WHEN Dorothy Thompson arrives to start her new job near Selby next month, she will be in charge of an 850ft chimney and 12 enormous cooling towers — and also the hottest seat in one of the City’s fastest-growing financial markets.
That market is carbon emissions trading, and Drax Power, the company at which Thompson was appointed chief executive last week, is as big in carbon as Halifax is in mortgages.
At today’s prices, her firm — owner of Yorkshire’s vast Drax power station — holds £215m worth of annual allowances to emit carbon dioxide (CO2), and expects to buy another 40% on the open market this year.
Emissions trading has had many doubters, especially those that said Europe on its own, without America, would struggle to establish a market mechanism to help firms become more environmentally friendly.
But since January, trading volumes have grown, carbon prices have soared and the City of London has moved into pole position to become the hub of this new market.
In January, the average daily carbon volume traded in Europe was about 300,000 tonnes but, give or take intermittent spikes, the daily average had trebled to about 1m tonnes by June.
The value of the market has grown even more sharply because the price of an allowance for a tonne of CO2 emitted has shot up from €6 (£4) to €20, with a peak in early June of €29. On those days in July when 2m tonnes were traded, the value of those transactions approached £40m.
The market is the result of the Kyoto agreement on climate change in 1997. This committed countries to reducing CO2 emissions to below 1990 levels. The European Union responded with a scheme that would give companies a strong incentive to do their bit.
Governments in the EU made estimates of carbon emissions from 15,000 installations in selected industries. In Britain more than 1,000 annual emission allowances were awarded for the 2005-8 period. Drax was the largest, with an allocation of 15.5m tonnes, and the Royal Navy air station at Culdrose in Cornwall the smallest, with 14 tonnes. Of those in the middle, Caledonian Cheese Company in Stranraer got an annual allocation of 12,480 tonnes, the Horlicks factory in Slough 6,925 tonnes and Rugby’s cement works 679,340 tonnes.
If a firm improves its energy efficiency and cuts emissions below its allocation, it can sell its surplus allowance on the market for a tidy sum. If its emissions exceed its allowance, it has to go into the market and buy allowances or face fines of €40 (£27) for every excess tonne of CO2 it emits.
Fans reckon trading volumes will soon be worth many billions of pounds per year. James Cameron at the investment boutique Climate Change Capital said: “I think this is likely to get bigger than the interest-rate-swaps market within 10 to 15 years, particularly once America joins in.”
Neil Eckert, chairman of ECX, the London carbon-trading exchange, points to what happened with the sulphur-dioxide-emissions trading market that started in North America in 1995. He said: “Last year the sulphur market had an underlying size of 9m tonnes, but the volume actually traded was 11m tonnes. If you use a similar ratio for the European carbon market, with a baseline size of 2.2 billion tonnes, then market volumes have a hell of a long way to grow.”
Using the same ratio of 11:9 would point to potential annual European trading volumes in carbon of 2.7 billion tonnes – worth £37 billion at current market prices. This figure would increase hugely if America decided to join.
Leading players are already enjoying the fruits of the market’s strong start this year. Paul Newman, managing director of commodities at Icap Energy, said: “Eight months ago we had one university graduate patrolling this beat. Now we have five people doing 45 trades a day between them.”
Cameron said: “Europe will be the centre of the global market as a result of it taking the lead. It will provide the benchmark. London is the leading centre and will remain so for years to come. The preparation has taken place here, and other financial centres are not so advanced, although there is also a concentration of expertise in the Netherlands.”
The market is attracting interest from hedge funds, former Liffe traders and the big banks.
Louis Redshaw at Barclays Capital said: “We were the first British bank involved and are now the biggest banking participant. We handle transactions that are many multiples of the standard market size of 10,000 tonnes. A million-tonne transaction is not out of the question.”
The carbon price has risen in the past few months. This is because power stations in Britain and on the Continent, faced with soaring oil and gas prices, have had to wade into the market. They were forced to buy allowances because the alternative fuel – coal – produces twice as much CO2 as gas per megawatt hour of electricity.
Newman at Icap Energy said: “Imagine you are running a power station. Suddenly you realise that gas is getting very expensive. What do you do? You move over to using coal. But burning coal threatens to push you over your emission allocation. So you ring our emissions desk and buy the extra certificates you need.”
In addition, exceptionally dry weather in Spain this year has robbed that country’s hydroelectric reservoirs of their water, forcing local generators to buy carbon allowances on the European market so that they can burn more gas and coal. There has also been speculative buying, as happens with a bull run in any market. The result has been that British firms have had no choice but to cope with the surge in carbon prices from €6 to €20 per tonne.
Melanie Wedgbury, head of external affairs for Drax Power, said: “Drax will have to buy a significant number of allowances – about 7m tonnes – to maintain output. Carbon is the main environmental constraint on coal-fired generation, and managing our allowances is critical to our business.”
