CO2 market brings windfall profits for generators

SINCE TRADING IN carbon dioxide emissions began to take off with the implementation of the European Union Greenhouse Gas Emissions Trading Scheme in January 2005, the price of an allowance to emit one tonne of CO2 has risen from €8 to about €27, hitting a peak of €29 in July 2005.

The emissions market, which sets a limit on the total amount of CO2 that industry can emit and which allows participants to trade emission permits, is already having a big impact on energy prices and consumption patterns, which could benefit renewable energy. The scheme appears to be working as intended, but is also having some unanticipated consequences, with surprising beneficiaries making what are effectively windfall profits from it.

Higher demand for coal and lower than normal reservoir levels in much of Europe, which means that less electricity can be produced from emission-free hydroelectric generation, has contributed to a steep rally in CO2 allowance prices since November. The price of an allowance to emit one tonne of CO2 rose from €19.75/tonne in November to more than €27/tonne in March.

At the same time as CO2 allowances have been appreciating, the gas-to-coal differential, the ‘clean-dark spread’, has narrowed in Europe because the price of gas has fallen and the price of coal has risen. Gas prices have fallen recently because of a more positive summer supply outlook; coal prices have increased modestly, driven by the colder and drier than normal winter in parts of Europe, as well as supply disruptions in South Africa.

The simultaneous high CO2 allowance price and compressed gas-to-coal switching price is significant, according to Merrill Lynch, because it could encourage a redirection of investment out of power plants using fossil fuels into generation based on renewable resources, which does not produce CO2.

This is because the total amount of CO2 permits in the market is such that substitution from coal to gas alone is unlikely to be sufficient to reduce actual emissions to the permitted level. With the cost of emitting more CO2 than a company has permits for at a prohibitive €40/ tonne, companies will be compelled, where possible, to do more than simply switch from coal to gas.

This can be costly. Power plants using renewable energy are expensive to build. However, renewable energy technologies benefit from big subsidies, which helps to make them more competitive.

Alternative attractions

“The run-up in oil and gas prices over the past two years has helped to level the playing field between renewable and thermal energies,” says Francisco Blanch, commodities strategist at Merrill Lynch. “After adding the carbon tax to thermal fuels, alternatives such as biomass or wind energy have become increasingly attractive, even before factoring in subsidies.”

Renewable energy is not the only option for companies faced with rising costs. They can also invest in more efficient technologies for existing industrial facilities to lower emissions or can create carbon emissions receipts through the Kyoto Protocol’s clean development mechanism (CDM).

The CDM enables companies from developed countries to invest in emission-reduction projects in less-developed countries and thereby gain tradable credits (CERs) for every tonne of CO2 certified as having been saved in these projects. Developed-country companies that expect to exceed their emissions allowances can buy these credits, which can then be used to meet their regulatory allowances. The rise in CO2 prices is encouraging more and more companies to take advantage of the CDM and then trade on CERs, which are becoming increasingly valuable.

In March, for example, French multinational speciality chemicals company Rhodia announced a project to generate close to 100 million CERs over seven years. Morgan Stanley estimates that this could earn the company between €468 million and €2.3 billion between 2007 and 2012.

The project involves two of Rhodia’s polyamide plants, one in Brazil and one in Korea. The plants release the potent greenhouse gas nitrous oxide (N2O), every tonne of which is equivalent to 310 tonnes of CO2

Rhodia plans to install combustion facilities at the plants to destroy the N2O they produce, thereby earning it CERs, which it will sell in the emissions market through a joint venture it is establishing with Société Générale Corporate and Investment Bank that will include both companies’ entire CO2 trading operations.

Hedging strategy

Rhodia has simultaneously announced the first stage of a hedging strategy with SGCIB that will involve the chemical company’s energy services subsidiary engaging in a forward sale of 8 million CERs. Of the 8 million, 6.5 million will be sold at a price of €15/tonne, raising nearly €100 million, to be spread equally over 2007 and 2008. The other 1.5 million CERs will be hedged using a price mechanism that is linked to the future price of CO2 allowances so that the firm can benefit from any further rise in emissions prices.

“We started to develop our emissions trading capabilities about 18 months ago when it became clear that CO2 was going to become a key component of the energy complex,” says Jerome Malka head of emissions trading at SGCIB. “The CERs generated by the project should help ensure that our joint venture with Rhodia becomes a key player in the CO2 markets.”

Although the emissions trading system clearly rewards companies such as Rhodia that can reduce their emissions, by giving them a valuable commodity they can sell, one surprising feature of the system is the way in which it has substantially rewarded some of the biggest polluters.

