The world of emissions trading is a confusing one. Its name is, strictly speaking, a misnomer, and it is driven by ecological concerns, overlaid by political machinations and executed within a red-blooded free market trading system.
Put in place by the Kyoto Protocol to reduce developed countries’ greenhouse gasses by 5% from 1990 levels, in two stages by 2008 and 2012, emissions trading refers not to the emissions themselves, but to the trading of rights to emit pollutants into the atmosphere. In Europe, this is governed by the caps on emissions at installations in member states in the EU’s Emissions Trading Scheme.
Trading, in itself, will do nothing to reduce emissions but by trading rights to emit, the costs of reduction are cut, which in turn helps polluters to comply with tighter limits. It is hoped that it will also incentivise them to establish cleaner technologies and policies – which, ironically, free up carbon dioxide (CO2) ‘credits’ that can be traded.
A trade takes place when it is cheaper for a party that wants to trade away the right to emit pollutants to eliminate its emissions than it is for an installation that wishes to buy those rights to reduce its emissions. This may seem convoluted but, ultimately, practitioners believe it will reduce overall emission levels and save costs.
In April, this thesis was borne out when EU data revealed that emissions for 2005 were significantly below expectations; this left many countries with surplus allowances and the value of CO2 credits collapsed. “We don’t know yet why last year’s emissions were below expectations – it is the first time that we have had reliable CO2 data – but emissions have come down,” says Lueder Schumacher, utilities analyst and member of the emissions group at Dresdner Kleinwort Wasserstein (DrKW). “The market mechanism is clearly working.”
DrKW has been a pioneer in the development of the emissions market. In 2001 it became involved with Hesse Tender, a pilot project aimed at trialling emissions reduction and establishing political support for the Kyoto Protocol, finally trading the first emissions certificates in Germany in 2002.
Finding solutions
“Early on, we saw how the issues surrounding emissions would affect a lot of our clients and wanted to be involved in finding solutions,” says Ingo Ramming, managing director in the emissions trading team. The bank subsequently executed the first emissions trade under standardised International Swaps and Derivatives Association (ISDA) documentation in June 2004; the first cash-settled trade in December 2004 (opening up the market beyond complying installations, to pure investors); and last June issued the first retail instruments linked to emissions rights for German private investors.
Mr Ramming says: “Clients began asking us how their businesses would be affected, what were their risks and how should they hedge those risks? We thought the best way was to establish liquid markets, so it was obvious that we should use ISDA contracts to create a market standard. Our first focus was to establish a market for compliance trading; the next aim was to open the market to financial investors [such as hedge funds] using cash settled contracts, which would help to build liquidity, and finally to broaden the market further to retail clients.”
The market is still small. Of the rights to emit 2.2bn tonnes of CO2 allocated each year in the EU, only 322m were traded last year. So far this year, 421m tonnes have been traded. Both of these are a long way from the one million tonnes that were traded in 2003, but why are trading levels nowhere near the full allocation?
Mr Schumacher explains: “We would only really expect those installations with a shortage of allowances to go into the market, therefore it is unlikely that the full allocation will ever be traded.”
That said, emissions trading will probably mirror trading in other commodities. Eventually, trading volumes will be multiples of the underlying product amount, says Martin Fraenkel, DrKW global head of commodities. “As the market continues to build liquidity and there is more hedge fund and other financial participation, the emissions certificates will get traded several times.”
Multidisciplinary response
DrKW believed the new regulations would have a broad impact on clients and that a multidisciplinary response was required, involving expertise in research, finance, trading, commodities and risk management. “Following on from what we learned during the Hesse Tender project, we developed an open infrastructure at the bank because emissions issues touch on so many different areas of the business,” says Mr Ramming.
For example, says Kamal Murari, global head of energy marketing, the links between emissions and other commodities markets, especially energy markets, mean that the pricing of various energy exposures is interrelated. Banks must therefore be organised to address client needs in a holistic way. “Corporates and other institutions will want to manage the full range of their energy exposures and banks have to be able to offer a palette of interrelated products to enable them to do so.”
Electricity providers are a straightforward example. Typically, such utilities use oil, coal or gas (the input) to generate electricity (the output). In the process, they produce carbon emissions. Some inputs, such as gas, produce less emissions than others, such as coal. Therefore the prices of inputs, outputs and the cost of emissions under the new regulations are closely related.
Managing ‘price risk’
“Utilities, and others, have to make a series of ‘price risk’ decisions – based on the cost of inputs, the likely price of outputs, the price of emissions and the subsequent choice of inputs. We help them to manage those risks,” says Mr Fraenkel. The development of a liquid emissions market gives clients much more control over how they manage their business, adds Mr Ramming. “Clients are able to pick and choose which of those risks they want to take, and which they would like to hedge.”
The emergence of a cash market – populated by investors such as hedge funds and, more recently, traditional institutional investors – is further developing the compliance market, or those installations that must comply with emissions limits. Financial participants provide liquidity to the market and drive development of more sophisticated and structured products to suit their investment needs. And that liquidity helps the compliance traders to hedge their exposures more efficiently, thereby encouraging greater use of the system.
Mr Ramming says this year there will be further “derivatisation” of the market, in which there will be a more liquid options market and more hybrid products. For example, one DrKW client was bullish on the future development of interest rates and the price of greenhouse gas emissions, and was looking for an investment vehicle to provide a packaged solution.
“This trade was extremely interesting from a relative value point of view towards the end of 2005 on the back of the flat/slightly inverted EUA [EU emissions allowance] forward curve,” says Mr Ramming.
The note was structured as a bilateral loan agreement (Schuldschein) issued by Dresdner Bank with a maturity of one year. It provided exposure to the interest rate and the emissions market, as the redemption was linked to both markets. “The client is able to generate yield pick ups if the interest rate stays below a certain barrier and EU allowances traded above the price at the trade date, and vice versa,” says Mr Ramming.
Another key driver will be project-based credits, such as those derived from clean development mechanisms (CDMs) – projects undertaken in developing economies that promote sustainable development and reduce emissions to below the level that would otherwise have occurred. Once certified, the reduction becomes a certified emission reduction, which is tradeable in the global emission trading scheme and can be used by developed countries to meet their reduction targets.
“For example, this year we have already put in place a hedging programme for a supranational involved in the CDM market, to hedge the price and convertibility risk of project credits. We provided the client with a long-term solution whereby they will sell us a specified amount of project-based credits at a defined price,” says Patrick Weber of DrKW’s emissions trading team.
Other opportunities
There are many other opportunities, says Michael Otto, associate, financing, specialising in emissions. One of those comes in the shape of corporates that have CO2 certificates sitting on their balance sheet that are not being used. “We offer them the opportunity to monetise certificates using repos or collateralised lending transactions. It is a valuable way to generate liquidity. The duration of the contract is flexible, being adaptable to the point of time when the corporate needs the certificates back,” says Mr Otto.
Initially many companies did not take emissions regulations seriously, believing that governments would make allocations so large that companies would be unaffected. But when the EU cut the allocations given out by Poland, companies took more notice.
“Emissions are increasingly central to corporate strategy,” says Mr Ramming. “Companies have responded to green issues, but have also realised that emissions trading can create real value in terms of improved cash flow and better earnings. Understanding that has been part of the transition process on the road to Kyoto.”
