Université Paris Dauphine
Derek W. Bunn
London Business School
Financial transactions involving carbon-related assets have emerged as a cornerstone of the international efforts on climate change mitigation. Moreover, integration of carbon risks into investment decisions is becoming a pervasive trend in many asset classes, with investor leverage putting market discipline on corporations to manage and disclose carbon-related performance data. In many ways financial markets have become pivotal to the implementation of international climate agreements. Following the financial crisis and the associated global economic downturn, however, market conditions for investors have worsened considerably. How will these adverse market conditions impact the evolution of carbon markets and the prospects for a long-term and effective post-Kyoto treaty? While many divisive issues remain on the negotiating table, optimists still look to the US administration to broker an agreement on climate mitigation and the development of global carbon markets. Moreover, "green" fiscal stimulus packages in many countries may usher in a new era of partnership between regulators and investors in areas of carbon finance, renewable energy and low-carbon technologies.
The “Carbon Markets” workshop held at the London School of Economics in May 2009 may be seen as an attempt to address some of these issues. During this one-day workshop (organized jointly by the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and the Grantham Institute for Climate Change at Imperial College) participants from industry and from policy-making and academic spheres were given the opportunity to discuss: 1) lessons from the European carbon market during the first trading period; 2) the construction of marginal abatement costs and their implications for carbon finance; and 3) wider issues about carbon finance and the current economic crisis. This workshop was followed later in 2009 by the second London Energy Forum on Climate Policy Risk and Energy Investment, which was organized by London Business School and held at The Royal Society. The crucial theme in that workshop was how effectively the carbon markets signal longer-term investment behavior in secure, decarbonizing power generation. The papers in this special issue draw upon both of these workshops.
The paper by Lederer investigates the governance effects of emerging carbon markets and what role they will play in a post-Kyoto treaty. The author focuses on reforming carbon governance through the Clean Development Mechanism (CDM) from an emerging-economy (eg, Brazil, China and India) perspective. Lederer discusses the pros and cons of the CDM as well as the reforms that are necessary, asking whether the CDM is a catalyst for, or an obstacle to, an effective and legitimate post-Kyoto agreement. Interestingly, his main conclusions indicate that the CDM might need reregulation but also that it has been successful in initiating the transition to carbonfree development pathways.
The papers by Taschini and Urech and by Chevallier and Sévi build upon the state of knowledge of financial econometric techniques applied to emissions markets. Both these papers detail how carbon allowances relate to energy and commodity markets. The paper by Taschini and Urech investigates the real option to fuel switch in the presence of expected windfall profits under the European Union Emission Trading Scheme (EU ETS). The authors develop a simple model to evaluate the value and the activation frequencies of generation systems consisting of coal- and gas-fired power plants, using a real options approach and the notions of clean-spark and cleandark spreads. Addressing the question of how expected windfall profit affect the profitability of a generation plant and its activation frequencies, Taschini and Urech show that, by internalizing opportunity costs, the rate of activation of the gas plant decreases while that of the coal plant increases. In the paper that follows, Chevallier and Sévi provide a jump-robust estimation of realized volatility in the EU ETS based on 2008 data. The authors document the measurement of realized volatility with respect to the presence of microstructure noise and jumps in the estimation procedure. For both the bipower variation and “median” realized volatility estimators, Chevallier and Sévi uncover the presence of around 5% of significant jumps in the intraday CO2 price series. The authors conclude that the MedRV estimator is a good candidate for modeling the intraday CO2 price volatility due to its superior properties in small samples and its ability to deal with zero returns.
Finally, the paper by Labre and Atkinson looks again at the CDM market but from a risk analytic perspective. CDMs expose investors to substantial project and operational risks, as well as to market price risk. A multistage conditional probability tree analysis is proposed to help the valuation of the early stage Emission Reduction PurchaseAgreement contracts. This is carefully calibrated and a case study illustration is provided for a hydropower project in China.
We conclude by thanking Walter Distaso, Jan Ahmerkamp, Filip Zikes, Tora Skodvin and Stefan Trueck for their comments, which helped the authors to further improve the content of their papers. The collation of these four papers would not have been possible without the tremendous help of Sam Fankhauser, Simon Dietz and Chris Wright in organizing the London School of Economics “Carbon Markets” workshop and of Will Blyth in facilitating the London Energy Forum. We take the opportunity here to thank all of them very warmly for their involvement at various stages of these events.
The real option to fuel switch in the presence of expected windfall profits under the EU Emission Trading Scheme