How trading in the EU carbon market works

The European Commission has closed down much of its flagship Emissions Trading Scheme for a week after the theft of permits from the Czech carbon registry prompted five countries to shut their national registries.

The Commission suspended spot trade on Wednesday in its $124.1-billion carbon market but allowed derivatives trade to continue. The theft of 4,75,000 permits, which was reported on Wednesday, follows a number of scandals to hit the market in the past two years including VAT fraud, a phishing scam and the re-sale of used carbon credits. Carbon trading is a market-based tool to limit greenhouse gases.

Below follows a factbox on how trade in the EU’s emissions trading scheme (EU ETS) works.

THE SCHEME

The largest carbon market in the world is the EU ETS. It covers around 12,000 installations in the European Union. Each member state sets its own emissions cap based on international and national emissions reduction targets.

Countries then distribute permits called EU Allowances (EUAs) to individual companies, which taken together equal the cap. Firms that do not have enough allowances to cover their emissions must either make reductions in emissions or buy another firm’s spare permits.

The allowances can be traded across the EU.

The scheme is split into three trading phases. The current, second phase runs from 2008 to 2012. The third and final trading period (2013-2020) will introduce tighter caps on industry and will auction the majority of EUAs to participants instead of giving them away for free.

MARKET PARTICIPANTS

Mostly consist of utilities, industrial companies, energy trading houses, hedge funds, banks and speculators.

DERIVATIVES

The derivatives’ trade in futures and forwards makes up 70 to 80% of the whole EU scheme. A price is agreed but allowance delivery and payment does not happen until a set date in the future.

Most contracts are for delivery in December of a particular year. Derivatives trade is regulated by member states’ authorities.

SPOT MARKET

There is also significant activity in the spot market, where traders can buy now and exchange immediately. It is largely unregulated because spot carbon permits are classed as normal goods by many countries.

EXCHANGES

Point Carbon analysts estimate that nearly 4.9 billion tonne of carbon dioxide equivalent were traded on exchanges and over-the-counter in the EU ETS in 2010.

The majority of transactions take place over exchanges. Exchange volumes represented 55% of the EU market last year, according to Prospex research.

There are five major exchanges that serve the market.

OVER-THE-COUNTER (OTC)

EUAs can also be traded OTC in the form of bilateral forward deals negotiated through brokers.

REGISTRIES

Each EU member state has its own registry with its own security measures and account opening procedures.

To participate in carbon trading, a firm operating in the EU ETS can open a compliance account in one or more emissions registries. Individuals can also open personal holding accounts.

The registry records the number of allowances held by account holders and the movement of allowances between accounts. This enables account holders to hold, transfer, cancel or acquire EUAs.

Opening a registry account ranges in difficulty from country to country. Some request identity documents and carry out strict security checks on all users. Others have been less stringent, requesting just two forms of proof of address to open an account.

Security measures are the responsibility of each member state’s registry, not the EU Commission.