Ironically, it is electricity generators, which produce almost one-third of all CO2 emissions in the EU and are the single biggest group of polluters, that have enjoyed the biggest financial benefits from the scheme.

Franck Schuttelaar, analyst at Gaselys, an energy derivatives trading joint venture between Gaz de France and SGCIB that trades gas, electricity and oil, estimates that electricity generating companies in France, Germany and the UK have between them received a windfall of more than €4.6 billion over the past year, solely because of the introduction of the CO2 market.

The yearly windfall profits arise because there is a big difference between the market valuation of CO2 allowances and the real cost that they represent to power companies. Moreover, power companies in competitive markets can easily pass on increased costs directly to their customers.

The difference between the market value of CO2 allowances and the cost they represent to power producers stems from the fact that the vast majority of their allowances are given to them for free.

The EU emissions trading scheme, like the Kyoto scheme that is due to begin in 2008, aims to reduce CO2 emissions by a small amount over each phase. Under the Kyoto Protocol the EU has the collective target of reducing its greenhouse gas emissions by 8% below 1990 levels by 2012. The system is designed to be short of the total number of allowances needed so that the total volume of CO2 emitted should fall; allowances up to the target level are given to polluting installations for free.

The system’s allocations to the electricity generation sector were among the most short of requirements but even at a conservative estimate free allocations cover about 73% of the total emissions of electricity producers.

The price of CO2 allowances feeds into the price of electricity. However the impact of the CO2 price on the cost of electricity generation for particular generators varies greatly, depending on how their electricity is generated. Coal-fired plants produce a lot of CO2 per MWh, whereas nuclear and hydroelectric power plants very little or none at all.

Power companies need only buy allowances for the amount their emissions exceed the number of allowances they hold. However, they benefit all the time from the higher electricity price.

The size of the windfall to electricity companies, worth hundreds of millions of euros, is largely lost on equity analysts, who do not yet understand how the CO2 emissions market is affecting the business.

Accounting uncertainties

They aren’t the only ones not yet up to speed. The issue of how emissions allowances should be treated in accounts is still unresolved. Companies reporting after the first year of the scheme will be using a variety of methods, which could produce substantial variations.

The International Accounting Standards Board produced a paper, IFRIC 3, which proposed an accounting treatment for the scheme. However, this was seen as unworkable and was withdrawn in June 2005, leaving the field wide open to a variety of accounting treatments.

“It is fair to say that with the number of variables to consider there is scope for significant variation in terms of the accounting impact,” says Ian Francis, head of Ernst & Young’s utilities practice. “This means that there is a potential for inconsistency in the sector.”

Although industries other than electricity utilities also benefit from the allocation of free allowances, few can pass on their costs as easily as electricity producers in competitive markets. Although the situation varies significantly from country to country, depending on the fuel used for power stations, electricity utilities can also achieve easy emission reductions in the short term by increasing their output from gas-fired stations and decreasing output from coal-fired ones.

The situation has caused some concern, particularly in Germany where industry groups have complained to the Bundeskartellamt, the federal competition authority, that power companies E.ON and RWE are using the system to unfairly pass on the CO2 costs to customers.

Environmentalists might not have foreseen that the biggest polluters would be among the biggest beneficiaries of emissions trading but the possibility did not escape some of the pioneers of energy derivatives. Enron, for example, was well known for being among the most vocal champions of the introduction of a cap-and-trade emissions scheme in the US. According to Enron documents now released to the public, executives at the firm believed that such a system would “do more to promote Enron’s business than almost any other regulatory initiative outside of restructuring the energy and natural gas industries in Europe and the United States”.

The CO2 emissions market is still very much in its infancy. Trading volumes have grown but average just 3 million tonnes a day both on exchanges and over the counter. However, CO2 market consultancy Point Carbon expects the market to grow to a $40 billion annual industry by the end of the decade.

The second phase of national allocation plans is due to be implemented at the end of June this year and will determine the number of allocations available. It will also involve the entrance of some substantial players to the market, including the EU’s eastern members.

Given the structure of the system, which reduces the number of available allowances each year, and the difficulty at least in the short term of reducing emissions, investing in CO2, which an increasing number of participants are doing, looks like a good bet.

The emissions market is having a big impact on energy commodities and on industries. It also appears to be succeeding in its aims by effectively internalizing the cost of CO2 emissions and turning the tide in favour of renewable energy.

The clean development mechanism is also proving itself. “The CDM is a great success story,” says Garth Edward, head of environmental products trading at Shell Trading. “Around one hundred million tonnes of emissions are being reduced yearly and that means there is a capital flow of $1.5 billion to $2 billion from the developed world to the developing world that’s both good for the environment and good for development.”