Here's how Hong Kong's deep capital pool and access to China puts city in good stead to be the green finance regional hub

·11 min read

The final instalment of a four-part series on the United Nations Climate Change Conference (COP26) in Glasgow looks at how Hong Kong can play a role in reversing global warming. The first three instalments are here, here and here.

Hong Kong's track record as a mature international financial centre puts the city in good stead to become a regional hub for climate finance and the trading of carbon credits, but success will require hard work on setting a standard for disclosures and risk management, industry experts said.

In particular, the nascent business of private sector-driven voluntary carbon credits trading is tipped to see explosive growth and present great opportunities, even if the city - with a tiny industrial sector - is not forced by the government to undergo mandatory carbon trading.

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A working group formed by the city's securities regulators is expected to finish a report next month to assess the feasibility for the city to be the carbon trading centre for the Greater Bay Area, comprising nine cities of Guangdong province, Hong Kong and Macau.

"The development potential of this sector should be enormous, given the size of China's economy, leadership position in many clean energy technologies and ambitious targets," said Martin Hennecke, Asia investment director of UK-based St. James's Place Wealth Management, which oversees £140 billion (US$189 billion) in assets. "A mandatory carbon trading home market is not a prerequisite to a potential vibrant voluntary market, given Hong Kong's natural advantage as the international arm of China, and the very large trading volume and liquidity advantage of the local exchange versus other regional competitors."

Carbon contract spot prices on display during the inaugural trading at the Carbon Market in Shanghai on November 26, 2013. Photo: Xinhua alt=Carbon contract spot prices on display during the inaugural trading at the Carbon Market in Shanghai on November 26, 2013. Photo: Xinhua

Hong Kong, which hosts Asia's third-largest stock market and the world's fourth-biggest for foreign exchange, could pick "the lowest hanging fruit" by launching carbon credit derivatives accessible to the investors in mainland China and elsewhere, he said.

This could be facilitated by the cooperation between the Guangzhou Futures Exchange and its 7 per cent shareholder Hong Kong Exchanges and Clearing Limited (HKEX) to trade futures contracts in carbon credits.

A range of investment products backed by credits can also be created to help investors diversify their portfolios and hedge against inflation, two investment strategies that have generally performed well in the past few years, Hennecke added.

China, the world's largest carbon dioxide emitter last year responsible for 30 per cent of emissions, set up a mandatory carbon-trading exchange in Shanghai in July to drive the nation towards its net zero emission goal by 2060. The Guangzhou futures exchange was established in April.

How big is the worldwide market for carbon offsets?

Voluntary Carbon Offset Market 2019

Volume

Average price

Value

Source: Fitch Ratings, Ecosystem Marketplace, Forest Trends

"The Task Force on Scaling Voluntary Carbon Markets identified the lack of liquidity and inefficient trading processes as key barriers to wider development of the market, so Hong Kong's expertise in stock and foreign exchange markets can be very helpful," said David McNeil, a director specialising in sustainable finance at Fitch Ratings. The task force is a private sector initiative started by Mark Carney, the United Nations Special Envoy for Climate Action and Finance.

Bill Kentrup, co-founder of Hong Kong start-up Allinfra, which provides digital tools that make carbon finance more efficient, expects some carbon trading platforms "with global significance" and carbon investment products to be launched in the city in the next three to six months.

"There is quite a bit of activity going on," he said.

Hong Kong is not new to carbon trading, Kentrup noted. He co-founded Noble Carbon Credits - one of the earliest Asia-based carbon trading platforms, almost two decades ago, and led Macquarie Capital's Asia carbon credit and renewable energy financing business from Hong Kong.

"Noble financed CDM projects in Asia Pacific, Latin America and Africa, and managed some of the largest carbon trading books globally ... so Hong Kong does have a history in being a leader in this space," he said.

The so-called Clean Development Mechanism (CDM) was a carbon credits trading scheme under the United Nations-led Kyoto Protocol for climate actions.

A coal processing plant in the Shanxi provincial city of Hejin on November 28, 2019. Photo: AP. alt=A coal processing plant in the Shanxi provincial city of Hejin on November 28, 2019. Photo: AP.

