Tuesday, March 23, 2010

CO2 Market Rift Over Hungary May Shrink Trading, Investors Say

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March 23 (Bloomberg) -- The United Nations carbon market, the world’s second largest, is at risk of shrinking until regulators close a loophole that allowed Hungary to sell credits that aren’t valid in Europe.

The European Commission couldn’t stop ministers in Budapest from unloading UN emissions offsets -- surrendered once under Europe’s cap-and-trade system -- to traders planning to resell somewhere else, according to the International Emissions Trading Association. Some of the credits ended up back in Europe, bringing spot trading of UN credits to a standstill last week.

“What we’ve got here is faulty drafting by the commission,” Henry Derwent, head of the group whose members include Morgan Stanley and Barclays Plc, said in an interview. “It’s destabilizing to find some credits surrendered in good faith in the EU suddenly being used elsewhere in the world. There’s something fishy about that.”

To discourage what’s being called “recycling,” the EU regulator set emergency rules on March 18 to suspend the role Hungary and other nations played in collecting emissions credits from about 12,000 factories and power plants. Still, Hungary doesn’t rule out more recycling. Nor does Lithuania, said environmental adviser Laura Dzelzyte, who argued against “demonizing legal carbon trade” in a March 16 e-mail.

The fix announced March 18 may not provide enough comfort, Derwent said. The commission will still allow emitters to surrender offsets during a compliance window from April 19 to May 1, so there’s a chance some of those credits may improperly find their way back into the EU system, Geneva-based IETA said.

Two Kinds of Credits

Hungary’s transaction was possible and legal because there are two main kinds of UN carbon credits. One, known as Certified Emission Reductions, is accepted in Europe’s market, the world’s biggest. CERs are also known as carbon offsets because they are created when polluters or investors pay for emission reductions in poorer countries in exchange for the tradeable credits.

Hungary figured out how to swap its more valuable CERs for less-valuable UN credits known as Assigned Amount Units. These are known as Kyoto permits because they are used to comply with the emission targets set by a 1997 treaty signed in that Japanese city. They’re no good in the EU system.

Officials in Budapest were looking to sell some of their Kyoto permits when Deutsche Bank AG discussed selling recycled CERs, Jozsef Molnar, chief of staff for the environment ministry, said yesterday in an interview. The proposed sale never took place because it didn’t pass “due diligence” at Germany’s biggest lender, the bank said yesterday in an e-mail.

‘Wouldn’t go Away’

“Before Deutsche Bank came to us regarding the CERs, we hardly paid any attention to this market,” Molnar said. “But market interest about CERs wouldn’t go away.”

So the country sold 1.7 million recycled CERs for between 9 euros ($12.17) to 9.5 euros a ton, Molnar said. CERs closed spot trading yesterday at 11.76 euros on BlueNext exchange. The Paris-based market, part owned by NYSE Euronext, reopened yesterday after the emergence of recycled credits triggered a three-day halt.

“Hungary might be playing with fire,” said Emmanuel Fages, a Paris-based analyst at Orbeo, Societe Generale SA’s carbon-trading venture with Rhodia SA. “They are playing the rules but they’re not playing the spirit.”

The European Commission advised Hungary not to sell its UN offsets, Jos Delbeke, head of the commission’s environmental unit, said in a March 17 interview. The country didn’t listen.

‘Rather Unhappy’

“I’m rather unhappy that this oversight is being used to confuse the market,” Delbeke said. “It seems there are also financial institutions involved. You’ve got to ask whether they are shooting themselves in the foot.”

The fallout from recycled CERs makes it harder to convince the U.S., Japan and Australia to move quickly to follow the EU’s lead on emissions trading, Derwent said. “This is linking not working well in practice.”

The widening spread between UN and EU credits shows that investors are becoming more wary about CERs, Derwent said. CERs traded yesterday at discount of 1.62 euros to EU permits, compared with 1.45 euros on March 11, the day before the recycled sales were disclosed.

“The market is reflecting a degree of recognition that there is more risk involved in using CERs than there was before this story arose,” Derwent said.

Carbon investors at the Bloomberg New Energy Finance conference in London last week said the market may have suffered damage. Investors are now “questioning the authenticity” of what they are buying, said Paul Kelly, chief executive officer of JPMorgan’s EcoSecurities unit. Secondary trading of CERs may come to a “grinding halt” as traders question their validity, said Abyd Karmali, managing director and head of carbon emissions at BofA Merrill Lynch.

‘Carousel Fraud’

The emergence of recycled CERs is the third incident in less than a year to raise red flags in carbon markets. Last year, some EU governments said unidentified sellers of carbon permits engaged in “carousel fraud,” where traders disappear after collecting tax and before forwarding it countries. Earlier this year, Internet fraudsters conned factories out of passwords and then stole carbon allowances.

Hungarian Energy Power kft, the nation’s broker, said it sold recycled credits on the basis they couldn’t be resold for compliance with EU carbon limits, Jozsef Spenger, a director at the Budapest-based energy trader, said in a March 18 interview.

Microdyne Ltd., the London-based carbon trader that bought offsets from Hungary, said it advised its unspecified Hong Kong client they “were already surrendered once,” according to a letter dated March 18. Microdyne is prohibited from naming its client, according to the letter confirmed by the company.

Nations have “no need to engage in recycling of CERs,” said Imtiaz Ahmad, carbon trader and vice president at Morgan Stanley in London. “It creates uncertainty and anxiety in the market, and also directly undermines the intent of the Kyoto Protocol to reduce emissions of greenhouse gases.”

--With assistance by Zoltan Simon. Editor: Mike Anderson, Steve Voss.

To contact the reporter on this story: Catherine Airlie at cairlie@bloomberg.net Ewa Krukowska in Brussels at ekrukowska@bloomberg.net; Mathew Carr in London at m.carr@bloomberg.net

To contact the editors responsible for this story: Stephen Voss at sev@bloomberg.net

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