A Hong Kong-based startup, AEX Markets, is looking to launch a futures exchange in the city that would cater to mainland-China based generators of renewable-energy certificates in a markets-based environment.
“Carbon caps need a carbon market to trade, and that requires governance,” said Jeff Huang, founder of AEX Holdings, the company behind the prospective marketplace. He says Hong Kong’s Securities and Futures Commission can provide the kind of international regulation and standards that don’t exist in mainland China’s capital markets, while also offering Chinese power generators a home base and Beijing a trusted business arena.
AEX is a long way from a full launch, but it is now incubating a project within Cyberport, a government-backed technology startup institution in Hong Kong, that is meant to serve as a proof of concept. Huang hopes to attract multinational issuers and traders from global financial institutions – and convert some of them into AEX shareholders.
Cap-and-trade
The idea of cap-and-trade in carbon is to enable market forces to put a price on emissions. A government caps the total amount of fossil fuels its private sector is allowed to produce, and then establishes a market to trade those allotments. Polluters can pay to augment their output while low-carbon-footprint companies can get paid for their unused quotas.
Cap-and-trade is more effective than a simple, one-size-fits-all carbon tax, it provides a market-based price for carbon, and it helps companies prepare for decarbonization, as governments set schedules to gradually reduce their caps.
The concept has been around since the 1990s and first went live following the Kyoto Protocol (an early environmental accord) in Europe, Asia, and some US states (cap-and-trade was once a bipartisan effort in America but Republicans ultimately torpedoed a nationwide scheme).
In 2023, the global value of carbon markets was $949 billion, and they are growing fast. China has the biggest cap in the world, with a design allowing 3.5 billion tons of carbon-dioxide emissions from some 1,700 power plants, which are mostly state-owned power generators.
Cap-and-trade has its problems. Standards vary across borders, the schemes can be complex, and the system can be gamed – for example, some companies in China and India expanded emissions of greenhouse gasses unrelated to their business, just to recycle them and gain carbon credits. Some environmentalists dislike the idea of letting companies pay extra to pollute.
Futures markets
Proponents of cap-and-trade say the best answer to these qualms, however, is “more markets”, namely, futures markets. As in commodities, stocks and currencies, futures markets reduce transaction costs and foster transparency and stability.
Futures markets have been around for a long time: Osaka rice merchants pioneered a futures market in the sixteenth century. But the heart of modern futures trading is in Chicago. That goes for emissions too. Futures markets work by providing standardized contracts (as opposed to bilateral or over-the-counter forwards and swaps), that trade in a central marketplace, with the venue serving as a central clearinghouse to reduce counterparty risk.
Futures allow sellers to know their price by locking it in: they can hedge against the unknowns over time. Of course, one person’s hedge is another’s speculative gambit. Regulation and effective risk management, such as margins, are therefore necessary.
The track record of futures markets is consistent, however: if they attract enough liquidity, they stabilize markets through better price discovery and by lowering the frictions of trading. In other words, futures markets only work if they enable speculative as well as prudent behaviors.
Carbon futures markets exist for these ‘voluntary’ markets (as opposed to credits under compulsory government schemes), operated by the likes of ICE (Intercontinental Exchange, which also owns the New York Stock Exchange) and CME. The fintech world sees a rising host of new, smaller exchanges built on blockchain rails, such as Singapore’s Climate Impact X and AirCarbon Exchange.
China emissions
But in Asia, the big opportunity is to provide a futures market for the world’s biggest cap-and-trade nation: China. The problem is that China’s government is bent on promoting its own version of contracts that operate only in a primary spot market. Authorities view the speculative element of futures markets as anathema.
This is not unique to carbon: China doesn’t allow single-stock futures either. And more market-oriented regulators in places such as South Korea and Taiwan often ban short trading. This is why Asia remains unfertile ground for hedge funds or quantitative investors who use futures and other tools for hedging and taking positions.
This anti-speculator stance poses a barrier, however, to China’s cap-and-trade scheme realizing its potential.
Despite its size, China’s market for ‘Green Energy Certificates’ is riddled with inefficiencies. It launched these GECs in 2017 for a few renewable energy sources, mainly wind and solar. GECs were meant to provide a domestic alternative to the widely used international renewable energy certificate, or I-REC, used by mainland power generators and other carbon emitters.
International versus domestic RECs
An I-REC represents transferable proof that one megawatt hour (MWh) of electricity was produced from renewable energy sources and added to an electrical grid. I-RECs are administered by the International Tracking Standard Foundation, which is based in the Netherlands.
There are many types of energy certificates around the world, but I-RECs represent the leading global version. As of 2023 companies had issued 283 million of them, representing 283 terawatt hours of electricity. One terawatt represents 1 million megawatts. This scale and liquidity means I-REC prices tend to be very low, although those prices vary by market.
Chinese authorities, however, have made a decisive move to halt I-RECs in their market. I-REC prices are low because they enjoy an international secondary market, which Beijing regards as speculative. As in other areas of economic life, the government is eager to push its homegrown versions.
In 2023, the National Development and Reform Commission, the Ministry of Finance, and the National Energy Administration changed the cap-and-trade regime, expanding the types of renewables that qualify, although only those for solar and wind power can be traded. Companies must now issue GECs instead of I-RECs. There’s no secondary market allowed for GECs, although officials say they will allow a futures exchange for emissions to be developed in Guangzhou.
Trading renewables in China
China does have futures markets for more traditional commodities. In fact, its biggest markets, such as the Dalian Commodity Exchange, the Shanghai Futures Exchange, and the Zhengzhou Commodity Exchange, are among the world’s biggest by volume, although they are almost entirely domestic in nature, with trading in contracts unique to China (such as bitumen or eggs futures).
