes to numbers of CDM ERPAs. The

large volumes in China are primarily due to a few

large HFC-23 projects. For the JI market, Romania

has been an active seller, but volumes becomesmall when comparing to CDM market volumes. In

fact, Brazil alone is about the same size as the total

JI market.

At the demand side, the implementation of the

Linking Directive gives EU ETS installations theability to use CERs directly for compliance. With

increasing prices for EUA delivery it is evident that

0

50100

150

200

250

300

350

Q1 Q2 Q3 Q4

CDM JISource: Point Carbon

Figure 4.10 Most towards the endQuarterly volumes in the CDM and JI markets in 2005, in Mt

CO2e-

0

50

100

150

200

250

300

Chin

aIn

dia

Euro

pe(JI)

Braz

il

Oth

er/U

nkno

wn

Afric

a

Oth

erAm

erica

Oth

erAsia

MtCO2e


Figure 4.11 Where are the sellers?Contract volumes in different host countries, as registered by Point Carbon,

in Mt CO2e.

Bottlenecks are being removed


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Carbon 2006

this has contributed to the demand for project

credits. The increasing number of carbon funds has

added further to the demand. This sector includes

governmental procurement funds, private sector

investment vehicles, and private-public funds (e.g.all World Bank funds). Point Carbon will return later in

2006 with an updated review of the different funds

that are available for private sector investment.

While CDM investments is now increasingly beingdominated by private investors and funds, JI is still

mainly attracting governmental buyers.

Figure 4.12 shows an overview of buyers in the

CDM and JI market, together with a breakdown ofvolumes on project type. As funds here include both

private sector and government investments, it is

clear that the private sector is by far the dominant

CDM investor. In terms of project types the large

volumes involved with the decomposition of HFC-

23, a by-product in the production of the refrigerantHCFC-22, accounted for almost two thirds of the

total volumes in the project market in 2005.

In addition to the direct project market, with ERPA

contracts, there is a considerable secondary market,where contracts for future delivery of CERs, not

necessarily with a specific project attached, are

entered into. However, this is primarily a company-

to-company market, although some such contracts

are offered through brokers, and it is difficult to get

full overview of what is transacted in this marketsegment. Point Carbon estimates the secondary

CDM market to have totalled 4 Mt, 50 million in

2005.

Exchanges are also beginning to offer CDM related

contracts. Carbon credit notes are being traded at the

JSE Securities Exchange, providing a carbon basedinvestor product, for delivery in 2008. However, the

volumes have so far been measly, as only just below

20,000 tonnes were reported transacted in 2005,corresponding to around 200,000. Interestingly

though, prices for carbon credit notes at JSE remain

substantially below EUA prices, currently trading atabout 14/t. The other exchange option, with Asian

Carbon and New Values offering CER auctions on

their platform, saw around 1.5 million traded in 2005.

Point Carbon does not register the CDM volumes

through New Values separately, and this has alreadybeen included in the 397 Mt total.

4.2.1 What drives the CDM/JI prices?

Prices for both CDM and JI project contractsincreased during 2005. This can mainly be explained

by increased demand from EU ETS companies

and the numerous carbon funds that became fully

operational for purchasing credits. However, pricesdiffer a lot from contract to contract, mainly based

on the distribution of risk between buyer and seller.

Moreover, mature projects are in general more

expensive than projects that have not yet reachedthe Project Design Document level. Also, delivery

is becoming more important. The price for credits

delivered before the end of the EU ETS 2005-

2007 period are currently fetching a premium . See

Unknown

3 % Governments

12 %

Private

42 %

Funds

43 %


Figure 4.12 Whos buying what?The relative share of CDM and JI buyers, and the relative share of different project types, by

volume. CMM: coal mine methane.

