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3. Price risk management tools

This section examines the price risk management tools and services available to mitigate the risk related to carbon price volatility. We first consider how the EU ETS has developed in size and in terms of the financial instruments available to participants, as an example of how other emissions trading schemes can be expected to evolve.

Secondly, we consider the relationship between the size of the participant and the transaction costs they face, including their ability to negotiate competitive prices.

3.1. EU ETS and Kyoto Flexibility Mechanisms

There has been considerable price volatility in the EU ETS market during Phase 1 (2005-7) with EUA prices reaching €31.6/t in April 06 and falling to €0.08/t in September 07. Whilst we don’t expect prices to collapse in this way in Phase 2 (2008-12), due to the ability to bank EUAs into Phase 3, there are significant price risks that will need to be managed.

Development of EU carbon market

The European carbon market includes both spot and forward trading of allowances. The forward market includes contracts with monthly, quarterly and annual expiration (typically December expiration) for the final year of the first trading period (2005-2007), and contracts with annual expirations (typically December expiration) for the second trading period 2008-2012.

Trading of EUAs is split between an over-the-counter (OTC) market and numerous exchanges. So far in 2007, exchanges have had around 30% of the market share, with the European Climate Exchange (ECX) taking over 80% of the exchange volume. Liquidity has increased significantly over the three years of trading. During the first 8 months of trading in 2007 an average of around 5,610,000 tCO2 traded each day, compared to 2,910,000 tCO2 and 743,000 tCO2 during the same time period in 2006 and 2005 respectively. Figure 3.1 shows the development of daily trading volumes from 2005 until September 2007.

Figure 3.1 Daily traded volume of EUAs (MtCO2) from Jan 05 to Sep 07

See figure at its full size (including text description).

One measure of the level of development of a traded market is comparison between the physical volume traded and the total physical demand (in this case, emissions). In 2006, this ratio for the EU ETS was around 0.5 (taking into account an estimate of the bilateral market size) and in 2007 YTD the ratio is around 0.9. Whilst this ratio is increasing every year, we note that in more developed markets such as the Nordic power and oil markets, this ratio is closer to 5.

Kyoto Flexibility Mechanisms

As mentioned above, the Clean Development Mechanism (CDM) and Joint Implementation (JI) market is split into a primary market, in which buyers invest in a particular project to receive the emission reduction credits, and a secondary market, in which buyers purchase credits (not associated to any particular project) from a seller with some guarantee of delivery (see section 2.4).

Several exchanges have now set up contracts that mirror the secondary CER market, for delivery in 2008 through to 2012. This has provided the CER market with more transparent price discovery and allows participants to simultaneously trade both EUAs and CERs on exchanges.

A large swap market has developed between these two credits. Any company in the EU ETS can import and use CERs to meet their target, as well as the usual EUAs. However, each government sets a limit on how many CERs can be used, typically 8% of the cap. This is an attractive option as CERs are cheaper than EUAs. For example, in the case where company A has more CERs than it can use within its limit, it may seek to swap its spare CERs for EUAs with company B that has not reached its CER limit. Company A gets to convert its unusable extra CERs for EUAs, on which there is no limit, while company B can still meet its target and benefits from the premium it charges for its efforts.

This deal structure is expected to extend to ERUs once the Joint Implementation mechanism, which is still in its early stages, has developed sufficiently. This market segment of CER-EUA swaps is growing in stature and typifies the increasing sophistication with which companies in cap-and-trade emissions trading schemes manage their risk.

3.2. Derivative markets

Derivative markets include various forms of futures and option contracts where no physical exchange of commodities will take place and these assist market participants in managing price risks. Derivative contracts involve a financial settlement between the parties which is determined by the difference between the contract price and an agreed price index. As of yet, the derivatives market for emission allowances is not very well developed and these currently represent a very small portion of the market size. The instruments available include:

  1. Futures: some of the allowance futures contracts can be considered as hybrids because a contract party can opt out of physical delivery and the contract effectively becomes a financial instrument;

  2. Calendar spreads: these can be used to capitalise on the idea that the price of EU emissions allowances change in a specific way between two expiration dates. This allows traders to take advantage of the price differences over time between the contracts;

  3. Options: the European Climate Exchange is the only exchange to offer option contracts on EUAs and Certified Emission Reductions (CERs) at present although other exchanges may follow suit as this market develops. Options are also carried out through the brokered OTC market;

  4. Swaps: a large swap market has developed for EUAs and CERs. This allows companies to import large quantities of CER credits into the EU ETS and to swap these for EUAs in order to respect the limits on the use of credits for compliance (see 3.1).

3.3. Hedging through other markets

The introduction of a pan-European CO2 price component into power prices has also led to stronger correlations between the various power markets. As well as this, CO2 costs have also had an effect on the volatility of power prices. This is because both power and CO2 prices react to some of the same fundamentals. For example, warm winters lead to lower power demand and hence fewer emissions, thus lower CO2 prices. As a result, power prices will experience a double downturn effect directly and indirectly through the CO2 pricing component. This means that an effective risk management strategy needs to consider the price risks in both CO2 and power (and related fuels) markets. Many of the players in the carbon market have positions in power and fuels markets as well, and so will be able to use hedging tools in these markets to position themselves within a suitable risk perspective.

As explained in section 2.3, weather is another important short-term price driver of CO2 as this not only influences energy demand but also the level of non-emitting renewable generation such as wind and hydropower. It is therefore possible to use weather derivatives as a tool in managing CO2 price fluctuations.

3.4. Financial Institutions

Financial institutions play a significant role in the carbon market firstly by adding liquidity to the market through their speculative activities but also through the products they offer. As well as products traded on exchanges and through brokers, financial institutions (and to a lesser extent some of the largest utilities) offer their customers a wide range of services in relation to the carbon market. These include:

  • Routes to market (either acting as a broker or trading on behalf of clients);

  • Portfolio management (maximising the revenue of a carbon portfolio);

  • Structured cross-commodity products (including EUAs, CERs, and other commodities – typically power and fuels);

  • Insurance products (relating to the delivery risks inherent with CDM and JI projects).

3.5. Summary

The carbon market is not yet as mature as many other more established commodity markets. However, in the case of the EU carbon market, there has been a 25-fold increase in the daily volumes transacted. There is a liquid spot and forward market both through brokers and on exchanges. Whilst the front years have most liquidity, it is possible to trade positions for the full time period of phase 2 (2008-12). The secondary CER market on the exchanges is also increasing in liquidity and this allows smaller players to access the CDM market without being exposed to the risks involved in the primary market. Finally, a number of financial products are developing, which is a sign of increased market maturity. These products should further increase the ability of participants to effectively manage their exposure to price fluctuations in the carbon market.

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