Why Are Environmental Commodities Important?
Environmental commodities are a class of commodities that take the form of non-tangible energy credits. The value of these credits derives from the needs of market participants to produce and consume cleaner forms of energy. The markets for these products formed as a result of government efforts to tackle greenhouse gas emissions (GHGs) and promote clean energy production and consumption.
Many governments across the world have been placing restrictions on the rights of entities to produce GHGs. Since many companies produce GHGs in the course of making their products, environmental commodities emerged as a way to buy and sell these rights. In other words, if you place strict limits on individuals’ and institutions’ rights to pollute, then those rights become scarce and valuable. Without any such limitations, the right to pollute would have no economic value since its “production” and “supply” would be theoretically unlimited.
Some governments have chosen to reward green energy producers by providing them certificates that serve as a type of subsidy. These certificates have economic value and are another form of environmental commodity. Compliance programs in some regions may require electricity producers, for example, to purchase these certificates to meet minimum requirements for green energy production.
Environmental commodities are one of the newest categories of commodities traded on global markets. Their importance is likely to increase as the world grapples with a growing population and the effects of fossil fuel consumption on the environment.
What Are Different Types of Environmental Commodities?
Most environmental commodities evolved as a result of government environmental policy. Government actions as they pertain to the environment usually do one of two things:
- Penalize polluters.
- Reward clean energy production.
Cap and Trade
In cap and trade, governments place a cap on GHGs. This is usually an annual cap and may apply to the whole economy or to specific sectors of the economy such as refineries or power plants. Often, the annual cap declines each year since the goal is to reduce emissions over time. The government then divides the total cap allowance into smaller cap credits.
The trade part of cap and trade is what enables the marketplace to determine the price of these cap credits. Companies can buy and sell these credits, each of which permits them to emit a certain amount of GHGs (create pollution). Since the credits cost money, companies have an incentive to cut emissions.
As an example of how cap and trade works, let’s assume the government instituted a total cap of 10,000 tons of carbon annually, and ten pollution-creating factories were responsible for all of the GHG.
The government could then create 10,000 one-ton carbon credits and either allocate them (give a certain quantity for free to each factory) or auction them (have each factory bid for the amount it needs). Each factory would be required to hold the number of allowances equal to its level of GHG emissions. If a factory needed more than the amount it received through allocation or auction, it would have to purchase additional credits in the marketplace. If a factory produced fewer GHGs than the amount it received, it could sell the excess credits in the marketplace.
This type of program penalizes companies that produce excess pollution by making their actions more costly.
Carbon offsets are projects that generate carbon credits for companies, but they do so outside the bounds of a company’s normal operations. For example, building a wind farm, installing solar panels, planting trees or forest preservation are all carbon offset projects.
The difference between cap and trade and carbon offsets is that the latter occurs outside of the government-mandated caps and are a way to reward clean energy production. However, carbon offsets are credits all the same and can be bought and sold in the marketplace.
Renewable Energy Certificates (RECs)
These credits are known as green tags, renewable energy credits, renewable electricity certificates or tradable renewable certificates. They are tradable energy certificates in the United States that represent proof that 1 megawatt-hour (MWh) of electricity was generated from an eligible renewable energy resource and contributed to the shared system of power lines that transport energy.
Solar Renewable Energy Certificates (SRECs)
These are RECs that are specifically generated by solar energy.
These tradable certificates are also known as energy savings certificates or energy efficiency credits. They work in a similar manner to renewable energy certificates. However, white certificates are awarded for gains in energy efficiency rather than the production of renewable energy.
How Did the Environmental Commodities Market Evolve?
A global market for environmental commodities wouldn’t have developed without the Kyoto Protocol. This diplomatic document, which was adopted on December 11, 1997, is an international agreement linked to the United Nations Framework Convention on Climate Change (UNFCC). It formally committed the signatories to internationally binding emission reduction targets.
Implementation of the Kyoto Protocol commenced on February 16, 2005. The detailed rules for the implementation of the Protocol, known as the Marrakesh Accords, were adopted in 2001. The first commitment period started in 2008 and ended in 2012. An amendment to the Protocol in 2012 added a second commitment period (2013 to 2020), revised the list of GHGs and made additional revisions.
The Kyoto Protocol, however, was controversial in that it placed a greater burden on developed nations for reducing GHG emissions. The justification was that these nations had contributed to GHG emissions for a longer time than the developing world and, therefore, were more responsible for reducing them. More than 100 nations, including China and India, were exempt from compliance under the treaty. The United States, which emits 35% of the world’s GHGs according to the Kyoto Protocol, saw this as unfair and refused to ratify the treaty.
In December 2011, Canada renounced the treaty and thereafter formally withdrew. The Canadian government noted that since China and the United States never agreed to the treaty, the Kyoto Protocol was unworkable.
In 2015, all nations agreed to sign the Paris Agreement, which effectively replaced the Kyoto Protocol. In this new agreement, the signatories agreed to limit warming “well below 2 degrees” above pre-industrial levels and below 1.5 degrees if feasible.
