Trading in Carbon Markets Sanjay Gakhar Vice PresidentMCX

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Trading in Carbon Markets Sanjay Gakhar
Vice President-MCX
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Kyoto Protocol

• Why? commitment to limit GHG emission
• Who? Industrialised countries (Annex I countries)
  
• GHG? 6 Gases CO2, CH4, N2O, HFC, PFC, SF6 6 Gases
  CO2, CH4, N2O, HFC, PFC, SF6
• How much? 5 below 1990 level of emission
• When? 2008-2012

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Reduction of GHG Available Mechanisms

• Command Control policies were 1st wave
  policies
• Also called Direct Regulation
• Ideological disputes over which is best

• Alternative to Command Control (1980s the
  1990s)
• Types of Market Mechanisms
• Cap and Trade Mechanism
• Taxes
• Why Market Mechanisms?
• Frustration with Command Control policies
• Command Control policies are not efficient
• Economists applied lessons of the marketplace
  to environmental policies
• Same goals at lower cost if we rely on
  market-mechanisms

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Emergence of Carbon Markets Climate Change

• Market incentives can be used to meet objectives
  set by an international agreement (Kyoto
  Protocol)
• Role of markets as a source of solutions on
  global climate change is now universally
  recognized
• Markets encourage business community
• The business community can turn problems into
  opportunities
• Markets key to establishing and development of
  renewable energies
• Allows companies to pursue state-imposed targets
  however they see fit

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Market Drivers for Clean Technology Investment

• High energy prices
• Energy security
• Rapid technology shift
• Need for power reliability
• Growing environmental concern

• Green Financing (Downside Risks)
• Costs and payback periods
• Efficiency of technology
• Lack of Infrastructure
• Institutional barriers

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Clean Development Mechanism

• Clean Development Mechanism (CDM) is an outcome
  of Kyoto Protocol, which came into force from
  February 16, 2005
• Purpose
• CDM is a mechanism established under Article 12
  of Kyoto Protocol as project based emission
  reduction activity in developing countries.
• The purpose of CDM is to assist Parties not
  included in Annex-I in achieving sustainable
  development by promoting environmentally friendly
  investment and contributing the objective of the
  convention and to assist developed country
  parties included in Annex-I in achieving
  compliance with their quantified limitation and
  reduction commitments.
• CDM allow Annex-I (industrialized) countries to
  meet their emission reduction targets by paying
  for green house gas (GHG) emission reduction in
  non-Annex-I (developing) countries.

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Carbon Credits A global Opportunity

• Carbon Instruments a new trading opportunity
• Markets gradually evolving
• Huge Risks in International Markets
• Risks make funding costlier
• Needs a market place with related products and
  instruments

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CDM Statistics
Source www.unfccc.int Assumption All
activities deliver simultaneously their expected
annual average emission reductions Assumption
No renewal of crediting periods
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Growth in CERs
Source State and Trends of Carbon Market, May
2008, published by World Bank
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Potential CERs supply till 2012
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Growth of Carbon Market
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Indias Role

• India viewed as one of the top-most suppliers of
  carbon credits.
• National Clean Development Mechanism in India, an
  initiative of Ministry of Environment and Forest,
  assess and approves projects that plan to cut on
  emissions.
• Credits generated from those projects are much
  sought after by various international companies
  from Europe and the USA.
• By 2012 Indian companies are expected to generate
  at least 8.5 billion at the going rate of 10
  per tonne of CER.
• Thus a trading mechanism set in place will only
  help India Inc. to continue their sustained
  growth by facilitating them to finance their
  growth by selling Carbon Credits in the
  international and domestic market.

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Issues related to CDM

• Fragmented market dominated by small and medium
  scale projects
• OTC trade and lack of price transparency
• No efficient spot market
• Lack of price awareness among sellers
• Need for a vibrant futures market to hedge
  against price risk
• Approaches have so far not been not been very
  systematic
• Requires participation of various public and
  private sector stakeholders
• A clear and comprehensive understanding of the
  advantages, procedures and pitfalls is required

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Risks in CDM

• Project risk
• Delivery risk
• - Quantity deliverable (leakages)
• - Timely delivery
• Price risk
• Credit risk

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Types of CDM CERs Deals

• Forward Contracts (current practice)
• For compliance
• For private sector investors
• For trading in the secondary market
• Upfront payment (a few but rare)
• CERs upfront payment on discount basis
• Project equity /Debt in lieu of CERs
• Spot Trading (yet to take place)
• Secondary Trading (emerging)
• Financing and hedging instruments (emerging
  currently)

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Commonly used price basis for CERs

• Fixed forward prices are still the norm in the
  primary market.
• Indexing the CER price to EUA - popular at the
  peak of Phase I in 2006, but volatility in EUA
  market made sellers interested in fixed price
  contracts.
• There have been reports of indexing primary
  contracts to exchange-listed CER in lieu of EUA.
• Average price of CERs offered by national
  governmental programs globally
• Average price of CERs offered by carbon funds

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Daily Volatility in CER prices
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CERs Criticality to the Indian Cos

