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Commodity / Emission Reduction Credits

Exploring the Emission Reduction Credits Market

A closer look into market dynamics, supply and demand factors, pricing trends and other factors shaping the ERCs Market.

A closer look into market dynamics, supply and demand factors, pricing trends and other factors shaping the Emission Reduction Credits Market.
Importance How it works Market Dynamics Supply & Demand

Future Trends

 

 
OVERVIEW

Emission Reduction Credits (ERCs) are tradable credits that represent the reduction of criteria-pollutant emissions as defined in The Clean Air Act.

ERCs only exist in Federal non-attainment areas – regions in the U.S. where air quality fails to meet the national ambient air quality standards (“NAAQS”). In non-attainment areas, stationary sources are subject to new source review (“NSR”), which may require new or modified air pollution sources to retire ERCs to receive an air permit, without which they may not legally operate. 

CO2 is not a criteria pollutant.  Criteria pollutants include ground-level ozone, carbon monoxide, nitrogen dioxide, sulfur dioxide, particulates, and lead. The most common ERCs are issued when facilities reduce their legally permitted emissions for precursors to ozone, known as oxides of nitrogen (NOx) and volatile organic compounds (VOC).

 

Importance of ERCs

Importance of ERCs

Environmental Impact

ERCs play a pivotal role in global efforts to mitigate climate change by incentivizing the reduction of greenhouse gas emissions. They promote the transition to a lower-carbon economy, supporting international climate goals such as those outlined in the Paris Agreement. By participating in ERC programs, companies can make substantial regional contributions to global sustainability efforts.
Economic Benefits

For businesses, ERCs offer a cost-effective way to comply with environmental regulations and achieve sustainability targets. Companies that reduce their emissions beyond required levels can sell excess credits, generating additional revenue. This not only enhances market competitiveness but also stimulates investments in clean technologies and sustainable practices.
Regulatory Compliance

ERCs assist organizations in meeting both national and international regulations on greenhouse gas emissions. By engaging in ERC programs, companies can ensure compliance with legal requirements while potentially profiting from their environmental efforts. This flexible, market-based approach allows businesses to choose the most cost-effective strategies for reducing emissions.

 

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HISTORY AND EVOLUTION OF ERCs

Origins of Emission Reduction Credits

ERCs exist as part of Federal programs passed during the Nixon administration to improve air quality as it directly impacts human health. Indirect effects of climate change are not covered in the Clean Air Act and are not managed with ERCs. Ground-level ozone, soot, and small particulate matter create breathing difficulty and tissue damage in humans. These effects are mostly seen in the population centers of the US where industrial activity leads to air pollution.

Current State of ERCs

There are three main non-attainment regions in the U.S., today:  California, Texas/Louisiana, and the Northeast.  Within each of these regions are specific air basins with unique regulations. In these individual jurisdictions, supply and demand conditions drive prices. Prices of ERCs vary widely depending upon the specific jurisdiction and the pollutant. While VOC in San Joaquin Valley California has recently traded for $175,000 per ton, VOC in certain parts of the Northeast may trade for several hundred dollars per ton. ERC market fundamentals change as credits are retired, as credits expire, or as new ERCs are generated through the banking process. 

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How ERCs Work

The US EPA requires that states regulate the permitting of facilities that will emit criteria pollutants in quantities that exceed the offset threshold. The offset threshold is defined by the specific non-attainment status of the air basin. An extreme non-attainment area will have a much lower offset threshold than a moderate non-attainment area. While a 4-ton NOx source would not require ERCs in Houston, the same source would require ERCs in Los Angeles. A new facility seeking an air permit that will allow for emissions beyond the offset threshold will trigger NSR & require that ERCs be retired. Before the state will issue an air permit that allows this new facility to operate, they must acquire & retire ERCs in the amount of their permitted emissions limit plus a small offset ratio which varies by jurisdiction (usually ranging from 1.1 to 1 on the low end to 1.5 to 1 in rare circumstances). 

