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.

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BANKS GOING GREEN !

Author : Harris K A , NMIMS

In finance and banking sector, the new mantra is going GREEN and banks which form the core of the financial sector are imbibing this mantra of going GREEN. It is in fact more than just becoming environment friendly. Going green is looked upon as a way to reduce costs and mitigate risk.

Banks like any other business, directly interact with the environment as consumers of natural resources. During their day to day business banks heavily contributes towards the carbon emission in terms of use of paper, electricity, stationary, lighting, air conditioning, electronic equipment etc even though this is moderate compared to other carbon sensitive industries like steel, oil and gas etc.  In the case of banks, the direct interface with the environment has considerably increased due to rapid growth of the banking industry.

Banks affect the environment Indirectly by financing intermediaries that have an external impact on the environment. They are the major source of long term funding to various industries such as cement, fertilizers, nuclear power, steel, oil and gas, paper etc which pollute the environment heavily.

Being a major source of fund provider, banks can play a crucial role in ensuring environmentally sustainable and socially responsible investments in the economy. Banks should try and reduce the increase in carbon footprint caused by them either directly and indirectly and should play a vital role in ensuring sustainable and environment friendly development.

Green Banking refers to the initiative by banks to encourage environment friendly investments, to give lending priority to those industries which have already turned green or are trying to grow green and thereby help to restore the natural environment. This initiative of green banking is mutually beneficial to the banks, industries and the economy. Moreover Green banking will ensure that the asset quality of banks are improved in future. Contrary to the belief, environmental friendly technologies make economic sense for the industries and

actually lessen their financial burden as well. The polluting industries face more resistance and often forced to close down or face massive resistance from the public. This adds to their cost enormously. So adopting environmentally sustainable technologies or modes of production is no more considered as a financial burden, rather it brings new business opportunities and higher profit. Green banking optimises costs, reduces the risk, enhance banks reputations and contribute to the common good of environmental sustainability. So it serves both the commercial objective of the bank as well as its social responsibility.

Banks have explicit and implicit environment liability.

Direct liability

All nations across the world are impacted by climate change and India is no exception. There has been continuous efforts from the entire global community to try and reduce the risk of climate change caused by increase in carbon footprint. India as a part of its initiative has made a commitment to reduce its emissions per unit of GDP 20 to 25 percent below 2005 levels by 2020. In this context banks also has the direct liability to comply with the relevant environmental regularity while conducting business. The direct impact including carbon emission of all the activities if not taken care of may lead to environmental degradation.

Deducted Liability

Deducted environment liability may arise from  the day to day operations of the bank. If the lending decisions of the banks are not done prudently as per the environmental criteria, then it may lead to credit risk, legal risk and reputational risk. Further unforeseen risk may also arise due to climate change and global warming. It is at the interest of the banks to practice green banking and thereby avoiding the aforesaid risks involved in the banking sector.

 1.  Credit Risk: 

 The credit risk can happen indirectly in the case when banks lend to companies whose businesses are adversely affected due to changes in environmental regulation. The costs of meeting new environmental requirements might be enough to put some companies out of business. Credit risk can also arise when a bank had given advances to a real estate firm whose property value fell because of environmental issues. Moreover small and medium enterprises (SMEs) engaged in manufacturing business do not have sufficient capital to shift to clean production methods. Hence there are chances of credit risk in these loan portfolios as well in case government comes out with stringent environment regulatory rules.

 2.  Legal Risk

 Banks are at a legal risks if they themselves don't comply with the environmental regulations. But more than inadequate environmental practices followed by debtors may lead to legal risk. The banks will be at a legal risk when they take possession of a collateral property (under SARFAESI or due to loan default) which is contaminated or is a pollution causing asset. For example, A company which has taken loan may incur legal liability to clean up the contaminated site which may further lead to bankruptcy. In such a case the bank's ability to recover the loan is stalled and if the polluted site is part of the collateral security, the value of the property intended to set off default losses is also reduced. If a bank has a proactive environment management system put in place then it can reduce this risk to a great extend.

3.  Reputational Risk:

Banks should watch out from financing environmentally objectionable projects. Banks are certain to lose their reputation if they are involved in some big projects which adversely affect the environment and causes pollution. In addition if loans are advanced to industries which pollute the environment, those industries will face restriction from public and are often forced to shut down their business, thereby creating over and above the reputational risk causing credit risk as well.

4.  Unforeseen risks.

Increase in carbon footprint may result in drastic side effects in the form of climate changes like rise in sea levels, draughts, cyclones etc. Such problems have an effect on the economic assets financed by the bank, which may lead to the risk of default. For example if a colony is hit by a severe cyclone leading to mass destruction, there would be high incidence of credit default on part of the industries financed by the banks. The climate change may also directly affect the material and financial assets of the banks.

To counter the above risks, it is imperative for the banks to develop strategies to reduce and mitigate the risk. We are in a world where every institution is working towards reducing the carbon footprint and in a low carbon economy there will be lot of challenges and opportunities for the banks. Most of the banks have taken up green programs at the operational levels thereby helping banks to reduce their own impact on environment. These include:

• Reduce use of paper - Most banks are computerized and operate on core banking solutions, and hence the transaction can be recorded electronically instead of using paper. This will help in reducing deforestation and also save cost, time and storage space. Customers should be encouraged to shift to E statement through campaigns.