There are two broad kinds of carbon trading regimes. Some are established by governments to enforce mandatory emission reductions, while others are voluntary schemes driven by the private sector and non-government organisations (NGOs). Both use market forces to tackle climate change.

Private-sector schemes mainly target companies and institutions seeking to meet their decarbonisation goals through "carbon offsets" by buying credits from project owners to make up for the shortfalls in their own carbon footprint reductions.

Different types of carbon credit markets have existed since 2005 when the Kyoto Protocol took effect, resulting in the establishment of the first international carbon trading system in the European Union.

Before expiring in 2020, the Kyoto treaty bound dozens of nations - mainly in Europe - to carbon cut targets which could be met by buying credits generated by verified greenhouse gases reduction projects in lower-cost developing nations.

Worldwide voluntary carbon credit market (2010 - 2021). alt=Worldwide voluntary carbon credit market (2010 - 2021).

Since the 2015 Paris agreement was adopted, over 190 countries have negotiated to create a new regime for internationally tradeable carbon credits, each representing verified reduction or removal of one tonne of carbon dioxide or the equivalent of other greenhouse gases.

A deal was reached last weekend at the United Nations Climate Change summit (COP26) in Glasgow, allowing countries to use offset credits from other nations to partially meet their climate goals. The mutual recognition of globally tradeable credits was a breakthrough as it led to more active and larger transactions among many more nations, compared to the CDM. In a compromise that further sweetened the COP26 deal, old credits from the CDM since 2013 - involving 320 million tonnes of reductions - will be carried over to the new regime.

To avoid double counting and deter abuses, countries that generate carbon credits can decide whether to export them to other nations, or to count them towards their own targets.

That closes the loophole in the CDM system that was the source of much criticism, where Asian manufacturers were called out for setting up facilities to eliminate fluoroform - a refrigerant and greenhouse gas that was more potent than carbon dioxide - after producing them in excess in the first place. After the double-dipping was exposed by environmental advocates, the UN tightened the credit rules for this category, and the EU banned their sale from 2013.

A freight train transports coal from the Gunnedah Coal Handling and Preparation Plant, operated by Whitehaven Coal, in Gunnedah in the Australian state of New South Wales, on October 13, 2020. Photo: Bloomberg. alt=A freight train transports coal from the Gunnedah Coal Handling and Preparation Plant, operated by Whitehaven Coal, in Gunnedah in the Australian state of New South Wales, on October 13, 2020. Photo: Bloomberg.

The demand for carbon credits is projected to skyrocket in the coming decades, as thousands of companies announced ambitious targets to shrink their carbon footprints to align with global climate efforts.

Almost one in five of the world's 2,000 biggest listed companies - with US$14 trillion in combined annual sales - have made some form of commitment to net zero carbon emission, according to a March report by researchers of The Energy & Climate Intelligence Unit and Oxford University.

Around 30 per cent are aiming to reach net zero by 2030, while just over half of them aspire to do so in 2041 or later. Around 40 per cent have indicated they will need some carbon offsets to reach the goals, while only 8 per cent ruled out using them. The rest have not specified their intentions.

Cutting 23 billion tonnes of carbon dioxide emissions - more than double China's entire footprint last year - by 2030 is needed to meet the 2015 Paris global climate agreement, which aimed to contain global warming to 1.5 degrees Celsius by 2100 from pre-industrial levels.

Sheep at the New Zealand Agricultural Greenhouse Gas Research in Palmerston North on March 5, 2012. Their belches are meticulously measured, part of a New Zealand research programme to slash emissions that farm animals contribute to climate change. Photo: AFP alt=Sheep at the New Zealand Agricultural Greenhouse Gas Research in Palmerston North on March 5, 2012. Their belches are meticulously measured, part of a New Zealand research programme to slash emissions that farm animals contribute to climate change. Photo: AFP

Some 2 billion tonnes will have to come from projects that remove it from the atmosphere, according to a report published in January by Carney's task force.

This would require a 15-fold jump in voluntary offset volume by 2030 from 2019 levels if all of the removal projects are financed by carbon credits, the task force projected, creating a market worth up to US$50 billion. The market could quadruple to US$200 billion by 2050, according to a forecast by the German bank Berenberg.