What is the Difference Between Voluntary and Mandatory Credits?
Carbon markets exist both under compliance schemes and as voluntary programs. Each of these schemes has produced its own carbon credit markets.
Compliance schemes operate under mandatory national, regional or international carbon-reducing programs.
Voluntary carbon credits, on the other hand, allow businesses, governments, individuals and others to purchase carbon offsets that were either created by compliance schemes or in the voluntary market. The latter are called Voluntary Emission Reductions (VERs). VERs can’t be used as carbon credits in the compliance market and therefore have smaller demand and less liquid trading markets.
Where Are Environmental Commodities Traded?
Environmental commodities have faced a difficult time gaining a foothold in trading markets. The Chicago Climate Exchange (CCE), founded in 2003, was North America’s only voluntary and legally binding GHG reduction and trading exchange. However, inactivity in trading led to its closure in 2010. The lack of a formal agreement by the United States to reduce GHGs led to its demise.
Exchanges with environmental commodity products include the following:
Carbon Trade Exchange (CTX): This is the world’s first and largest electronic exchange for trading voluntary carbon offsets.
CBL Markets (CBL): This electronic exchange connects buyers and sellers of voluntary and compliance GHG emission products in both the North American and Australian markets.
CLIMEX: This exchange is a market leader in green certificates and emission rights through its auction platform and through direct trading between parties.
CME Group: In March 2017, the CME launched California Carbon Allowance (CCA) futures contracts in partnership with CBL. The CME also offers other global emissions contracts.
European Climate Exchange (ECX): This exchange, which was formerly a subsidiary of CCE, manages the product development and marketing for ECX Carbon Financial Instruments (ECX CFIs). These products are listed and admitted for trading on the Intercontinental Exchange (ICE) Futures Europe electronic trading platform.
European Energy Exchange (EEX): This is the leading energy exchange in central Europe. The EEX offers markets on emissions auctions and emissions secondary markets.
What Are the Main Environmental Commodity Trends?
Several long-term trends could create investment opportunities in environmental commodities over the next two decades:
- Climate Change
- Population Growth
- Environmental Regulations
There is ample evidence that climate is changing, and there is a growing consensus that human activity is contributing to these changes.
According to the US National Aeronautics and Space Administration (NASA), carbon dioxide levels in the air are at their highest in 650,000 years, and average global temperatures are 1.8 degrees Fahrenheit higher than they were in 1880. Seventeen of the 18 warmest years on record have occurred since 2001.
All of these facts are contributing to a growing global consensus that GHG emissions must be controlled and regulated, which bodes well for the environmental commodities markets.
Increases in the world population and demographic shifts could fuel demand for environmental commodities.
Two hundred years ago, less than one billion humans inhabited the earth. Today, the United Nations estimates that there are over 7 billion people on the planet. Today’s population size is roughly equivalent to 6.5% of the total number of people ever born!
Populations are increasingly moving out of rural areas and into urban centers. The World Economic Forum estimates that the number of people living in cities could reach 6.4 billion by 2050. The urbanization of the world will very likely lead to even higher GHG emissions. These trends could exacerbate an environmental crisis and lead to a call for more market-oriented solutions. The global environmental commodities markets could benefit from these trends.
There is growing evidence that countries across the world are taking GHGs more seriously and instituting regulations to curb them.
In the Paris agreement, China pledged to cut its carbon emissions by 60 to 65% by 2030, compared to its 2005 level. The country has also set a goal to raise its share of energy generated from solar, wind, nuclear and non-fossil fuels to 20% by 2030. China also intends to target 2030 as the year it reaches its peak carbon dioxide emissions.
China has is also beginning to take a tougher stance on pollution-causing industries such as mining. Crackdowns on environmental pollution have caused the shutdowns of more than half of the lead and zinc mines in parts of the country.
However, there is still important resistance to mandates on emissions reductions. The US withdrawal from the Paris Agreement may be an impediment to environmental commodity trading in the world’s largest economy.
What Are The Top Environmental Commodity Investment Resources?
Investors can find additional information on investing in environmental commodities from the following sources:
CME Group: This US futures and commodities exchange has detailed information on the suite of environmental commodities available for trading on its platform.
Environmental Protection Agency (EPA): This US government agency website has good information on RECs and how they work.
European Commission (EC): This legislative institution in the EU has detailed explanations of the cap and trade scheme in Europe and the dates for the implementation of different components of it.
European Energy Exchange (EEX): The exchange provides auction calendars and extensive product information on its environmental commodity offerings.
United Nations Framework Convention on Climate Change (UNFCC): The website for the UN agency responsible for the Paris Climate Accord has a comprehensive implementation timeline for the Accord and a plethora of reports on climate change, GHG data and other environmental topics. UNFCC also has PDFs detailing each country’s strategies to meet its obligations under the Accord.
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