Mark Klein, energy-risk director at Scottish Power, another big generator, said: “We have gas plants and coal plants. Through different exchanges and bilateral agreements, we have bought carbon allowances to cover our generation position to 2007. There have been some days when we have been buyers of allowances, fewer days when we have been sellers.”
Corus, the Anglo-Dutch steelmaker, has reduced its CO2 emissions by 11.5% in Britain, thanks partly to the purchase of a more efficient scrap metal “bloom caster” in Rotherham.
Corus said the carbon saving in Britain had offset excess emissions at its Dutch plants, saving the company from having to buy carbon allowances.
Elliot Morley, the minister for climate change and environment, said of the carbon-trading scheme: “Apart from one or two difficult cases, people have accepted it and got on with it. Industry is very comfortable.”
Seeing the balance-sheet value of carbon allowances is also influencing attitudes in companies, Morley said. “Carbon trading engages finance directors. It takes the issue of energy efficiency right to the top of the company.”
Environmentalists give the scheme half a cheer. Catherine Pierce of Friends of the Earth said the scheme could be a really effective tool for reducing emissions in refineries and power stations, but current restrictions on industry were not stringent enough.
Unsurprisingly, British firms involved in the scheme have concerns about its future and fairness, and about the recent price trend.
The Scotch Whisky Association, which represents distilleries, is worried about “the costs and administrative burden involved in managing such a complex system”, and “loopholes” that enable firms in some other industries to move production out of the EU to avoid emission curbs.
Matthew Farrow, head of environment at the CBI, said the employers’ body was mostly positive about the carbon market given the government target of reducing Britain’s emissions by 60% by 2050. But there were concerns. “It is important that all countries have robust national allocation plans,” he said. “France tried to use a loophole to exclude a large part of its chemical industry, until it was overruled by the European Commission, and we are concerned that some countries may have tried to get larger allocations than they should have.
“We also hear a lot of concerns from member companies that allocations are wrong, due to misunderstandings or clerical errors. For example, manufacturers with efficient combined heat-and-power plants might be counted as part of the generating sector and given tough allocations as a result.”
Klein at Scottish Power said: “The real unknown for generators and for the petrochemical and cement industries is the allocation method that will be used for carbon allowances in phase two from 2008 onwards, the critical period for meeting the Kyoto targets.”
Details of phase two are not due to be released until next June, after which some very rapid investment decisions may have to be made by generators.
Could the Bush administration’s hostility to Kyoto stifle Europe’s carbon trading market? On July 28 America, Australia, China, Japan, India and South Korea signed an Asia Pacific Partnership to promote the spread of technologies to counter climate change.
Andreas Arvanitakis, at the analysis firm Point Carbon, said there was a small risk that this rival approach might “undermine at board level the concept of cap-and-trade emissions-trading schemes”, although at the moment the partnership was “no more than a name”.
Many American companies hold a different view from their government. General Electric, which recently announced a doubling of its annual research spending on cleaner technologies to $1.5 billion (£843m) by 2010, said: “We like the European emissions-trading scheme as a way forward.”
CARBON TRADERS CLEAN UPTHE infamous Hurricane Andrew in 1992 blasted holiday homes to matchwood and stripped the roofs off tens of thousands of buildings in Florida.
It also brought Richard Sandor, an American innovator who helped set up the Chicago financial futures market in the 1970s, into contact with Neil Eckert, a British insurance executive.
Sandor was launching a contract to trade hurricane insurance risk, so that firms could protect themselves from another Andrew.
In 1995 the two men worked together to set up Brit Insurance, a Lloyd’s of London insurer.
While Eckert took the helm at Brit, Sandor struck out to launch a market that American companies could use to trade allowances for sulphur-dioxide emissions.
To the surprise of the many sceptics, the sulphur market grew to embrace many of America’s biggest companies, and the price of an allowance rose from $100 (£56) a tonne to $800.
‘Every time Richard came to London, we would sit down together and talk,’ said Eckert. ‘Richard wanted to repeat with carbon what he had already done with sulphur. We decided that British investors would be more receptive than those in America, and so raised £30m in 2003-4 for Climate Exchange plc.’
This firm, quoted on the Alternative Investment Market, is a 50% shareholder in the European Climate Exchange (ECX), which began trading in April this year. Allowances for 108,000 tonnes were traded on the first day.
ECX faces competition from two other European exchanges — EEX, based in Leipzig, and Nordpool, based in Oslo — and from over-the-counter trading, through firms such as Icap, which at present accounts for about as big a volume in carbon as all three exchanges put together.
However, thanks partly to a link-up with the International Petroleum Exchange that has made the big oil and gas companies natural customers for ECX, the brainchild of Eckert and Sandor has grown its volumes quickly. On July 4, for the first time, more than 1m tonnes of carbon were traded on ECX.
Every time a trade comes into the firm’s office in London’s Bishopsgate, the noise of a cash register sounds. Eckert said: ‘Liquidity breeds liquidity. The more trading there is, the more people get interested.’
