By Grzegorz Peszko

Carbon Finance, 6 March 2009

This article also appears on www.carbon-financeonline.com

Negotiations over the sale of surplus Assigned Amount Units are gathering momentum, with a few deals already concluded. Grzegorz Peszko outlines ways to calculate a fair price in this nascent and opaque market

As a market for Assigned Amount Units (AAUs) is just emerging, there is little public information about prices, structures and terms of specific transactions. In the absence of information from a marketplace, the parties to AAU trades have to find a “fair” price that could stand up in parliamentary hearings and that would satisfy taxpayers’ concerns. While it is hard to define what such a price should be, there are alternative methodological approaches for transparent and fair price negotiations that are being applied, before the AAU market matures enough to reveal price information.

Four main approaches to establishing an AAU price are emerging:

• modelling;
• cost-plus method;
• auctioning; and
• benchmarking.

Modelling
AAU price estimates are sometimes derived from economic modelling of the hypothetical future price of carbon credits. Models can provide comprehensive and objective decision-making support, but are of limited use for today’s pricing decisions, when the AAU market is still immature. Even basic fundamental market analysis suggests that the market equilibrium price should be zero, because potential AAU supply exceeds expected demand.

However, a ‘positive’ AAU price is emerging because different market players have different trading strategies and some sellers will enter the market late, if at all. Many of these strategies are driven by short-term political considerations rather than long-term economic optimisation, hence modelling of this hypothetical market is inherently difficult. However, the possibility of banking them into the next commitment period adds extra value to pre-2012 AAUs. Lastly, the economic models treat all AAUs as homogeneous commodities, which they are not, given how sensitive buyers are to country and transaction-specific risks of AAU delivery and ‘greening’ – where revenues from the sale of AAUs are channelled to emissions-reducing activities in the seller’s country.

Cost-plus method
This method derives an AAU price from the unit costs of reducing greenhouse gas emissions. The idea is simple – the seller would not be willing to accept less, and the buyer would not be willing to pay more for an AAU than they would have paid to reduce the equivalent of one tonne of carbon dioxide in their respective countries. The buyer’s projected cost sets the AAU price ceiling, while the seller’s sets the floor. The seller could choose a specific greening activity, of which the marginal unit cost can be used as an indicative price for domestic emission reductions.

One version of this method derives a present economic value of AAUs from discounting the future compliance cost back to today’s terms1, on the assumption that AAUs can be banked into the post-2012 era. The minimum value of an AAU equals the price at which the seller is indifferent between selling the units now or keeping the surplus for future, when the country may have to either invest in internal abatement or buy credits to comply with caps.

This method is strongly linked to the greening programmes, or Green Investment Scheme (GIS), in the seller’s country. However, it delivers a price range rather than the particular contract price. It requires a lot of information, for example on the marginal – rather than average – mitigation costs in both countries. Unit costs for the GIS project should also be incremental, because AAU revenues will rarely finance the entire project. Furthermore, project costs would need to be known before the AAU Purchase Agreement is closed, which is rarely the case.

A number of conceptual and practical weaknesses limit the application of this approach in negotiations. It is used to determine price boundaries, rather than an actual unit price. This method is more suited to setting a floor price. Buyers will always have a choice between reducing emissions domestically or purchasing emissions credits. Therefore, the price of alternative Kyoto commodities, eg certified emission reductions (CERs), will establish the ceiling price.

Auctioning
AAUs can be offered for international bid and sold to the highest bidder. There are many different auction models, some more beneficial to sellers, others to the buyers2.

Auctioning is a politically acceptable, efficient and transparent method to discover an AAU price. However, auctions are more suited to selling homogeneous goods – AAUs are heterogeneous, as they are supported by different greening measures. Bilateral negotiations (also with several buyers) make it easier to incorporate buyers’ preferences into a transaction and pricing structure. Branding of differentiated AAU products may facilitate auctions in future. Sellers can also choose a quasi-auction approach – issue a request for proposals to several buyers, and then invite those buyers who meet minimum eligibility criteria, including price, for one-to-one negotiations.

Auctions may attract buyers of varying credibility and expose sellers to higher payment risk. On the other hand, new entrants, such as privately-held firms, could increase the number of potential buyers, strengthening the case for auctioning. To reduce payment risk, sellers may have to conduct due diligence of buyers’ credibility, establish eligibility criteria for bidders and hedge or transfer payment risk through contract structures (eg, through a letter of credit or other guarantees used in trade finance).

