Carbon emissions trading may not seem an obvious market for banks to tap, but growing numbers are doing so. And, far from being a ‘fad’, emissions trading appears to fit well into banks’ wider businesses.
Carbon emissions trading has begun to gather real momentum in Europe over the past 12 to 14 months as a result of the introduction of the EU’s Emissions Trading Scheme (ETS). The ETS is a legally binding cap-and-trade system designed and implemented to put EU member states on track to meet their Kyoto greenhouse gas emissions reduction targets. It sets a cap on the amount of carbon dioxide (CO2) emissions allowed in member states, initially during the 2005-2007 period, thereby making CO2 emissions a relatively precious commodity in a limited timeframe. Without prohibiting emissions beyond the set cap, it seeks to encourage compliance within it by penalising excess emissions and establishing a market in carbon credits.
Large installations
At present, the EU-ETS scheme covers only CO2 emissions from large, stationary installations. About 11,500 installations are involved in the scheme in the following five sectors: power generation, refineries, ferrous metals, pulp and paper, and building materials.
The headline figures do not immediately suggest that banks’ trading desks would be obvious entrants to the market. Altogether, the installations in the scheme were allocated 6572 million tonnes of CO2 for the 2005-2007 period but of those only a fraction have been traded – Barclays Capital estimates that just 400 million tonnes of CO2 had been traded by the end of January this year. Moreover, this activity was split between:
Some trades have been on a cash-settled basis, others have been physically settled by delivering the certificates. And even in the over-the-counter market, three forms of documentation have been used to support similar trade types.
Still, nearly all of the large all-service and investment banks have now established some sort of activity in the nascent emissions sector. They are there with good reason – not least because all the companies directly involved in the ETS form a good (and often profitable) part of their client base. These companies need to incorporate emissions management in their business and risk management strategy since any increased expenditure or income resulting from ETS compliance will directly affect their cash-flow and bottom line performance. The scheme also affects the type of investments that the companies need to make in their industrial facilities, the financing conditions they can expect and their credit risk ratings.
David Kitson, global co-head of energy trading at JPMorgan, says: “To me, the reasons behind banks’ involvement in this market are very compelling. They tend to be very efficient at market-making and at warehousing risks. Through our involvement in this market, we can help these firms to finance their credits as well as plant upgrades or any future installations that they may be building out.”
Commodities overlap
The most obvious area of overlap between emissions and banks’ regular capital markets businesses is in commodities trading. Paul Dawson, a director in the emissions business at Barclays Capital, notes, for instance, how the price of carbon allowances is linked to the prices of other commodities that his bank is trading, making it an obvious addition to BarCap’s large-scale commodities trading arm.
“Carbon prices are driven by the prices of coal and gas and, in turn, carbon prices have become a key driver of wholesale electricity prices,” he says.
“As a trader across a range of commodities, we therefore have to understand and participate in the carbon emissions market and, in doing so, we are also able to offer our customers the ability to manage their emissions-related risks,” he says.
Mr Dawson believes that monetising allowances will become increasingly important for these firms, which is another area in which banks can help. This is because allowances are allocated in advance every February, but the surrender of the previous year’s allowances does not happen until April. At any time, companies are therefore likely to be holding a year’s worth of allowances that they could monetise by selling or financing in repo transactions.
“Our experience in structuring financing and risk management solutions for customers means that banks like Barclays Capital are well placed to execute these types of transaction,” Mr Dawson says.
“As a bank, we can provide a very efficient route to the market and play a useful intermediation role for our customers, especially as we have a pan-European focus and a broader sectoral coverage than many other market participants, including the trading arms of some utilities,” he adds.
Cleaner projects
There is also a close link between emissions and project finance. To encourage companies to engage in emission reduction, the ETS also encourages investment in cleaner projects. For instance, a company implementing a clean development mechanism (CDM) project, such as a hydroelectric power plant, will receive certified emission reduction certificates (CERs) in return. These can be exchanged later for ETS credits that can then be sold on, and banks financing such installations can ‘forward purchase’ the emission rights, reducing the cost of capital for funding their implementation.
Ingo Ramming, managing director, new product development, in the capital markets group at Dresdner Kleinwort Wasserstein (DrKW), says: “Emissions trading has particularly strong potential in the field of project finance and gives project developers the chance to generate additional income sources by investing in efficient technology.
“Banks can apply modern derivatives technology to help to strip future emission rights and, by securitising these cash flows, they can either help to reduce the financing needs of a project developer or reduce their refinancing costs by embedding them into derivative instruments or other products,” Mr Ramming adds.
Pioneering role
DrKW first looked at the emissions market in 2001, when it was involved in a pilot emissions project in Germany. It has since played a pioneering role in the market, executing the first EU emissions trade under standardised International Swaps and Derivatives Association documentation, and later the first cash-settled emissions trade. DrKW also issued the first retail product linked to emissions rights, when in June 2005 it launched retail certificates for German private investors.
Mr Ramming adds: “The emissions business impacts on many parts of the bank and our wider group, fitting well into our capital markets business and affording synergies with other businesses in the Allianz group.”
UBS, which is also involved in the market, recently tied up with Diapason Commodities Management, a privately-owned Swiss commodity operator, to bring another innovative product to market. In March, the two firms launched the first-ever biofuels index, an index tracking a range of commodities used in the production of the two major forms of alternative fuel: ethanol and biodiesel.
The idea behind the joint venture was to develop an index that could be used as the basis for structured financial projects that offer exposure to the alternative fuels that should, in theory, be boosted by schemes such as the ETS.
Mergers and acquisition (M&A) transactions in the related industries are now also being affected by the emissions business, experts believe.
Mark Lewis, director in charge of utilities equity research at Deutsche Bank, says: “If one assumes there are going to be long-term constraints on carbon emissions, then there is going to be an incremental tightening of the carbon cap, which will in turn favour those companies that already have low carbon intensive portfolios. As a result, the generation mix will increasingly be taken into account in utilities-based M&A transactions.”
Because the immediate onus to reduce CO2 emissions has been put on the power generation industry, Mr Lewis says the impact of the ETS has also become a huge issue for the utilities sector. This means that analysts like himself have to distinguish very clearly between utilities that are heavily reliant on coal-burning plants and those with low carbon-intensive power plants.
He says the scheme has already had an economic impact on utilities companies such as British Energy. Because it relies on nuclear power generation, the company has performed very strongly over the past 12 months. “This is because the cost of carbon has been priced into the base costs of fossil fuel generators, which have had to absorb the opportunity costs of not selling their CO2 rights, and in turn this has pushed up wholesale power prices. That increase has translated into economic margin for nuclear generators like British Energy,” Mr Lewis explains.
Small but promising
Although there are only about 40 regular participants in the market today, which trade small volumes, bankers remain confident of the market’s future and their role in it. Aside from the currently traded raft of emissions instruments, they hope to be structuring hybrid or basket products soon, linking emissions exposure to exposures in other commodities, such as coal or gas, or even to interest rates. As the market gains in liquidity, a tradeable repo market may even emerge, offering holders a cheaper method of financing their stock and others a chance to short-sell in times of heightened pricing.
Jose Cogolludo, European head of commodity sales at JPMorgan, says that he expects the European emissions market to reach the same size as the German power market this year, but he adds: “There is clearly potential for it to grow far larger.”