ERC, compliance carbon, or LCFS markets served by AEGIS are highlighted in green.

ERC, compliance carbon, or LCFS markets served by AEGIS are highlighted in green.
ERCs are generated when a source reduces its permitted emissions by an amount greater than what is required through regulation. The most common situation is when a source shuts down & surrenders its air permit. The facility may submit paperwork to the state as part of the ERC banking process. If successful, the emitter will be awarded a fraction of their original permitted emissions limit in the form of ERCs. This allows for the continued permitting of new sources while prohibiting net new sources of significant stationary-source emissions. In other words, the negative impact on regional air quality from large stationary sources should only decrease over time. 
ERCs may generally be sold by the holder to any entity. Prices are agreed upon in each transaction and are not set by regulators. Economic development tends to drive demand, and prices tend to fall with demand in recessionary economies. In extreme cases, a lack of supply can lead to a business even shutting down in order to generate ERCs needed by another project with sufficient financial backing to compensate the former party. Transfers are managed by the state regulatory agencies and usually involve transfer fees charged by the agencies. Transfer fees range from about $100 to about $1,000 and can be charged per ERC certificate or per total transaction depending upon the agency involved.
Because ERCs represent reductions in regional air pollution having little to do with greenhouse gases which are global pollutants, they cannot generally be used across jurisdictions. Emission reductions in San Francisco have negligible benefits in New York. However, neighboring regions that share significant airflow may be eligible for inter-region use of ERCs often at an increased offset ratio. 
Market Dynamics

Market Dynamics

Anyone may purchase ERCs. In some cases, investors buy them and trade them like other commodities. Only a permitted source may retire ERCs, and only a permitted source may bank (generate) ERCs. These processes are managed by the regional air agency under the authority of individual states under the ultimate supervision of the US EPA.
These credits can be traded bilaterally, allowing companies that exceed their emission reduction targets to sell excess credits to others who need them to comply with regulatory requirements. This trading creates a financial incentive for companies to reduce their emissions and supports the development and implementation of innovative technologies and practices aimed at improving air quality.

 

UTILIZATION OF ERCs
Companies use ERCs to permanently offset their permitted emissions ensuring there is no net new, large, stationary source pollution of the criteria pollutant in question.
 
CAP-AND-TRADE PROGRAMS
Cap & Trade programs are not ERC programs.  They are an entirely different mechanism to achieve a different set of goals other than those defined in the Clean Air Act.  In cap-and-trade systems, a regulatory body sets a cap on the total amount of emissions that can be emitted by all participating entities. This cap is typically reduced over time to achieve specific environmental targets. Entities receive free allocations of instruments, known as allowances from regulatory bodies, and can purchase allowances (each representing a unit of emissions – in many cases, a metric ton of CO2 but other pollutants as well.) through auctions or the secondary market. If an entity has enough allowances to cover its emissions as required by regulation, it can save its surplus for future use or sell the excess allowances to other entities.
 
Cap-and-Trade Auctions

These are periodic events where allowances are sold to the highest bidders. Entities participate in these auctions to secure the allowances they need to comply with their emission limits. The auction process is transparent, and the prices reflect the current market value of the allowances. Examples include the California Cap-and-Trade Program and the Regional Greenhouse Gas Initiative (RGGI).
Secondary Markets

After the initial auction, allowances can be traded on secondary markets. Companies that have surplus allowances can sell them to others who need more to meet their emissions obligations as required by regulatory bodies. This trading can occur through organized exchanges or over-the-counter (OTC) markets, where buyers and sellers negotiate directly. Speculators, including financial institutions, hedge funds, and individual traders, participate in these markets, adding liquidity and potentially driving price movements.

 

VOLUNTARY CARBON MARKETS
Apart from regulatory markets, there are voluntary carbon markets where companies and individuals purchase instruments, known as carbon offsets, to offset their emissions voluntarily. These markets are not driven by regulatory requirements but by corporate social responsibility goals and consumer demand for sustainable practices.
 
