Amid growing concerns about global warming and climate change, carbon credits could give utilities in the Middle East an economic incentive to reduce their emissions.
The environment has been a hot topic recently, and carbon emissions credits trading in particular. Companies that are energy efficient can build up an over-supply of credits, which they can then trade to organisations that produce a lot of carbon emissions. This has the potential to create a range of financial instruments based on the trading of credits.
There are signs that a carbon credit scheme could be successful in the Middle East, particularly within energy-producing countries. In the UAE, Masdar, an initiative by the Abu Dhabi Government to promote advanced energy and sustainability, recently signed an agreement with Dubai Aluminium Company Limited (DUBAL) to develop and register a project under the Clean Development Mechanism (CDM) of the Kyoto Protocol which will reduce greenhouse gas emissions associated with aluminium smelting.
I think the energy commodities sector is going to transform in the near future, helping create that price transparency.”Steve McMillan.
"We consider this project an important milestone in Masdar's goal to create a low-carbon culture within our national industries," said Masdar CEO Dr Sultan Al Jaber of the agreement.
The CDM project, which is one of the first of its kind in the Middle East, aims to monetise greenhouse gas emission reductions resulting from DUBAL's improved processes at its existing aluminium smelter at Jebel Ali. This could eventually see emission reductions being turned into tradable carbon credits.
Masdar now claims to be actively developing a portfolio of CDM projects in oil and gas, power, renewable energy and heavy industry.
Steve McMillan, CEO of International Mercantile Exchange (IMEX), is enthusiastic about the prospects for carbon trading. "I think it's a massive opportunity for the region," he says. "Carbon emissions opportunities in the Middle East are dramatic. Energy production in itself obviously creates opportunities to create carbon emissions reduction schemes and various other opportunities. I'd like to think we'll be involved in trading."
The carbon credit scheme is relatively new, and in Europe the financial industry is still considering how best to create derivatives from it.
"We're watching closely," says Firas Mallah, head of Middle East office, Dexia Asset Management. "The general market cap is fixed in terms of the volume of traded emissions and the prices could vary. This is very similar to a regular commodities trade where you can trade in instruments linked to carbon emissions such as futures, but I believe that at this stage with the volumes we see it is mostly straightforward carbon emissions unit trading.
"We think just like any other commodity you will have to wait for a larger volume before you have an active derivatives market on that."
Once a significant number of CDM projects have actually been registered, and come on-stream with the generation of carbon credits, we believe that will signal a process where the trading of such credits will be a logical next step.”Tilak Doshi.
However, the Middle East will need to show a commitment to reducing carbon emissions before trading in carbon credits is feasible. Tilak Doshi, executive director, energy, at Dubai Multi-Commodities Centre (DMCC), which has entered into a memorandum of understanding with Dublin-based firm EcoSecurities to work towards making Dubai the regional centre for carbon emissions reduction and trading, says: "For carbon credit trading to emerge as a viable activity in the Middle East, there needs to be a growing base of investments in carbon emission reduction technologies and processes.
"For example, the recent Qatar Gas investment in reducing carbon emissions from gas flaring has been followed by announcements of other Clean Development Mechanism (CDM) projects in the UAE and elsewhere.
"Once a significant number of CDM projects have actually been registered, and come on-stream with the generation of carbon credits, we believe that will signal a process where the trading of such credits will be a logical next step. We see this as part of the process where the Middle East region will emerge as an increasingly sophisticated trading hub. Dubai is likely to play a critical role in this."
Navin Khianey, business development manager at financial services firm Emirates FX, has looked into the carbon emission credits scheme in operation in the European Union and believes its implementation was somewhat flawed.
"The first mistake they made was that the allowance levels under the scheme were far too generous and excessive," he says. "In many cases, the carbon credits dealt out were higher than the actual amount of carbon produced in that particular economy.
"Secondly, the ETS (Emission Trading Scheme), or any carbon trading system, has failed to encourage any meaningful investment in carbon-producing technologies, which was one of the ideas that this would actually provide an incentive to invest money in other instruments that reduce carbon emissions."
The Emission Trading Scheme, or any carbon trading system, has failed to encourage any meaningful investment in carbon-producing technologies.”Navin Khianey.
Trading in financial instruments based on carbon emissions could be some time away for the Middle East, but growing trade in other commodities is expected to create new opportunities. IMEX, which will operate from Energy City Qatar, a dedicated industry hub, is likely to be used as an intermediary for trading Qatar's massive gas reserves, among other energy commodities. Trading in gas is a different proposition to oil: there is no cartel of producers, no common pricing mechanism, and a lack of price volatility.
IMEX's McMillan says: "If you look at the energy commodity space globally, outside of a few sectors there isn't really price transparency. I think that is the prerequisite of any marketplace. I think once you get to credible price transparency, all markets tend to grow quite dynamically at that point.
"Volatility is important, but at the end of the day, you can't have volatility until you've got price transparency and price credibility, and that's where we see the opportunity," says McMillan.
"Historically, a lot of energy products have been traded off price assessment services, as opposed to what I would call real, credible and transparent tradable pricing," he adds.
"I think the energy commodities sector is going to transform in the near future, helping create that price transparency."
More commodities are coming onto the local market: DMCC is looking to begin trading in gasoline futures, a contract for plastics, and what is believed to be the first steel futures contract.
"The gasoline futures contract will capitalise on the fact that gasoline is the only product in which the Mid East Gulf is net short, with Iran being one of the world's largest importers," says Colin Griffith, executive director, gold, DMCC.
Many investors are entering commodities as a way of diversifying their portfolios. Dexia Asset Management offers a commodities fund based on futures of the three major commodities indices: the Goldman Sachs Commodity Index (GSCI), the Dow-Jones-AIG Commodity Index (DJ AIG) and the Reuters-CRB futures price index (CRB).
"This gives flexibility and high liquidity, while making sure that we balance the fact that those three indices have different exposures to certain areas. If we have views on a certain commodity versus another we overweight or underweight one of those indices," explains Dexia's Firas Mallah.
Diversification is a key issue for investors in the Middle East. "A lot of the investors we talk to already consider the fact that most of their economy is linked to oil, directly or indirectly," says Mallah.
"As a revenue stream, they look to diversify away from oil, if anything. We looked at the correlations that commodities markets have with traditional asset classes and we found that they are actually very uncorrelated.
"Historically, with equity the correlation is about 25%, which is very little, and with bonds it's around -4%, which is quite small as well. In bad years for equities we've seen commodities do extremely well, and on very good years for equities, commodities have still fared well enough, but almost neutral or close to fixed income performance."
The greater range of tradable commodities coming onto the market gives the flexibility to manage risk and return. However, investors may need to diversify further to protect themselves, judging by the slump in world financial markets earlier this year, when commodities prices were also hit.
As for carbon trading, over 750 CDM projects are currently registered worldwide - but very few of those are in the Middle East.
The fact that utilities in this region are looking into renewable projects is a clear sign that they are willing to reduce their carbon footprint - but little has been said regarding their level of interest in carbon trading so far. Only once more CDM projects, such as that between Masdar and DUBAL, are registered, will the potential for carbon trading in the region, and in particular for trade hub Dubai, be fully realised.