Following the birth of this pan-European burden sharing agreement in October 2003, trading volumes of European Emission Allowances (EUA) quickly reached 500,000 tonnes in 2003 (each EUA is equal to one tonne of CO2) and have since risen to 6.3 million tonnes in the year to the end of November. Alongside the companies directly affected by the scheme, financial market players have quickly been drawn in.
Energy market correlation
Part of the banks’ motivation is to understand the CO2 market because of its impact on other commodities that they are already trading. For example, the primary source of electricity across Europe is fossil fuels. Fossil fuels when burnt produce CO2 and if CO2 is going to become an input cost, there will be an impact on electricity prices.
“A good knowledge of the CO2 market is vital,” says Louis Redshaw, head of environmental markets at Barclays Capital. BarCap set up its two-man environmental desk in March to maximize the opportunities presented by the EU ETS. It aims to work with the existing commodity trading and sales team at the bank. “If you are long electricity, you are actually also long CO2. You might therefore want to sell carbon to hedge your electricity exposure. Alternatively, if you are short electricity, you might want to buy carbon to hedge against the element of the electricity price that is affected by CO2 prices.”
James Emanuel, a director at Evolution Markets, which specializes in structuring transactions and providing consulting and risk-management advisory services for energy markets, concurs. “You’ve got banks like Morgan Stanley, Goldman Sachs and BarCap for example, that are all heavily involved in energy commodity trading and they naturally have an exposure to carbon through their positions in the energy markets,” he says. “All these markets are inextricably linked, so if they’re buying power going forward and that power has a correlation to the carbon market, then they’ve got carbon exposure. The only way they can cover this is by directly trading in the carbon market. This has been a huge incentive for banks to participate.”
Hedge funds will also want to participate in the market and Claude Brown, partner at law firm Clifford Chance, expects that they will add significant momentum to it: “Hedge funds are constantly looking for asset type diversification and as they have already diversified into commodities, and other uncorrelated risks such as catastrophe and weather risk, they will see this as a further opportunity for diversification for them.”
Companies that are affected by the scheme can opt to invest in relevant technology to facilitate emission abatement. In such instances, companies might enter into an agreement with a firm that provides these services by buying the equipment with cash and emissions allowances. So, effectively, the EUAs can act as a form of loan collateral. Banks are certainly thinking this way.
“We view an EU allowance as hard currency, so it can therefore be securitized,” says Seb Walhain, director of environmental products at Fortis Bank. The Dutch bank set up its own environmental team on December 1 2003 with about 35 staff involved across the bank. “Consequently our lending criteria are softer,” he adds. “We have already issued loans to corporates where EUAs have been used as capital and we expect it to be an area that will take off as the scheme gets under way.”
Regulation and standardization
Although the emissions market is still in its infancy, trading of emission allowances in preparation for future compliance deadlines began in 2003. In February 2003, Shell Trading and Nuon Energy Trade and Wholesale announced the completion of a forward sale of a “significant volume” of first commitment period EU allowances by Shell Trading to Nuon. The sale of 200,000 assigned amount units (emission allowances) by the Slovak Republic to a large Japanese trading house was reported in March 2003, and in December 2003 the purchase of emission reduction units representing more than 400,000 tonnes of CO2 equivalent by the Dutch government from Bakony Power Plant, a Hungarian power producer, was announced.
Most of the trades in the carbon market in 2003 were forward trades. Trading in advance of compliance periods involves some risk. Consequently market participants have had to address the issue of transaction structures.
Surprisingly, only a few banks have undertaken this challenge, with DrKW, Fortis Bank and Barclays Capital leading the way. In June 2004, DrKW and Fortis Bank executed the first ever trade of EUAs using a contract adopted from the International Swaps and Derivatives Association master agreement. The use of an Isda master agreement for trading in the EU ETS was critical in facilitating the entry of banks and other financial institutions by allowing netting of open market positions in various markets between counterparties.
“Banks are subject to the most rigorous regulatory framework in order to protect the interests of their clients. The Isda agreement allows the bank to operate in financial markets while efficiently conforming to this regulation,” says Emanuel.
