The FSA has been passively monitoring the situation for some time. An unregulated section of the carbon credit trading market has been raising red flags all over the country. The watchdog says it has received an abnormal number of carbon trading schemes that purport to sell environmentally friendly, certified carbon credits, but in reality might be selling little more than empty promises.

When the UN Clean Development Mechanism came into practice in 2005, as dictated by the Kyoto Protocol, carbon credits worked to reinforce targets for countries to reduce their emissions of greenhouse gases. The Kyoto Protocol rightly predicted that some countries would miss their targets while others would go beyond them, and that this would generate a high-value market for the surplus credits. Global emission targets are reduced over time, so that by 2020 they will be 21 percent lower than in 2001, according to the EU Emissions Trading System. Together with partners like the European Commission, the UN Kyoto Protocol signatories have been under close scrutiny as they trade or use up their carbon credits every year. These regulated credits are known as certified emission reductions (CERs). Trade is diligently monitored by the appropriate bodies, the UN and its partners like the EU ETS, and credits can only be bought or sold between countries. As such, credits generally maintain a high market value.

The Kyoto Protocol limits the emission targets to countries, but individual companies saw the opportunity for business. Suddenly, there was a market for private emission credits that could be generated by any low carbon company, like a solar panel project or a forestry scheme. Any company has an unavoidable carbon footprint from its energy bill or its office waste and by purchasing carbon credits from other businesses, there is a chance of offsetting these emissions while investing in eco-friendly projects globally.

But in practice these voluntary emission reductions (VERs) schemes have taken on a life of their own. Largely unregulated, the carbon trade has evolved into a complex commodities market, with its own trade exchange, the Carbon Trade Exchange and countless traders selling different varieties of carbon credits to investors of varied experience. VERs have nothing to do with the original UN CERs and are loosely based on the Kyoto Protocol scheme, with brokers often pointing out that it is a growing market. Though not illegal, the trade currently falls outside of FSA jurisdiction leaving investors potentially exposed to misinformation.

The FSA has issued several warnings recently, explaining that carbon trading is by nature a highly speculative business that should be left to the most experienced of investors. And while there are some reputable businesses operating in the sector, such as JP Morgan which has a large Environmental Securities arm, and a handful of independent verifying standards authorities, the nature of the business means it is more susceptible than others to rogue traders.

Because VERs are voluntary and not enforced by a governing body such as the UN or the European Commission as is the case with CERs, they are reported to be worth pennies, with reports by the National Fraud Intelligence Bureau suggesting they are being offered to investors for over 100 times their value. The result is that investors can potentially be laden with over-priced, unsellable credits. “We suspect that many of these firms are essentially overseas boiler rooms or landbanking firms simply selling a highly dubious new investment product and jumping upon the green/eco-friendly bandwagon,” said Jonathan Phelan, Head of the Unauthorised Business Department at the FSA.

The financial watchdog has recorded many instances of traders cold-calling vulnerable investors and trying to convince them to invest in carbon credits using misleading information. “The caller may claim carbon credits are the new big thing in commodity trading, industries now have to off-set their emissions, the government is focusing on green developments or that it is an ever growing market,” says the FSA. ”While not all carbon credit trading schemes are a scam, it is often not made clear to investors that trading on these markets requires skill and experience.”

Brokers that trade in the VER market might be aware of the growing scepticism revolving around the unregulated carbon credit market. It is not uncommon for unscrupulous traders to try and dress up their image by offering other trades or commodities that are more verifiable, such as gold, silver or even fine wines. Sometimes the other commodities offered by brokers are perfectly legitimate, but in some cases they act as a front in order to make operations look more upstanding to enquiring investors. The broker will then offset their carbon trading against their other trading tools, in order to appear as a fully functioning, well-established and growing firm.

VERs are not only a threat to investors but can potentially undermine the CER market globally. NFIB warns that companies are not likely to purchase carbon credits from individual investors. “Companies will purchase carbon credits from other companies or brokers and these deals take a lot of time to set up and are heavily regulated – for this reason carbon credits are not investments that an individual can make money on.”

But large investment institutions such as BNP Paribas and JP Morgan have been profiting from VERs, but in their investment model the banks buy into conservation schemes, clean energy producers or ‘ecofactories’, and by sponsoring the programmes they gain access to their surplus carbon credits. Christian del Valle, environmental markets and forestry director at BNP Paribas in London, told The New York Times that for the time being, these credits have been shunned into the periphery of commodities trading and are only sold in the limiting voluntary carbon market because the international community has struggled to come up with new and effective regulation for emission credits during UN climate talks.  “There is growing impatience with the multilateral process, not only from practitioners such as myself, but more importantly, from many forest countries,” said del Valle.

Renewed investment in environmental projects by private institutions could help protect forest areas and develop green projects, but by failing to monitor and regulate voluntary carbon credits, governments are allowing sub-par credits to flood the market, leaving private investors at the mercy of cowboy traders. “Thus far the multilateral process has not delivered meaningful on-the-ground results, and forests continue to be lost because the only accessible price signal today indicates they are worth more cut down than standing,” said del Valle. Because of the lack of international consensus, the regulated CER market is also stalling as countries trade fewer credits each year.

Like many other commodities in Europe, the value of CERs has been sliding over the past few months, as slow demand has been exacerbated by weak economic conditions. There are fears that the market is already oversupplied. Excess credits have the potential to undermine the whole system, which is based around tight targets in order to guarantee high value credits.

In an attempt to stem the flow of unrequited credits, Connie Hedegaard, the EU climate commissioner, has announced steps to curb the amount of emission allowances to be auctioned in Europe before 2013. “The EU ETS has a growing surplus of allowances built up over the last few years. It is not wise to deliberately continue to flood a market that is already oversupplied” said Hedegaard in a statement published on the European Commission website. “This is why the Commission today has paved the way for changing the timing of when allowances are auctioned. This short-term measure will improve the functioning of the market.”

There is potential for the carbon market to make a difference in helping countries and companies to reduce their greenhouse gas emissions in a sustainable and cost effective way. But regulators must step in to ensure that rogue traders are brought to justice for misleading investors and selling in a market in which they have no place.