• Recycling paper - Used paper should be shredded and ink cartridges should be refilled.

• Minimize plastic consumption - As far as possible banks should try and reduce the use of plastics. Banks while providing documents for example Fixed deposit receipt, loan agreement should use eco friendly pouches instead of plastic pouches.

• Practice energy conservation - Banks should adopt renewable energy solutions at branches and ATM kiosks like the solar power. They can make use of compact fluorescent lamps (CFL) to save energy consumption. Energy saving campaigns should be conducted for the same.

• Build green buildings - Banks should make sure that the buildings in which are operate comes under the category of green structures which make less use of scarce natural resources and minimize waste.

• Reduce air pollution - By providing common transport to the employees working at a same branch carbon emission can be reduced. Also the personnel employed at a particular branch and coming from same place may pool together, thereby again reducing carbon emission.

• Thin computing and e-waste management - Thin computing should be adopted to reduce the need for many personal computer in branches. E-waste should also be managed due to excessive  IT usage.

• Corporate social responsibility - As a part of their CSR activities banks should organize environmental campaigns such as tree plantations, pollution checkups, etc.

Many Indian banks have started to realize the importance and they are taking up various GREEN BANKING initiatives:

ICICI bank

• 50% waiver in processing fee of cars that use alternate mode of energy like electricity and CNG. Cars like Reva, LPG or CNG versions of Tata and Maruti variants.

• Reduced processing fees for purchasing 'Leadership in energy and environment design' (LEED) certified buildings.

• Assisted a company to develop a product that provides an eco friendly air conditioner alternative to conventional air conditioner.

IndusInd Bank

• "Human aur Hariyali" campaign which introduced solar powered ATM`s. The banks expects to save 1980 Kwh of energy annually. They are also supporting environment friendly finance programmes and providing incentives to go green.

 IDBI Bank

 • Exclusive group for working on climate change and more specifically carbon credits advisory to the clients to deal with clean development mechanism (CDM), carbon credits of Kyoto protocol and voluntary emission reduction (VERs) authority.

• Entered into agreements with multilateral agencies and buyers of carbon credit like KfW Bankergruppe, Federal republic of Germany to offer  complete range of CDM related services tailor made to suit the needs of the clients.

SBI

• Green home loan scheme which supports environment friendly housing projects and offer subsidy and interest rates reduction.

 Union Bank of India

• Energy audits conducted annually and measures implemented to bring down the energy consumptions. Installation of solar water heaters in the banks building.

Axis

• Facility of e-statement and for each e-statement registration by a customer, Axis bank will donate a note book to the needy and poor.

 

The Opportunities

 

The Green banking, on one hand it provide challenges to the banks and on the other hand it provide many opportunities as well. It is strongly believed that within the foreseeable future carbon will have a price tag attached to it. And it gives banks a role to play in transition to a low carbon economy.

Banks may formulate innovative financial solutions and re design the existing ones so as to incorporate environmental perspectives. Some areas of development could be:

• Green banking financial products - Loans with financial concessions to companies which undertake environmental friendly projects such as manufacturers of fuel efficient automobiles, solar and wind equipments etc. Banks can also introduce a ‘Green Fund’ to provide climate conscious customers the option of investing in environmental friendly projects. Besides introducing specific green banking products, banks can incorporate an Environmental Impact Assessment ( EIA) in their project appraisal while financing any project to measure the nature and magnitude of environmental impact as well as suggest environmental risk mitigation measures.

• Carbon credit business - Indian banks can involve themselves in carbon credit business, wherein they can provide all the services in the area of Clean development Mechanisms  (CDMs) and carbon credits including services of  identification and funding of CDM projects, advisory services for registration of CDM projects and commercialization of CERs under different structures to meet the requirements of its customers, acting as an intermediary for buying certified Emission Reductions CERs on behalf of end-users or carbon funds, financing against CERs and CERs receivables, and other related banking services. As India has huge potential for carbon credit business, Indian banks can set up dedicated carbon credit cells to capture a major share of this carbon credit business.

 

Future of Green Banking

 

In future the Green banking will become the order of the day. And we expect a lot of associated green products, green services and green regulations would come into picture.

• Green excellence awards and recognitions - The Reserve Bank of India or regulatory authority will recognize and reward the environment conscious providers of green loans on an annual basis. By doing this environmentally irresponsible firms may run the risk of hurting their bottom-line as well as their image in the market.

• Green rating agencies - Green rating agencies will be set up to provide green analysis of lenders and users of green loans via different ratings.

• Green Investment funds - Green mutual funds will be in markets and climate conscious customers can invest in environment friendly projects. Moreover investment in these would attract tax concessions as well.

• Green insurance - The IRDA shall come up with green insurance in which cover is provided for different kinds of environmental risks

• Green accounting and disclosure -  Green accounting standards would be developed and it should be mandatory for companies to give environment disclosures in the annual reports.

 

Conclusion 

 

Financial institutions and banks in particular have an important role to play in this context by contributing to the creation of a strong and successful low carbon economy. They should expand the use of environmental information in the credit extension and investment decisions. The endeavour will help them proactively improve their environmental performance and creating long term value for their business.

In future, business with a higher carbon footprint would be seen as a riskier business and banks may keep themselves away from financing such business and would look for financing new technology solutions that capture or reduce carbon emissions.

The Green Banking is thus the order of the day and it will definitely benefit the banks, the industries and the environment as a whole.

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