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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.

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Geothermal Power Plant in Iceland – Image via Wikipedia

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:

1. Penalize polluters.

2. Reward clean energy production.

Cap and Trade

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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.

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Carbon Offsets
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.

Planting New Trees – Image via Wikimedia

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)

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These are RECs that are specifically generated by solar energy.

Solar Energy Farm – Image via Flickr

White Certificates
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.

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Pollution from a Power Plant – Image via Pixabay

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.

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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

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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?
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Several long-term trends could create investment opportunities in environmental

commodities over the next two decades:

1. Climate Change

2. Population Growth

3. Environmental Regulations

Climate Change
There is ample evidence that climate is changing, and there is a growing consensus that
human activity is contributing to these changes.

Projected Climate Change and Its Impact on Agricultural Yields by 2080 – Image via Wikimedia

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
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