Barclays Capital and Shell International Trading and Shipping Company went on to complete the first CO2 emissions trade based on the official published version of this Isda contract a month later. The deal involved the trading of EU emission allowances for delivery in December 2005 at an undisclosed price.”We could have traded before but we wanted to wait for Isda to finally publish their documentation,” says BarCap’s Redshaw. “Our ultimate ambition is standardization of this new commodity full stop and that starts with trading documentation. Our motivation was to wait for that standardization so that we can push that standard document out to all our customers and hopefully achieve a standard form of governance of transactions.”
Price discovery
Last month Shell Trading and a large European corporate entered into a deal, resulting in EUAs trading for settlement in December 2008 at a price of €9/tonne of CO2. It marked an important point in the price discovery process for the later period of 2008-12.
But with an unmapped forward price curve, how accurate is this price? “At this point in time it’s impossible to calculate the price of an EUA in 2008 but that’s immaterial,” says Emanuel. “The importance of this trade is the ability for participants to now fix a price for the sale and purchase of allowances from 2008 onwards against which they are able to asses the viability of any investment in emission abatement. This is the true essence of the trading scheme.”
BarCap’s Redshaw also points out that aside from playing a key role in the drive towards industry standard documents, banks can offer competition. “If we compete with other traders in this market, we make the market more efficient,” he says. “As a consequence, the bid-offer spreads get narrower due to our participation and a company will be more inclined to enter this market and either invest in their energy efficiency process and sell off their excess allowances or buy them in to make up a shortfall, with the certainty that they are getting a good price in a liquid, efficient market.”
Banks are also establishing services to help companies manage counterparty risk. BarCap’s Redshaw refers to this as a route-to-market service. He argues that companies that are obliged to trade their emissions by the scheme are not generally keen or necessarily able to give out parent-company guarantees to a large number of companies. “If you want to trade in the market, then you’ve got to have trading agreements with at least 25 companies, if not more, to get the best prices that are on offer,” he says. “We can optimize that exposure and act as an intermediary to the wider market for those customers.”
While overall volumes are small compared with traditional financial markets, is there enough margin in emission broking and trading for the banks to make money? “There is a fee to manage a client’s administration but we really make the money by building up a natural position in the market,” says Fortis Bank’s Walhain. “By taking on clients’ orders and increasing the liquidity in the market, our position in the market is much better.”
It’s certainly a volatile market. Trading of CO2 emission allowances picked up in the summer once the European Commission started approving countries’ plans for setting CO2 emissions for industrial sites, ending uncertainty over the amount of quotas available. Trading volumes of EUAs hit 530,000 in July, a significant jump from 130,000 in June. But as trading volumes rallied, the price of EUAs almost halved from a high of about €13/tonne in Q1 2004 to around €7/tonne in July.
The price of EUAs was a key area of discussion at Euromoney’s fourth annual emissions trading conference last month. Atle Christiansen, director of Point Carbon, an independent analysis group that set up the Carbon Market Trader in April, a one-stop-shop on-line facility for traders, analysts and risk managers aiming to efficiently trade and hedge their carbon risk exposure, spoke about a number of factors that will determine price in this highly politicized market. “The fundamentals that will affect the price of EUAs range from weather to coal and gas prices to policy,” he said. “Companies can’t sit back. They have to know what to look out for so they can understand price formation and capture a good price.” Peter Vis, acting head of unit for industrial emissions at the European Commission, argued that if this trading scheme is to work, there has to be a scarcity of allowances to create competitive pricing and liquidity.
Trading volumes set to rise
In April 2004 the European Energy Exchange surveyed 200 companies from 13 European countries. The companies were asked to estimate the total trading volume in the EU for years 2005, 2006, 2007 and 2008-2012. The results showed that after a moderate start, a steady increase in the number of traded CO2 certificates is to be expected. Assuming a total allocation of 2,200 million tonnes of CO2 within the EU-25, the average estimate of the total trading volumes, based on a price of €7 per certificate, is €1.4 billion in 2005 and €4.2 billion in 2008.
“I’m not expecting trading to take off in any major way on January 1,” says BarCap’s Redshaw. “But once companies start to monitor their emissions and think about how they’re going to cover any shortfalls or surpluses they may incur, trading volumes will start to pick up.”
Trade sizes have been getting bigger too. “While the standard clip was about 5,000 EUAs earlier this year, it has since increased to 10,000 more recently, seeing also clips of 100,000 and even one of 400,000,” says Point Carbon’s Christiansen. “So we expect the standard clip size to increase further to 25,000 or even 50,000.” Most of these trades are conducted by counterparties seeking knowledge of how the market works.