Project-Based Offsets

In voluntary markets, carbon offsets are often generated from specific projects such as renewable energy installations, reforestation, and methane capture to name only a few. These offsets are verified by third-party organizations to ensure their validity and additionality, a complicated standard that is the subject of intense debate.  Additionally, in its purest form holds that the reductions would not have happened without the financial incentive to generate carbon offsets.
Carbon Offset Registries

Registries like Verra's Verified Carbon Standard (“VCS”), the American Carbon Registry (“ACR”), the Climate Action Reserve (“CAR”), and the Gold Standard issue voluntary carbon credits. These registries provide transparency and credibility, ensuring that the projects meet stringent criteria.
Supply and Demand Factors

Supply and Demand Factors

Several factors influence the supply and demand for ERCs, allowances, and offsets, driving price movements in the market:
Regulatory Changes

Changes in emission caps, the introduction of new regulations, or modifications to existing ones can significantly impact supply and demand. Tighter caps generally increase demand and prices, while more generous caps can lead to oversupply and lower prices.
Economic Activity

Economic growth can increase emissions, thereby raising the demand in the market as companies seek to comply with their limits. Conversely, economic downturns can reduce emissions and demand.
Technological Advancements

 Innovations in emission control technologies can affect supply and demand. For example, technological developments that reduce or eliminate emissions reduce supply as new facilities may not exceed the offset threshold and therefore do not need ERCs to receive an air permit.

 

Market Sentiment and Speculation

Like other financial markets, emissions markets are influenced by trader sentiment and speculation. Expectations about future regulatory changes, technological developments, and economic trends can drive market behavior and price volatility. Speculators add liquidity to the market, but speculator involvement generally increases prices and volatility. 
Weather and Natural Events

Events such as unusually cold winters or hot summers can impact energy demand and emissions, influencing demand. Natural disasters affecting industrial operations can also affect market dynamics.
Corporate Sustainability Goals

 Increasingly, companies are setting ambitious sustainability targets, driving demand in voluntary carbon markets for offsets. Consumer preferences for environmentally responsible products also contribute to this trend.
IMPACT OF SPECULATIVE TRADING
While speculative trading enhances liquidity and market efficiency, making it easier for businesses to transact, it also introduces price volatility. Businesses relying on ERCs and allowances for regulatory compliance need to manage the risks associated with this volatility. This might involve using financial instruments like futures and options to hedge against price fluctuations, ensuring they can procure the necessary credits at predictable costs.
 
Competitive Pressures

Speculative trading can drive up prices during periods of high demand or market optimism, making it more expensive for businesses that need to meet regulatory requirements. Companies must stay informed about market conditions and consider strategic purchasing and trading practices to manage costs effectively.
Strategic Planning

Businesses can engage in strategic planning, such as purchasing in advance when prices are lower or by entering into long-term contracts to secure a stable supply of ERCs and allowances at predictable prices.

 

PRICE TRENDS AND VOLATILITY
ERC and allowance prices can be volatile, influenced by the interplay of supply and demand factors. Historical data shows periods of sharp price increases due to regulatory tightening or supply constraints, followed by periods of stability or decline as markets adjust. Understanding these trends is crucial for businesses and investors participating in emissions markets.
 

Future of Environmental Commodities

Innovations and Emerging Trends

Technological advancements and new market mechanisms are shaping the future of emissions markets. Innovations such as blockchain technology for transparent tracking of credits and the development of new types of credits (e.g., blue carbon credits for ocean-based projects) are enhancing the efficiency and reliability of market-based emission reduction systems.

Long-term Outlook

As global climate policies evolve, tradable commodities are expected to play an increasingly critical role in achieving emission reduction targets. Expanding markets and continuous innovation in offset generation and trading will enhance their impact on global sustainability efforts, driving progress toward a low-carbon future.

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