Some sovereign buyers are unwilling to engage in competitive bidding, particularly now when AAU trading is in the early stages and many uncertainties and risks remain, including reputational risks associated with greening. Officials may find it difficult to obtain a flexible mandate from their authorities, such as finance ministries or parliament, and may find it difficult to explain their choices after the event to taxpayers.

Auctioning is best suited to relatively small transactions with homogeneously greened AAUs. Auctions can provide additional efficiency and transparency to the price-setting process when there are more AAU deals and when benchmarks for greened AAUs are better known. This can be facilitated through improved standardisation of contract terms, in particular those on greening. This is why the European Bank for Reconstruction and Development, in consultations with several sovereign AAU traders (both buyers and sellers), has developed a publicly available template for greened AAU transactions.

Benchmarking
Benchmarking uses a proxy to establish a ‘fair’ unit price by taking an agreed reference price and adjusting it for transaction-specific risks. It can also be applied to price formulas.

A representative benchmark for AAU prices should be derived from the price that other market players have recently paid for the most similar commodity. There are at least four possible candidates for this price: greened AAUs, primary emission reduction units (ERUs), primary CERs and secondary CERs.

Actual AAU transactions will establish a natural benchmark over time, but, for the sake of comparison, all key terms of transactions should be known. This includes details of proposed GIS projects, because the AAU price will depend on the transaction-specific risks, such as greening risk. No such terms have been disclosed in bilateral AAU transactions concluded so far, and AAUs are not publicly traded yet.

From the sellers’ perspective, the most similar transaction would be the sale of ERUs from Joint Implementation projects, but, so far, few ERUs have actually been issued. Before issuance, ERUs have very diverse risk profiles, so a single benchmark is difficult to establish. A similar argument applies to primary CERs.

For buyers, secondary CERs are the best substitutes for AAUs, for compliance purposes. Secondary CERs are virtually free from project and delivery risk, and their reputational risk is low. Representing verified emission reductions and, in principle, sustainable development benefits to developing countries, CERs raise fewer concerns among NGOs about environmental integrity than other carbon credits, in particular AAUs, which are often associated with the negative label of ‘hot air’ despite greening efforts. But this also means that secondary CERs usually carry the highest price tag of all carbon credits available on the global market. Secondary CERs are widely, and publicly, traded on exchanges and thus have the most transparent prices.

Given the very low volume and transparency of AAU and ERU trading, and the absence of a secondary ERU market, the secondary CER price seems the most robust benchmark. The compliance risk of these instruments is the same. Environmental integrity remains the main value gap, but it can be bridged by the quality and integrity of greening of the AAUs.

In the second step, the benchmark is adjusted to account for risk components and how this risk is shared between the seller and the buyer. Price spreads are estimated for risk attributes related to the terms of the transaction and the integrity of underlying greening projects. Risk factors used to calculate spreads for pilot AAU transactions included:

• Kyoto compliance risks;
• greening risk (environmental and operational integrity of the greening plan; legal basis; procedures and criteria; GIS operator; implementation and crediting periods);
• structure of pricing and payments, eg advance payments, payments upon greening; and
• technology, region, country and any additional benefits (tied procurement, additional social/environmental benefits).

Price adjustments are not always based on measurable factors, so in the infant stage of the AAU market, a degree of discretion and intuitive judgments are inevitable. The price should be perceived as fair by both counterparties. Different methods can be applied jointly: the cost-plus method can establish an acceptable price range, in particular the price floor, while benchmarking can help achieve a single fair contract price within this range through bilateral negotiations or a quasi-auction.

The choice of price mechanism will be determined by the practicalities and political economy of AAU trading. In early transactions, sellers may find it more efficient and less risky to use simple approaches such as bilateral negotiations with sovereign government(s). Even in the case of auctions (or quasiauctions), sellers may want to set a floor price in a rational and transparent way, for example by using a cost-plus calculation or a benchmark.

For AAU trading to gain credibility, the early transactions, in particular between governments, should be fully transparent. There are no reasons for government buyers and sellers to keep the terms of transactions confidential and hide how public funds are used.

Because AAU trading is so vulnerable to abounding concerns about environmental integrity, it is the shared responsibility of buyers and sellers to ensure that the AAU price structure duly reflects the greening risk and to resist the temptation to “race to the bottom” with the quality of the GIS projects in exchange for lower prices and a quick sale.