Market-based Solutions for Climate Change:

In the past few years there has been a whirlwind of market-based solutions for climate change implemented and/or suggested at all levels of government. The European Union got the ball rolling in 2005 with the European Union Emissions Trading System (EU ETS), which continues to evolve and remain central to their climate policy. In North America there has been serious action initiated by states and provinces. The Regional Greenhouse Gas Initiative (RGGI), driven by Northeastern and Mid-Atlantic states and focused on electric power generators, has been developing and enacting a regional strategy to reduce greenhouse gas (GHG) emissions which includes a cap-and-trade program. Elsewhere in North America, the Western Climate Initiative (WCI) has taken a strong stance, calling on members to reduce 50 to 85 per cent of carbon dioxide emissions from current levels by 2050. The WCI involves a number of initiatives, including a regional cap-and-trade program that targets many industries in a growing number of provinces and states.

American citizens and industry are holding their breath for presidential elections, where both candidates are suggesting instituting a market-based climate solution. Meanwhile, in Canada, the Conservative Government's Turning the Corner Plan proposes a “baseline and credit system” with 2010 as the initial compliance year. The system would target and regulate the emissions of a number of industries, including cement factories, energy producers, chemical manufacturers, pulp and paper, oil sands, etc. The government would establish targets and each year the emissions would be verified. The polluter would be left to equate its actual GHG emissions against its intensity-based GHG emissions reduction target. The discrepancy between the imposed target and the actual emissions may be offset by the purchase of emission reduction credits from other regulated polluters in Canada, the purchase of offset credits from non regulated polluters in the domestic market, by contributions to a technology fund, and/or by the purchase of Certified Emission Reductions under the Kyoto Protocol’s Clean Development Mechanism.

The Montreal Climate Exchange:

The Montreal Climate Exchange (MCeX), a joint venture between Canada's oldest exchange, the Montreal Exchange (MX), and the Chicago Climate Exchange (CCX) was established in 2006. The two exchanges came together, in the wake of proposed cap-and-trade programs and baseline and credit systems, with their respective expertise, to provide a market-based solution to help companies and all those involved in addressing the most serious environmental challenges, especially reducing GHG emissions. The MX brings knowledge of Canadian markets and expertise in trading systems, clearing, market regulation and financial risk management to this new partnership, the CCX is North America’s only voluntary legally binding rules-based GHG emissions allowance trading system. Just this past June, in Quebec, the Montreal Climate Exchange (MCeX) launched trading of futures contracts on Canada carbon dioxide equivalent (CO2e) units.

Futures Markets Explained:

Crude oil, electricity and natural gas end-users should be quite familiar with futures markets and futures contracts as financial markets for these commodities have existed for quite some time.

A futures market is a concept that grew out of forward contracts, which were established 150 years ago. In the 19th century there was mounting frustration amongst North American farmers who suffered from never knowing the demand or prices for their crops in advance. When supply exceeded demand, prices would crash and surplus crops would be left to rot in the streets. In the off seasons or when a crop did badly, prices would sky rocket. Forward contracts were contracts between farmers and buyers with a delivery date set for a particular point in the future. The parties would agree on a future price based on expectations for a set amount of a farmer's harvest. These contracts served to stabilize prices for buyers in the off and bad seasons and to save farmers huge losses when expected demand exceeded real demand.

Futures contracts, derived from the forward contract model, are a financial contract between two parties that agree to exchange either a set of financial instruments or physical commodities at a fixed future date with a corresponding volume and price. The party who agrees to deliver a commodity is the short position, while the party who agrees to receive the commodity is the long position. The long position has to post cash to cover all or a percentage of the position. Profits and losses are accrued on a daily basis as the market price of the commodity or financial instrument in question fluctuates. When the contract end date arrives the long position has the option to take delivery or settle financially. In the case of the MCeX, the carbon credits are the commodity in question, both regulated polluters and non-polluters will enter into contracts where each ton of CO2e will be priced according to expectations. Polluters will be shooting for the cheapest deal, while non-polluters will try to get the highest selling price possible. As the price rises the short position will experience profit loss and the long position will make money, and vice versa with a drop in price.

The futures market is a play place for both the risk averse and the risk loving, where hedgers and speculators, respectively, contribute to the dynamic nature of the market. Hedgers and speculators will trade contracts for the future delivery of carbon credits without necessarily having the intention of actually receiving or delivering the credits. As indicated above, hedgers take a position to guarantee a future price for their product, while speculators take a position with the aim of benefiting from the inherently risky nature of the market by buying or selling to make a few dollars based on predictions about declining or rising prices.

Conclusion:

Few will engage in the futures market, but many can use it as a tool in their financial planning. The real value of this market is 'price discovery'. Futures markets, by nature, are highly competitive and operate on the fast flow of a large volume of information about the real world that affects the commodity in question. A futures market is an economic tool to determine future prices based on today's estimated amount of future supply and demand. The market will provide potential stakeholders the price signals needed to measure the price of a tonne of CO2e. This provides the information needed to manage emissions risks at the lowest cost.