Carbon credit derivatives trading, its implications and opportunities for India

Abstract

The purpose of this study is to examine and understand the scenario a year after the Kyoto protocol came into force. In particular we concentrate on the emissions market comprising of the European Union Emission Trading System (EU ETS) and OTC flexible instruments like Clean Development Mechanism (CDM). Based on an ex-post evaluation of the EU experience, we then discuss the Indian scenario in light of the Kyoto protocol. Any discussion of an emissions trading system would be incomplete without an understanding of the USA SO2 (under the Clean Air Act) trading system which is currently the most well established emissions trading regime in the world. (Ironically however the USA refuses to ratify the Kyoto protocol.) We discuss in brief the market mechanism and the trading history of the SO2 system. In examining the EUA market we do a quantitative analysis of the futures and spot prices and test the first level of market efficiency. A mathematical analysis of the relation between the spot and the future prices is also in order, to evaluate the presence of arbitrage opportunities. The carbon credit market has been responding well to market fundamentals and we establish this point by examining a few major market fluctuations which tie-in very closely to fundamental changes. In doing this we also highlight some of the other factors that influence the carbon credit prices. In the Indian context, the Clean Development Mechanism (CDM) is of special interest due to the sudden spurt in number of projects over the last year. Since India and China have been the two main participants in the CDM sphere, we do a comparison of the quality and quantity of the CDM projects proposed in the two countries. The Indian stance towards such projects has been evolving over time and we highlight these changes in stance specifically w.r.t the policy of inclusion of sinks. Though the initial purpose of this study was to examine the utility of carbon credit derivatives in India, the nascent nature of the market has instead shifted our focus to the establishment of a carbon credit spot market and a trading system in India. A detailed roadmap for setting up a detailed trading system in India is beyond the scope of this study (refer to Damodaram-2001),however we do discuss a few issues that can be encountered during setting up an emission trading system in India in light of the EU experience. We also list a few design issues that need to be taken care of in designing a derivatives system.