A surplus of carbon offsets has caused a dip in certified emission reduction (CER) prices, reported Reuters last week. The news agency further predicts that carbon credits are yet to hit rock bottom.

On Oct. 14, CERs reached a price of €7.13 per unit – an all-time low. Their value slightly recovered later in the day, climbing to €7.28 per unit.

CERs are carbon credits issued under the Clean Development Mechanism (CDM) – one of three flexibility mechanisms stipulated in the Kyoto protocol by the United Nations Framework Convention on Climate Change (UNFCCC). CDM allows industrialised countries to achieve their emission reductions by investing in offsets generated by projects in developing countries. The CDM Executive Board then evaluates the carbon reducing capacity of these offsets and issues carbon credits.

In the current sluggish economic conditions, the market has seen a record number of issued certified carbon credits, explained Reuters. So far this year, 254 million CERs have been certified. In comparison, the number of CERs certified in 2010 was 132 million and in 2009– 123 million.

But are low carbon prices so bad after all? Not quite, if you ask Tim Worstall, fellow at the UK Adam Smith Institute. The dropping price of carbon credits, explained Worstall, means the system is, indeed, working, which is “excellent news.” In an article for Forbes magazine, he writes: “A high price would show that it is difficult to reduce [emissions]: people are willing to pay the high price for the permit rather than stop emitting. Similarly, a low price tells us that people are finding it easy to reduce emissions.”

But beyond the environmental functionality of emission units, their lower costs might even bring some investment benefits. The timing is, perhaps, ideal for investors to forward-buy carbon credits, considering that in 2013 the EU ETS will be entering its third phase. According to the Department of Energy and Climate Change, one of the main adjustments that will occur post 2013 is that allocation of emission certificates won’t be done via allowances, but via auctioning. This means parties, which fall under the compliance program, will have to bid for CERs.

“At least 50 per cent of allowances will be auctioned from 2013, compared to around 3 per cent in Phase II. This will improve the environmental effectiveness and economic efficiency of the EU ETS. In the UK, there will be 100 per cent auctioning to the power sector. This will also be the case across most of the EU,” states the DECC website.

In addition, access to project credits under the Kyoto Protocol from outside the EU will be limited to no more than 50 per cent of the reductions required in the EU ETS.

These changes will affect CER prices in two ways: 
1. Limiting the number of allowances and making polluters bid for their offsets after 2013 means that, in 2012, right before these changes take effect, more industries would want to take advantage of pre-auction costs and stock up on credits for future use. Higher demand in 2012 could subsequently lead to higher prices for CERs.

2. Limited access to carbon credits produced outside of the EU — in, say, China-means the cost of CER production will go up. After all, developing offset projects in Europe typically costs more than outsourcing them to China. Higher production costs will lead to higher prices after 2013. Again, polluters would want to take advantage of pre-Phase III carbon credit prices, which can potentially drive up demand in 2012 and help carbon credit prices bounce back sooner rather than later.

Carbon credit prices are, of course, influenced not only by the evolution of the EU ETS, but also by the overall state of the global economy. It would be unreasonable to look at them as commodity units, which exist in a vacuum. Therefore, we cannot exclude the possibility that the overall decline in commodity prices and the financial market crunch can adversely affect carbon trade.

We also have to bear in mind that the Kyoto Protocol, the very agreement under which these units are defined and exist, is due to expire in 2012. The compliance carbon market will likely see some changes depending on which signatory countries re-commit to reducing carbon emissions and which, if any, pull away.

Moreover, revisions of the Kyoto Protocol might also lead to an increase in emission reduction targets.