The carbon market has more than doubled in the last year and is estimated at approximately $64 billion in 2007, up from $31 billion in 2006. The allowance-based system of the EU Emission Trading Scheme (EU ETS) generates the biggest share of the market, over $50 billion in 2007. The EU ETS requires large emitters of carbon dioxide to annually surrender to the government the number of EU Allowances (EUAs) equal to their annual emissions, but also accepts for compliance purposes a limited number of credits created pursuant to the Clean Development Mechanism (CDM) and Joint Implementation (JI) flexibility mechanisms of the Kyoto Protocol, accounting for $12.9 billion and $499 million of the market, respectively.

Prices for primary forward Certified Emission Reductions (CERs) and Emission Reduction Units (ERUs) have been increasing significantly over the past year, with CERs trading at more than 26% over 2006 levels and ERUs at more than 38% above 2006. This dynamic rise in ERU prices is in large part attributable to the emergence of private sector buyers for the first time in 2007, with Japan in particular making some significant purchases in Eastern Europe. This is compounded by the establishment of JI procedures in a number of countries that appear to have substantially reduced regulatory uncertainties. Prices in 2008 appear to be continuing this trend as reports from the first quarter of the year show primary CER prices increasing again.

A report by the World Bank issued last month entitled “State and Trends of the Carbon Market 2008” cites sustained interest in CDM and increased competition during 2007 as part of the cause for these increases. The report predicts that the demand for carbon credits by industrialized countries could exceed 2.4 billion metric tons over the 2008-2012 period, whereas supply is estimated at only 1.83 billion metric tons, suggesting a shortfall of close to 600 million metric tons. This estimate is up from a predicted 300 million ton shortfall predicted by the World Bank just one year ago.

The increased competition for CERs could be caused in part by the procedural challenges facing the CDM market, with projects stuck in a backlog due to the fact that an average of one to two years may elapse between the inception and implementation stages. As of May 1, 2008, 3,403 projects were in the CDM pipeline with only 2,122 in the validation stage. Uncertainties regarding the future of the use of Kyoto-based offsets in the EU-ETS after 2012 have contributed to industry anxieties. While Assigned Amount Units (AAU’s) have been touted as one possible solution to the shortfall, it should be noted that companies regulated under the EU ETS, accounting for almost three-quarters of the demand from Europe, cannot use AAU’s to meet their EU ETS obligations. Some analysts have predicted that a shortfall in available credits could push the price of credits as high as 45€/ton, up from 25€/ton at present.

China is by far the biggest supplier of primary CERs and although the recent World Bank report cites that the country provides a tacit price floor for carbon credits, stronger prices were recorded in the first quarter of 2008, with some projects obtaining prices up to 40% higher than in 2007. Buyers have linked their attraction to the Chinese CER market to the reliability of business partners and predictability of regulatory processes. However, the deadly earthquake earlier this month in the Sichuan province may have knocked out up to 5% of China’s supply of carbon offsets, which is likely to exacerbate the carbon credit shortfall. Stockholm-based project developer Tricorona, which has over 10 offset projects in the region corresponding to 8 million tons of emission cuts through 2012, said that there was still no information on the status of the projects or the extent of the damage. EcoSecurities Group Plc, the biggest manager of greenhouse gas cutting projects, reported that 5 of its 46 projects in the Sichuan region are still not back up and running normally and it expects to experience a reduction of about 450,000 CERs in 2009 and 2010. Even for the projects still in operation, the earthquake could interrupt the monitoring of emissions cuts, thereby delaying a company’s receipt of credits. The uncertainty as to the availability of these credits could add to the rising costs of CERs.

While the carbon market today is experiencing growing demand and rising prices, the future of the carbon markets remains unsettled, especially in a post-2012 world. The World Bank’s report notes that under the European Commission’s post-2012 proposal, the issued CERs and ERUs would be “less flexible and less fungible, limiting their risk management and compliance utility vis-à-vis the EUA.” Policymakers and regulators in the United States, Europe and elsewhere therefore must develop clear, predictable and transparent policies that provide for market continuity as we look ahead to Phase III of the EU ETS and the post-Kyoto system.

For further information about this topic, please contact Akin Gump.