• CERs have and are emerging as an additional but
  substantial source of income
• Many times revenues from sale of CERs act as the
  dividing between the cos overall profits and
  losses
• With annualized volatility of more than 20
  percent (Aug07-Jul08), the income from CERs have
  become unpredictable
• Income from CERs through naked projects are still
  more vulnerable to market conditions
• Solution lies in effective usage of derivatives
  product available through futures exchange like
  MCX to secure the cos bottom-lines

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Hedging at MCX Coming to the rescue

• No differential pricing on MCX as the case is in
  forward and spot markets.
• Convenience of trading CERs in INR, thereby
  denying the need of Forex hedging.
• Option of reversing the position in futures
  market at MCX, if situation arises unlike the
  case in other markets.
• Players are brought to a single platform, thus,
  eliminating the laborious process of identifying
  either buyers or sellers with enough credibility
• The MCX futures floor gives an immediate
  reference price. At present, there is no
  transparency related to prices in the Indian
  carbon credit market, which has kept sellers at
  the receiving end with no bargaining power.
• The price discovery on the Exchange platform
  ensures a fair price for both the buyer and the
  seller

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Role of Exchanges in Mainstreaming CDM Projects
in India

• Provides a reference price
• Links buyers and sellers
• Price risk management
• Capacity building is encouraged
• Place to sell CERs
• Increased comfort levels for both sellers and
  buyers
• Effective tool for transacting carbon assets
  (cost, efforts, standardization)
• No credit risk
• Credibility of price

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Mixed bag of participants in Futures trading

• Hedgers
• Producers
• Intermediaries in Spot Markets
• Ultimate buyers
• Technology partners

• Investors
• Arbitragers
• Speculators
• Portfolio Managers

• Diverse participants with
• wide participation objectives
• Project Financers
• Funding agencies
• Corporates having risk exposure in energy products

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Why MCX?

• Designed to offer an advanced, standardized and
  financially guaranteed tool
• Cost-efficient trading risk management
  opportunities
• MCX alliance with the Chicago Climate Exchange
  (CCX)
• First exchange traded environment product in the
  Indian Subcontinent
• Timeline matches with Western markets
• Compliment natural gas and crude oil contracts
• No forex risk
• Futures prices serve as world reference prices

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MCX CER Contract Comparison with Global Benchmarks
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Correlations in Carbon Markets
Correlation of MCX CFI prices with INR equivalent
ECX EUAs prices (Jan 21 Jul 15, 2008)
93.69 Correlation of MCX CER prices with INR
equivalent ECX CER prices (Jun 9 Jul 15, 2008)
97.45 Correlation of ECX EUAs prices with
Nordpool CER prices (Jun 21 2007 Jul 15,
2008) 77.11
09 Jun 15 Jul,08
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MCX Following the Global Benchmark
MCX ECX CER Correlation 97
Source Bloomberg
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MCX Much More than Futures

• MCX plans to cater the entire value chain of
  carbon market
• Services currently present Futures trading
• Services shortly expected Carbon Trading
  System (CTS)
• Strategic Tie-ups of MCX in context to Carbon
• Tie-up with Chicago Climate Exchange
• Tie-up with IDEACarbon
• Expected tie-up with Deutsche Bank

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MCX initiatives in Carbon Trading

• First only Indian Exchange to enter into a
  strategic alliance with an International Exchange
  of Emission Credits
• On 20 Sept, 2005, MCX stroked a Licensing
  Agreement with the Chicago Climate Exchange
  (CCX), which has majority stake in the European
  Climate Exchange (ECX)
• MCX launched mini-sized versions of Carbon
  Financial Instruments (CFI) as traded on ECX on
  21 January 08
• These mini-CFI are the first exchange traded
  environment product in the Indian Subcontinent
• MCX launched CER contracts on 09 June 08
• Designed to offer the Indian community an
  advanced, standardized financially guaranteed
  tool to participate in the global emissions
  marketplace

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MCX An Overview

• MCX is a fully electronic multi commodity futures
  exchange - Permanent recognition from Govt. of
  India.
• Live operations since November 10, 2003
• Average Daily Lots Traded (Jan-Jun 2008)
  262,000 approx.
• Average Daily Turnover (Jan-Jun 2008) Rs.
  13,200 Crores/USD 3.28 billion approx.
• Highest Daily Turnover - Rs.28,058.39 Crores/USD
  6.52 billion 15 July 08
• Highest Daily Contracts Traded GOLD 153,015- 15
  July 08
• Highest Daily Contracts Traded SILVER 156,748
  7 Nov 07
• Highest Daily Contracts Traded CRUDE OIL
  139,63510 June 08
• Highest Daily Contracts Traded COPPER- 118,656
  16 Aug 07
• Operations from 600 centers with over 1800
  members 48400 Trading Terminals (TWS)
• Among the leading commodity exchanges globally
  (in terms of contracts traded)
• No. 1 in Silver futures trading
• No.3 in Gold and Crude Oil futures trading

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MCX Shareholders Global Strategic Alliances
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MCX in Indian Commodity Market
Market Share of MCX (2008)
Market Share of MCX (2007)
The data is till June 2008
Turnover Rs Crore
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