Voluntary credit trades are currently mostly done through bilateral negotiations. Project details and certified credits are lodged at registries run by crediting programmes such as Washington-based Verra and Switzerland-based Gold Standard.

Some trading is done via platforms such as Singapore's AirCarbon Exchange launched in 2019. It deploys blockchain technology to increase trust, through immutable files of electronically stored data. Nascent Climate Impact X completed a pilot auction of carbon credits backed by a portfolio of forestry projects on November 1. The carbon exchange set up by DBS Bank, Singapore Stock Exchange (SGX), Standard Chartered Bank and the city state's sovereign fund manager Temasek will host regular auctions from early 2022.

Further afield, the London Stock Exchange announced on November 5 that it is developing a capital markets solution to facilitate the public listing of carbon funds.

The April 19, 2021 opening ceremony of the Guangzhou Futures Exchange, in which Hong Kong Exchanges and Clearing Limited (HKEX) owns 7 per cent. Photo: Handout alt=The April 19, 2021 opening ceremony of the Guangzhou Futures Exchange, in which Hong Kong Exchanges and Clearing Limited (HKEX) owns 7 per cent. Photo: Handout

Trading of voluntary credits had grown in leaps and bounds, with 2020s transactions volume surging 80 per cent from a year earlier to 189 million tonnes. Since 2005, a total of US$1.74 billion of trades have been recorded. In the first eight months of this year, 293 million tonnes of voluntary credits were traded by 172 companies, at an average price of US$3.1 per tonne, according to Ecosystem Marketplace.

Prices are low due to a surplus of unused carbon offset credits, McNeil said. "A two-tier system of low-cost, low-quality and high-cost, high-quality offsets is the most likely outcome in the absence of a global agreement on international emissions trading," he said.

Prices should rise to US$20 to US$30 a tonne by 2030 for the world's emissions reduction efforts to be credible, according to a report by Trove Research and University College London.

"We are only at the beginning of the [growth] journey," said Matthew Townsend, a London-based partner at international law firm Allen & Overy. "There is a significant way to go to inject sufficient price transparency into the market and other aspects of governance."

The world's major carbon dioxide emitters in 2020. Source: BP Statistical Review of World Energy. SCMP Graphics alt=The world's major carbon dioxide emitters in 2020. Source: BP Statistical Review of World Energy. SCMP Graphics

"We need a single set of rules which determine what projects will be eligible, and provide sufficient legal certainty and veracity to the credits," Townsend said. "There is much more work to do to set up the framework for voluntary markets to function properly, whether on sectoral or regional basis."

A major milestone in the global regulation of sustainable finance was crossed on November 3, when various international standards setters agreed to consolidate and unify their rules. A prototype of disclosure requirements was published.

Ashley Alder, the chief executive of Hong Kong's Securities and Futures Commission (SFC) also chairs the International Organization of Securities Commissions (Iosco), and he expected the prototype standards to be endorsed by the end of this year.

He hoped Hong Kong's regulators will be able to finish incorporating them into companies' audit and listing rules by the end of next year or early 2023.

This would help build a strong foundation for growing green finance - including carbon credits-backed investment products - in Hong Kong, whose ambition to become a sustainable finance hub is "seriously realistic," he said on November 5.

Still, investors need to be aware of transparency, liquidity and the technology risks of projects on which credits are earned and traded, as they often involve complicated measurement and governance issues.

In forestry, one of the more prominent industries where voluntary carbon credits have been traded, ascertaining that sellers have sound legal rights and land titles are part of the due diligence process that is key to ensuring the credits generated are worth what they were traded for, said Allen Overy's partner Scott Neilson in Tokyo.

"It gets quite granular and complicated ... some trees grow faster and sequester more carbon dioxide, while regenerative agriculture practices that enhance crops' resilience to climate change give rise to different levels of carbon dioxide absorption and releases," he said.

The voluntary market is expected to see significant growth in the next 18 months with the launch of multiple sector-focused schemes, Townsend said.

"The next two years will be critical," he said. "Realistically it will take two to five years for the markets to settle down with robust transparency and rule books."

This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2021 South China Morning Post Publishers Ltd. All rights reserved.

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