Risks in Trading Carbon Credits
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Trading carbon credits is a new system that began in the 21st century. An early leader in this growing market was the Chicago Climate Exchange (CCX), founded in 2000 by Dr. Richard Sandor. The CCX also established the European Climate Exchange in 2005. Companies that emit greenhouse gases such as carbon and methane can purchase Carbon Financial Instruments through exchanges like CCX. This means they can buy credits from companies who exceeded targets in emissions reductions to comply with the binding contract of exchange membership.
Political Risk
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Carbon credit buyers assume political risks when they buy credits for greenhouse gas reductions from projects in other countries. Zurich Insurance describes this easily for the newcomer to carbon credit trading -- the host government can take actions that prevent you from realizing benefits of emission credits and political violence in a foreign country can disrupt the project's operations.
Financial Risk
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In some cases, the buyer of a carbon credit (i.e. a Carbon Financial Instrument) needs to ensure a project for which credits are bought will be completed. Companies such as Zurich Insurance provide the buyer with credit insurance to protect against commercial default (failure of the project) and political risks. If a buyer is going to buy credit insurance for political and commercial risks, the cost of insurance will influence the decision to buy carbon credits.
Information Risk
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One of the unique aspects of the carbon trading market is that it is founded by political arrangements within countries and between countries. The UK's Financial Services Authority published an important study of the risks in grading carbon credits in 2008. Jonathan Hill, Thomas Jennings and Evie Vanezi found an important risk to be information risk. The carbon trading market is new, and the trading of carbon credits has become a commodity (although not physical) securitized with derivatives (in a secondary market).
Transparency is needed. "As a politically-generated market, the quality of emissions trading markets is heavily dependent on the amount and quality of information available about emission quantities and allowances," according to Hill, Jennings and Vanezi.
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