The next big thing?

Carbon emissions credits trading could be popular in ME, as growing range of commodities becomes available to investors.
The next big thing?
By Daniel Stanton
Sat 01 Sep 2007 12:00 AM

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.

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.

Steve McMillan, CEO of IMEX (International Mercantile Exchange), is enthusiastic about the prospects for carbon trading.

I think carbon emissions opportunities in the Middle East are dramatic.

"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 think it's a massive opportunity for the region and 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."

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), 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 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."

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. 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.

"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."

In bad years for equities we’ve seen commodities do extremely well.

Another important diversification tool is gold. "It has been shown that if you include a proportion of gold in your portfolio - your dollar, euro, yen, sterling holdings - then it improves the overall performance, and in particular it limits downside risk," says Jill Leyland, economic advisor to the World Gold Council.

"A particular element of that which is important to many central banks including the Middle East region, is that gold is a dollar hedge." This could be a factor behind the Central Bank of Qatar's decision in May to add 3.1 tonnes to its holdings. This brings its total purchases this year to 11.3 tonnes, having previously held less than a ton.

"If we look more broadly at gold as an investment, the prime strategic long term reason is its diversification properties," says Leyland. "Basically, returns on gold are not correlated in general with many mainstream investment assets."

This can even turn into a negative correlation during times of stress. "In other words, it performs when you most need it to," she says. "That's the number one reason for anyone putting gold in an investment portfolio as a strategic long term move. Clearly in the short term there can be tactical reasons: for example, the fundamentals of the gold industry are looking very strong at the moment, which is one major reason why we've seen the price of gold rise."

However, the growing range of non-interest-bearing investments now available to regional investors could mean that gold becomes less prominent in Islamic portfolios. Three- and six-month sukuk now offer an attractive short-term alternative for Islamic investors.

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, if last month's performance is anything to go by: as world financial markets slumped, commodities prices were hit too.

Khianey of Emirates FX is bullish on gold and oil, regardless of their short-term movements. He also suggests that a more unusual commodity could prove attractive to traders - milk. With growing consumption of dairy products in new markets, combined with a drop in production caused by floods in the UK and the conversion of Indian farmland to industrial land, prices could be on the up.

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