What do "used" offsets mean for the carbon market?

It's probably important to highlight the fact that this doesn't represent a case of "double-counting", as I just heard on the radio. But it does mean that low-value certificates were essentially swapped for higher-value certificates, and that means someone who acted in good faith has gotten the shaft.

My question now is this: if BlueNext isn't taking decisive action to correct this, what value does it bring?

It might be a nuisance, but it would not have been impossible to immediately identify the unfortunate owner of these dubious certificates, figure out how much they had lost (perhaps by holding an immediate emergency auction to find out what the market will pay for them), reimburse them, then figure out a way to spread that loss among all participants, and then, finally, go after the Hungarians for restitution.

There may be something like this going on now, but it would have sent a strong signal to the market if it had been taken immediately.

You may be asking why it's the exchange's role, and the answer is simple: commodity exchanges from the Chicago Board of Trade to the London Metal Exchange have always done everything in their power to ensure that the product being moved around its warehouses is, in fact, the product people believe they are trading. This is a basic value that exchanges bring to the table -- just as derivatives exchanges bring the value of clearing and settlement to the market (which is why exchange-traded futures and options markets weren't racked by the scandals that swept the over-the-counter derivatives market in the last few years).

If exchanges don't take responsibility for the integrity of the products traded on their platforms, then they are little more than highly-sophisticated message boards.

I'd welcome feedback from the exchanges on this.

To clarify this a bit. I see there being two separate issues highlighted by these recent events.

The first issue is procedural and involves the ability of BlueNext and other exchanges to assure market participants are not defrauded on their exchange. There is obviously a responsibility for the exchange organization to regulate this, but there is a concurrent lapse by the trader who enters "used" credits back into the exchange even though the contract under which they were previously acquired allegedly forbid it explicitly. In this sense, the unidentified London trading house is responsible for bringing forbidden credits back into the exchange. This is likely the reason that the Hungarian parties on the front end of this mess have gone public already while BlueNext and the London trading house have yet to do so.

The second issue is more fundamental, and involves whether there should be such a thing as a "used offset" transaction. As you point out, this opens a window for arbitrage on a very large scale (Point Carbon has suggested Japanese companies may take advantage of this multi-million dollar opportunity). There is obviously then a clear jolt to market value, but the apparent acceptance of "used" offsets is what troubles me more and will likely be the major fodder for market opponents.

On the procedural issue, I guess the question will be who is responsible for preventing these products from being traded on an exchange. All of these offsets and allowances have serial numbers, and it shouldn't be that difficult to filter out the bad ones if we're integrated with the registries.

On the issue of "used" or "recycled" CERs, I'd like to take a stab at shedding some light -- but I'm really a voluntary and forest guy, so this should be seen as a best-effort attempt and not taken as gospel.

Basically, I understand that it is legal under some circumstances to swap a CER for an AAU (AAUs are "assigned amount units" that reflect a country's emissions relative to its Kyoto commitments. Countries that beat their targets have extra AAUs, and countries that fall short have to buy them).

A CER is not the same as an AAU, however. The former is generated from a specific project through the Clean Development Mechanism, and is an offset, while an AAU is an allowance that is given away.

Countries ARE allowed to swap their AAUs with CERs under the Kyoto Protocol, but it is up to individual countries and trading schemes to decide which types of CERs they want to recognize within their system. The European Union Emission Trading Scheme (EU ETS) does not, for example, recognize any offsets from forestry, even though the Kyoto Protocol does recognize them.

A "recycled" CER is, as I understand it, a retired CER that has been taken off the shelf, where it is replaced by an AAU, and then placed back in circulation. This essentially amounts to swapping an AAU for a CER.

I don't know exactly what the deal is with Japan, but I do know that the EU ETS does not allow the use of recycled CERs, even if someone puts an equivalent amount of AAUs off to the side, as was apparently the case here.

I'd really welcome clarifying comments on this -- as I mentioned above, this is a bit outside my area of expertise.

I'm not really sure any kind of arbitrage will be allowed here. It looks more like a trade that should be scratched as in-valid.

There are two distinct issues here:
1. Whether it is appropriate to allow countries to swap AAU's for retired CER's? With the benefit of hindsight it seems clear that this should not be allowed and therefore the rules need to be ammended. That's the nature of an evolving market - mistakes are identified and the gaps closed as quickly as possible. But to be clear, Hungary did nothing legally wrong - the rules permitted them to do this transaction and they sold the retired CER's to a broker who was fully informed that they were not usable for EU ETS compliance.
2. Somewhere in a chain of transactions after this initial trade someone committed fraud. They knowingly bought the cheap CER's and sold them as full value CER's to an unsuspecting party without highlighting the "tainted" status. This is pure fraud and we can only hope that we will see a shame faced trader in handcuffs before too long.

The after effects of this fraud have caused further reputational damage to the oft criticised EU ETS and as Mr Zwick said, the exchange and all the innocent people who have been unfortunate enough to have subsequently touched these CER's need to get together and close the issue down. It seems unfair that the last person holding the hot potato should bear all the loss - particularly if they have received the CER's via an exchange transaction.

So, after this issue is finalised, Europe will have learnt another lesson important lesson on how to run an an ETS and hopefully a fraudster will be convicted and put in jail. We look forward to the rest of the world, and the US particularly, introducing their carbon caps with the benefit of European practical experiences.....