GECs are also just one type of renewable energy market in China. There are also spot power markets, power purchase agreements, and mandatory purchases of renewables. This complexity leads to different prices, so the expansion of GECs is meant to introduce a degree of standardization. But without a secondary or futures market, it will remain difficult for buyers of GECs to manage changes in macro conditions or the business environment.
GECs are growing fast. Companies issued 8.5 times more GECs in 2023, 176 million, than in the previous year. Buyers also redeemed 176 million GECs, representing 176 terawatt hours.
That’s big. Consider than in 2023, global emitters issued 283 million I-RECs. The GEC market is already 62 percent that of the leading global standard.
But big isn’t necessarily better. GEC prices by the end of 2022 were $7/MWh, but I-REC prices were far cheaper, at $0.75/MWh, according to ITSF. Prices vary depending on technology, origin, and other specifications. But the upshot is that it’s about ten times more efficient to trade carbon globally than it is in China.
(I-REC figures also include issuance from Chinese companies; these certificates will remain in circulation, but Beijing has ordered its state-owned enterprises to stop issuing I-RECs, and SOE power comprise the bulk of the mainland issuance.)
Enter AEX
Various tech platforms and markets are emerging around the world to trade I-RECs more efficiently, but that’s not going to happen in mainland China with GECs. For one thing, international investors don’t want to handle an asset that’s essentially controlled by the state, in which the data is unable to be shared overseas.
The idea behind AEX is to base a regulated futures market in Hong Kong where Chicago-style execution and clearing can address these market frictions, in a jurisdiction that’s part of the People’s Republic of China and is a vital capital-raising center for Chinese SOEs. Huang hopes this will mean he avoids the fate of I-REC in China.
The issuers are state-owned power companies but the buyers of A-RECs could be multinationals operating in China who produce goods there but face various international environmental regulations, and will need an internationally recognized certificate for those Chinese emissions.
A-RECs will help companies lock in carbon prices when they retire their renewable-energy certificates. Over time, various types of contracts will enable AEX to develop a yield curve, and extend the visibility of carbon prices across different maturities.
Jeff Huang and Richard Sandor
Huang, a Beijing native, has been involved in futures and climate-related products throughout his career, in both China and the US. He got his break by working for Richard Sandor in the 2000s.
Sandor created the world’s first futures contract for climate (for sulfur), and then founded the world’s first carbon trading venue, the Chicago Climate Exchange, which was later acquired by ICE. He was an early proponent (since the late 1960s) of exchanges demutualizing and becoming for-profit entities, and for also going electronic.
Sandor recounts in his memoir, “Good Derivatives”, that regulation – and clear property rights – played an important part in fostering this industry. The creation of the US Commodities and Futures Trading Commission in 1974 expanded the definition of commodities to intangibles, setting the stage for financial futures, catastrophe bonds, and emissions trading. CFTC rules also clarified that the trading of futures did not mean the underlying instrument was being traded (thus removing the Securities and Exchange Commission, with its retail investor protections, from the equation).
Properly regulated futures exchanges “democratized the spot market”, erased the asymmetrical advantages of entrenched insiders like big brokers, and made spot markets more transparent and efficient – provided the contracts were structured properly and attracted liquidity. “Markets should not be assumed to exist,” Sandor wrote. “Markets are created, and liquidity must be built.”
Herding cats
This will apply to AEX too, and Huang faces a Herculean task. He must convince mainland entities to issue his international-style certificates, called A-RECs. The registry will be built on blockchain, to enable provenance.
That in turn requires winning acceptance from various Beijing bureaucracies. He must also convince big global buyers, both other companies looking to purchase renewable allotments from China and financial institutions looking to make markets or invest in these assets. China’s commodities exchanges are basically black boxes to foreigners, who will not be encouraged by Beijing’s decision to kick out I-REC.
Huang has experience in bringing together US and Chinese interests. He worked for Sandor at the Chicago Climate Exchange in the mid-2000s, and advised CCX on establishing a joint venture in China.
Sandor was keen to take CCX abroad, and one of his projects was the creation of the Tianjin Climate Exchange. Huang helped with introductions to partners such as Chinese oil major PetroChina. He also brought in Sungard (now FIS) technology to operate the new exchange.
CCX became the only foreign entity to hold equity in a Chinese exchange, and Huang served as its assistant chairman. Today TCX trades the emission rights of sulfur dioxide, chemical oxygen, and greenhouse gases, and its shareholders have expanded to include the likes of Ant Group.
Hong Kong is the place
But TCX is a spot market and its participants are domestic. Huang says being subject to Chinese governance and regulation limits TCX’s appeal to foreigners and its impact in green finance. Meanwhile, he doesn’t see Hong Kong Exchanges and Clearing (HKEX) as able to fill the gap.
“My goal is to bring China into the twenty-first century with international trading and regulatory standards,” Huang said. “We can bring Chinese SOEs to Hong Kong where they can meet global financial institutions. Global liquidity can help China decarbonize efficiently, and create a global cap-and-trade, like QFII,” referring to China’s qualified foreign institutional investor scheme.
The pilot at Cyberport should launch in October. It is designed to prove these contracts can make money for buyers and market makers, and provide transparency into what is otherwise an opaque domestic market. Fundraising has been difficult, but if AEX can prove a futures market for China emissions can work, he hopes to attract strategic investors.
Success could also help Hong Kong reassert the viability of being a China-based international financial center, with a green tint.
Huang says he is calling his product ‘Carbon Connect’, a play on the existing StockConnect scheme between HKEX and its counterparts in Shanghai and Shenzhen.
“But the real ‘connect’,” he said, “is derivatives and price discovery. Core climate trading is spot, but it’s meaningless without a futures market.”
