A Carbon Exchange in India

With the world gearing in for emissions reductions as per Kyoto Protocol, India is leaping in at the opportunity created by this immediate global concern.  Mr. Jairam Ramesh’s statement clearly indicates that India does not want to be left behind in this brand new market.  The Indian government is designing the National Mission on Enhanced Energy Efficiency under the NAPCC so as to create a roadmap for energy reduction and efficiency.  As per 2004 data India’s carbon emissions stand at 1/20^th of those produced by the USA.  This presents to us an immense opportunity for trading our lower carbon production levels with countries that intensively consume energy and increase carbon emissions.  However, in order to maximize advantage, India needs to follow the carrot and stick approach; enforce strict regulations governing carbon caps on one hand and promoting energy efficiency through trade and tax mechanisms on the other.  This is necessary as huge investments to the tune of about EUR 600 billion may be required and the government would have to create monetary mechanisms to promote the same.  After having created strict emission caps, the creation of an internal carbon trading system on the lines of existing international models, would help Indian companies reach these cap levels.

When we talk about ‘trade’ one may ask ‘how exactly do companies trade pollution’?  The latest currency on the block is the ‘carbon credit’ which measures the amount of carbon emitted into the earth’s atmosphere.  1 carbon credit is equivalent to 1 metric ton of carbon dioxide CO₂ emitted into the atmosphere.  The United Nation Framework Convention on Climate Change (UNFCCC) has established various mechanisms, International Emission Trading, Joint Implementation and Clean Development Mechanism, to facilitate trading of these Carbon Credits.  Within these mechanisms, India comes under the purview of the Clean Development Mechanism (CDM) established for Non Annex 1 or developing countries.  The carbon credits generated from CDM projects are called Certified Emission Reductions (CERs) and can be traded bilaterally or on exchanges such as the MCX only with Annex 1 or developed countries.

As of now, the commodities exchange of India, the MCX, is involved in futures trading of carbon credits.  The exchange has enabled Indian companies to get more fair prices for their carbon credits as opposed to those obtained by bilateral agreements between companies.  However the drawbacks of the MCX exchange is the lack of liquidity in the trade of carbon credits within the exchange.  Further, we need to have a mechanism by which companies can efficiently trade carbon credits within India, and create a free market for intra-India trade.

As mentioned, we need to go a step beyond status quo so as to monitor carbon emissions in India and create mechanisms to reduce them.  This can be done by first creating targets as per sector and size of a plant.  The NMEEE has designated a 3 step PAT or Perform Achieve and Trade process to enable Indian companies to achieve energy efficiency.  The first phase involves goal setting specific energy consumption (SEC) target for each plant, second phase is the reduction phase where companies would need to achieve these targets. The third phase would be the trading phase whereby companies that meet or over-perform on these targets may be issued energy certificates or permits that may be traded on an internal energy exchange.  Companies that do not meet required standards would be penalized.  

In order to promote projects that promote energy efficiency, tax breaks and exemptions for the profits made on energy efficiency projects could be given, a national fund to support such projects could be created, and risk guarantee funds for banks to insure them against risks associated with leverage be provided for such projects.

Overview of the Indian Market

In India there are a number of small and dispersed projects being rum primarily by SME’s to improve their processes.  As of Feb 1, 2010,475 CDM projects were registered with the CDM executive board in India out of which 243 were small scale. The Estimated CER generation stands at 240 million.  This indicates the potential that such a market may hold in case an internal trading platform is created.  Growth and diversification of carbon markets will be linked to investor and companies’ understanding of such a market and its instruments.  In the event of creating exotic carbon based derivates and instruments, rating agencies will also play an important role.  For instance, in the European Union strong local demand and supply has enabled development of exchange based carbon futures and spot markets.  However, the absence of a local market deters the prospects of carbon trading in India.  Indian firms need access to such a platform which provides them with sufficient liquidity in terms of energy/ carbon permit trading.  Such a market may also attract huge overseas investments.

Prospective market structure and players in India

India may soon have such a carbon trading system, with the government pondering over market based instruments to keep industrial emissions under check.  Mr. Jairam Ramesh has asked state pollution control boards to automate their emission monitoring process by following the Tamilnadu model.  Real-time emission monitoring is the starting point for the three step PAT process recommended by the NMEEE.  The Cap and Trade system permit based trading will, in effect, offset excess credits and mobilize credits within the country.  In the credit/permit transaction, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions.  Thus, in theory, those who can reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest cost to society.

Price Discovery

The mechanism of price discovery is very important to understand the trading system.  Unchecked energy use and hence emission levels are predicted to keep rising over time. Thus the number of companies needing to buy credits will increase, and the rules of supply and demand will push up the market price, encouraging more groups to undertake environmentally friendly activities that create carbon credits to sell.Whether the company will set or not will depend on the Marginal Abating Cost (MAC) incurred by the company.  MAC is the cost the company would incur to reduce 1 metric tonne of carbon or to gain 1 credit.  Suppose Company A’s emissions exceed by 1 compared to the allowed limit, then it has two options, either buy the credits from another company B or Improve its processes to reduce the emission. Now if the price of the credit in the market is 15 and the cost for reducing the emissions for company is 50,then it is more profitable for the company to buy a credit from the market, however  if the cost of improving its own processes were to be 10 then it would go for the latter option.  This cost is called as the Marginal Abating Cost (MAC).  The MAC and price will be determined by demand and supply forces.

Market player

·         Speculative investors

The emergence of a new market attracts risk capital and early speculative investors who provide liquidity in return for higher returns. As the market will mature and liquidity increases, the involvement from mainstream investors is expected to step up and lower the costs.

·         Carbon brokers

They can come into picture when the transactions are highly structured and the value-add of a knowledgeable broker is considerable.  They can bring in information to aid the investors in the process of trading leading to a more structured market

·         Insurance companies

The need for insurers is seen on account of impact of climate change on property, health risks etc and the new business avenues arising out of the carbon market

·         Exchanges

A structured market and liquidity of credits will encourage more competitive market and new exchanges being setup for trading

·         Credit rating agencies

The potential of carbon emissions to impact the long term value or credit of a company will be enhanced by the entry of credit rating agencies that will help evaluate the financial standing of the company for CDM related loans.

Conclusion

Feasibility of such a market for trading depends on a number of factors such as determination of proper rules and guidelines governing emission caps, monitoring of emissions, setting up of regulation authorities and auditors, and many other factors.  Having said this, the market would immensely help India to reduce the overall carbon footprint, which will in turn make India an attractive destination for foreign investments.  This is especially true since India is growing at a phenomenal growth rate and will be requiring huge investments in the infrastructure and energy sectors.  Further, improvement of energy processes will help improve the bottom-line and reduce dependence on non-renewable resources.  The process could be a win-win proposition for all, and help India remain at par with global changes in technology and sustainability.