National Commodity and Derivatives Exchange Ltd (NCDEX), the country’s leading agricultural commodity bourse, launched futures trading on carbon credits this month. Rival exchange Multi Commodity Exchange of India Ltd (MCX) had launched its version of carbon credit futures nearly three months ago and within three weeks of a government notification, allowing carbon credits as a tradable commodity.
MCX may have had a head start, but initial turnover data suggest that NCDEX may capture the market in India. In the first two days of trading, the latter clocked a healthy turnover of Rs36 crore for its contract expiring in December 2008. MCX, on the other hand, has managed an average daily turnover of only Rs77 lakh for its December 2008 contract since its January launch. It would be presumptuous to jump to conclusions based on data for two trading sessions; but a look at the contracts chosen by both also suggests that the initial trading data may be a sign of things to come.
MCX has a penchant for introducing “benchmark contracts”, which are contracts that are benchmarked to products in overseas markets. Both its gold and crude contracts, for instance, are similar to the COMEX gold and NYMEX crude contracts available on the New York Mercantile Exchange, the leading global exchange for the two commodities. This has helped it garner a higher share of the market in these products in India.
MCX’s choice for a carbon credit futures is based on a similar philosophy. Its contract mirrors the European Union Allowances (EUAs) contract traded on the European Climate Exchange, the world’s largest bourse for emission trading. More than 90% of its volumes come from this product, while the balance comes from the recently launched Certified Emission Reductions (CERs). NCDEX has designed its own product with CERs as the underlying.
Difference between EUAs and CERs
According to the Kyoto Protocol, developed countries agreed to reduce their emissions to certain target levels. If they’re unable to do so, they have to buy emission credits from those with surplus or generate carbon offsets, which are generated from emission-reducing projects. CERs are a form of carbon offset.
Each of the developed countries puts caps (known as allowances) on corporates and other organizations to achieve its target. Each unit of allowance gives the owner the right to emit one tonne of carbon dioxide or an equivalent quantity of greenhouse gas. Organizations that haven’t used up their allowances can sell them, while those who overshoot their limit need to buy allowances as credits. The European Union, the first to start voluntary compliance in 2005, has designed a trading scheme under which EUAs are traded.
There are no buyers or sellers of EUAs in India, simply because there are no emission reduction obligations on developing countries. It’s interesting, therefore, that MCX has chosen it as the underlying. But organizations based in India can generate carbon offsets, or CERs, through approved emission-reduction projects such as wind farms and energy efficiency projects. India has the largest number of approved projects, with a 34% share based on registered projects, and is one of the largest sellers of CERs. (Since most projects are relatively small in size, India’s share based on the number of CERs generated is lower at 15%.)
Currently, organizations that generate CERs enjoy minimal bargaining power, as the average project is small in size. As a result, intermediaries such as funds, consultants and non-banking financial companies make a fat profit by pooling together small quantities and selling them to buyers in developed countries. NCDEX hopes that sellers would get a better deal through the price discovery on the exchange. Since NCDEX’s contract caters to genuine end-users, it could get a higher share of the market. But MCX’s premise is that since the European Union is the largest market for carbon credits, EUAs would be the benchmark instrument in the segment. Also, CER prices have a high correlation (about 80%) with those of European allowances. So Indian carbon credit generators could still hedge price risk using the MCX platform. MCX is also working on a facility by which Indian organizations can deliver CERs in lieu of EUA obligations.
From an end-user’s perspective, the NCDEX platform seems superior, as the underlying product is the same as what they’re dealing in. But note that not all CERs are the same—some developed countries don’t accept offsetscreated by hydro projects, for instance. So, trades that are marked for delivery on the NCDEX will have to be matched by the exchange. Given the complications, it’s likely that some trades won’t get matched and will need to becash-settled.
MCX, on the other hand, has the advantage of having a product that closely resembles the most liquid carbon credit futures contract in the world. Once interest builds up in India for this segment, it’s likely that it would attract speculative interest, just as it has in the case of gold.
So even though the NCDEX contract seems better suited to the end-user in India, the MCX contract enjoys much higher liquidity, thanks to a large speculative interest. Would the story repeat with carbon credits? Perhaps not — the initial pool of liquidity, at least, seems to building around the NCDEX’s contract.
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