HFC

66 %

Unknown

11 %

CMM

7 %

Renewable

6 %

Waste

3 %

Other

7 %

Carbon funds add further to demand


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28 February 2006

Box 4.1 Point Carbons CER contract categoriesPoint Carbon has developed forward Certified Emissions Reductions (CER) contract categories in order to

provide a tool to structure prices and forward CERs according to consistent criteria. The categories are based

on how different risks are distributed between seller and buyer. The categories are broad, and prices vary within

them, according to specific risk factors linked to project or market maturity. Currently, the largest share of

forward CER transactions are found in category 2 and 3.

Price category Approx. price

range (/t CO2e)

Description

1 3-6 Non-firm volume. Buyer buys what seller delivers even if

emissions reductions turn out not to qualify as CERs.

2 5-10 Non-firm volume. Contract contains preconditions, e.g. that

the underlying project qualifies for the CDM.

3 9-14 Firm volume. Contract contains preconditions (as above).

Usually strong force majeureclauses and high credit rating

requirements.

4 2-14 Firm volume. No preconditions. Forward spot trades will in

the future fit this category. Currently only the JSEs Carbon

Credit Notes fit under this category.

0 % 20 % 40 % 60 %

AAU prices

Other factors

Earlier deals

Political factors

EU ETS 08-12 price

CDM Methodology panel

Share of responses


Figure 4.13 Short-term price drivers for CDM and JIBased on responses from our web-survey


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Carbon 2006

Box 4.3 for an overview of Point Carbons contract

categories for CDM projects.

Figures 4,13 and 4.14 show what the respondents

to our web-survey saw as the most importantprice drivers in the short- and long-term. Decisions

by the CDM Methodology Panel are seen as very

important in the short term, as this is primarily what

determines whether a specific project will qualify forCDM or not. It is also clear that the link between

EUA prices and CDM/JI contracts are viewed by

many as a relevant issue. Increasing EU ETS prices

will tend to increase demand for imported credits,

and this will also increase the prices paid for said

credits.

4.3 Other marketsAlthough the carbon market now to all extent is

focused on EU ETS and Kyoto instruments, there are

still some other operational greenhouse gas trading

systems that should be considered.

By far the largest of these is the New South Wales

Greenhouse Gas Abatement Scheme in Australia,

which totals 78% of the physical volume in the other

markets, and 93% of the financial value. In total, theother markets segment which also includes the

voluntary Chicago Climate Exchange in USA and

the UK ETS, which will finally come to an end this

year clocked in 7.8 Mt CO2, corresponding to an

estimated 52 million. Figure 11 shows the volumes

and value of these markets in 2005.

We do not expect very significant growth in these

markets. The UK ETS is in its final year, and theNSW scheme remains pretty stable from year to

year. If any growth is to take place, CCX is the most

likely candidate, as US companies might seize the

opportunity to gain carbon trading experience andenvironmental credentials at the same time.

UK ETSThe UK ETS continues to cling to a straw. Point Carbon

estimates that approximately 300,000 tonnes CO2were transacted over the year, corresponding to a

financial size of some GBP750,000 (1.09 million

estimated).

AustraliaThe New South Wales Greenhouse Gas Abatement

Scheme reported 222 trades over 2005, with

February and October the busiest months at 35

and 29 trades respectively. This marks delivery oncontracts, whether spot or forwards, not when the

contracts are agreed. The market has remained

largely illiquid over the year, with some months

0 % 20 % 40 % 60 %

Other factors

Earlier deals

AAU prices

CDM Methodology panel

EU ETS 08-12 price

Political factors

Share of responses


Figure 4.14 Long-term price drivers for CDM and JIBased on responses from our web-survey

Other markets saw 7.8 Mt,estimated to be worth 52 million


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seeing just a handful of trades and sideways price

movement. 6.1 million tonnes of CO2 were reported

as transferred, corresponding to an estimated

financial size of AUS$78.2 million (48.5 million

estimated).

USAThe Chicago Climate Exchange grew considerably

in 2005, from 77 to 129 members. Furthermore,

the participants agreed to extend the programme

for four more years, with a new tentative end date

in 2010. Last year wa

Carbon 2006 -- Towards a Truly Global Market

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