BarCap’s Redshaw hopes there might be an opportunity to tap into smaller companies. “The headlines today are all about trades of 10,000 tonnes or 50,000 tonnes but what if a customer just wants to buy 1,000 tonnes?” he says. “We would like to be able to provide a route to market for smaller installations affected by the scheme. This is an area where there has been very little discussion and we are investigating ways in which to get that 1,000 tonnes or even 100 tonnes to a customer at competitive prices.”
Meanwhile financial market participants are already thinking ahead to trading emission allowance derivatives.
Because of the lack of a liquid underlying market and uncertainty as to the pricing of allowances, a full-scale derivatives market has not yet developed, although it is certainly expected to do so, once a liquid spot market emerges.
In anticipation of this, some European exchanges are launching new contracts based on emission allowances. Exchange trading will happen next year and at least five exchanges are looking to launch products based on the EU ETS, with the European Climate Exchange (ECX) and the German based European Energy Exchange (EEX) making the most noise.
The ECX, owned by the Chicago Climate Exchange (CCX), announced in September that it would offer ECX products on the International Petroleum Exchange’s trading platform, including futures contracts by the end of 2004 and cash contracts to follow in early 2005. However, it has since admitted that it had not anticipated the delays in the EU’s establishment of national registries. These are electronic databases aimed to enable the European Commission to regulate the companies affected by the scheme by monitoring issue, holding, transfer and cancellation of allowances.
These contracts are now scheduled to be launched in the first quarter of 2005. Peter Koster, CEO of ECX, says that these products will provide the liquidity that derivative players are crying out for. “Both emitters and financial institutions will hugely benefit from these products as they are standardized and cleared contracts, traded on a regulated exchange, offering both liquidity and price transparency.”
Like oil but without the transport cost
The products were introduced by Richard Sandor, who directed the launch of the CCX, which provides a similar greenhouse gas trading market in the US. This is a huge advantage for the ECX as it will have automatic access to an established customer base already trading on the CCX.
“We didn’t want to create a new electronic platform for these products,” says Philip Brown, UK director of ECX. “That’s why we chose the IPE as it is already cleared by the LCH.Clearnet and its existing customer base will be important players in the European emissions market.”
Several indices are already being talked about and the EEX was the first to start a CO2 price index at the end of October. It publishes a reference price for the trade in CO2 certificates throughout Europe on each trading day. At present, there are seven European energy corporations, including E.ON Sales and Trading and RWE Trading, participating in the EEX price determination procedure. The EEX argues that this reference price is based on transactions actually concluded and that it can hence be considered a reliable price benchmark. But Emanuel argues that a reliable index can only be based on a liquid spot market, in which settlement terms are standard and credit risk has minimum impact on price.
A swap market won’t take off until people can trust the depth of the spot market. Redshaw says: “If you buy an index and you are a physical participant, you ultimately want to turn that index exposure into a physical exposure through the spot market. But the spot market is unproven and unless it demonstrates it has depth, buyers that want to unwind their swap and physically hedge may cause the spot price to spike suddenly, which could mean a swap doesn’t actually give you a hedge.”
Like the ECX, the EEX is planning to launch a spot market for emissions certificates in January, which will operate over the same platform as the spot market for energy. “The infrastructure to create these products is already in place for the electricity market, so they are really an incremental addition,” says Hans-Bernd Menzel, chairman at the EEX. “By combining them with other energy activities, it keeps the cost down and will enable market participants to use a variety of products at any one time.”
Some sceptics regard the scheme as smoke and mirrors; that companies are merely swapping allowances rather than genuinely investing in emission abatement. But whatever side you take, it’s hard to find another viable means to help companies comply with the Kyoto Protocol. The EU ETS is an ambitious project and, like all other markets, there are clear financial gains to be made. However, these gains will only be possible if there is a scarcity of EUAs in the market.
As January 1 2005 draws closer, many wonder just how big this market could be.
“Due to its international nature, it has the potential to mimic the FX market in terms of high levels of liquidity,” says BarCap’s Redshaw. “It’s like oil but without the transport cost, so like FX, physical delivery doesn’t get in the way.”
