Don’t get caught out: tricks to survive the UK emissions trading marketDon’t get caught out: tricks to survive the UK emissions trading market

Introduction

Launched on 2 April 2002 and comprising 34 directly participating organisations (see edie news story), the UK Emissions Trading Scheme (ETS) also presents an opportunity for all 6,000 companies party to Climate Change Agreements (CCAs) (see edie news story) to use emissions trading to either help meet targets, and therefore minimize the risks of losing their Climate Change Levy (CCL) rebate (see edie feature), or to generate extra revenue through selling any over-achievement.

Risk Management

To companies exposed to the CCL, the rebate is worth anywhere from a few thousand to millions of pounds. For companies that are in danger of missing their targets, and therefore losing their rebate for at least two years at the end of the compliance year – for some this is as early as September 2002 – there are a number of solutions available, such as product mix algorithms, tolerance bands and relevant constraints. However, there is significant risk in relying on these options if they have not been approved by the Department for Environment, Food and Rural Affairs (DEFRA), or they may not be sufficient to cover the entire shortfall. Also the cost of installing the necessary sub-metering for algorithms may be prohibitively high.

Purchasing sufficient allowances (1 allowance = 1 tonne CO2 equivalent) in the emissions market to cover any shortfall in meeting CCA targets provides a tool that allows participants to confidently ensure targets are achieved and the CCL rebate is retained. Companies holding excess allowances own a commodity which has value in the UK emissions trading market, through selling or which can be banked freely until 2007.

Most CCA participants hold ‘relative’ targets, which are measured in energy efficiency or emissions per unit of output. The 34 participants in the ETS have ‘absolute’ targets, which involve total emissions in tonnes of CO2 or total energy used. Whereas an absolute target caps the total emissions, a relative target actually allows total emissions to increase if companies meet their energy efficiency targets.

CCA participants with energy efficiency or ‘relative’ targets can use allowances from either the absolute or relative sector for compliance. In the absence of allowances from the relative sector, since these are allocated only at the end of a target period (a baseline and credit system), companies looking to hedge any risk of missing targets now should look to the opportunities to source allowances from the ‘absolute’ sector.

They should also be aware that allowances are traded on a market controlled by demand and supply. Allowances are currently trading around at prices 50% higher than in May 2002. The current offer price in the market is now at £10 (28 Aug 02) and there is very limited volume on the offer side. Conversely there is significant demand to purchase allowances, which is expected to increase as CCA targets come to an end, starting at the end of September. It is therefore possible that if the supply side of the market remains limited then the price of allowances could increase further.

Participants need to be aware that by waiting too long to enter the market they could have to pay extremely high prices for allowances to cover any shortfall.

For companies looking to purchase allowances to cover any shortfall from their targets the following steps should be:

1. calculate shortfall in terms of tonnes CO2 equivalent;
2. find out the current offer price per allowance in the market;
3. calculate your maximum budget (this will determine the maximum price you are able to pay for allowances);
4. either pay the current best offer price in the market or put a bid to the market below the best offer; and
5. trade will be closed when a final price and terms are agreed.

Getting Value

For CCA participants looking to trade forward, prior to any allocation of allowances, there is some risk of non-delivery due to the “baseline and credit” allocation system, although this risk can be reduced by selling a conservative volume of allowances.

Companies looking to sell any over-achievement on targets should note the current high price of allowances in the market and look to take advantage of this. At current prices an overachievement of 2,000 tonnes of carbon dioxide equivalent (tCO2e) could possibly generate revenue of £20,000. Of course there is the additional cost of third party verification to take into account but if this is around £5,000 then the high allowance price allows companies to still generate significant revenue from the sale of allowances.

However, if companies wait for the end of the target year, when many CCA participants have collated and verified their data, they risk entering a market when there could be many sellers. This could significantly reduce the value of allowances in the market. Those who begin the verification process before the end of the target period will be best placed to gain value for any over-achievement.

Companies thinking of banking 2002 allowances may also wish to consider looking at spreads or swaps between 2002 and 2003 allowances. To sell the spread you would sell 2002 allowances for immediate payment and buy equivalent 2003 allowances for payment and delivery in May 2003. This strategy maximises your revenue flow by swapping the 2002 allowances, which you don’t need for compliance in 2002, for 2003 allowances, which can be used for compliance in 2003 or 2004. Not only can you take advantage of the price difference between the two vintages (currently around £2) but also gain interest on the cash received for 2002 allowances.

Summary

Trading

There are no restrictions on trading for companies with absolute targets and trading specifically within the relative sector. The one constraint to trading is when transferring allowances from the “relative” sector to the “absolute” sector, which is restricted by the gateway mechanism (see below). There will be significant “first mover” advantage for companies who get to the front of the queue to pass through the Gateway and transfer allowances from the relative sector into to the more flexible absolute sector, potentially increasing the value of the allowances.

Registry

Once the terms of a trade have been agreed the allowances are delivered by transferring allowances from the seller’s registry account to the buyer’s designated account. Prior to the establishment of CCA compliance accounts, participants can set up a trading account with the UK Registry to hold any purchased allowances. This can be done simply via the UK ETS registry website at www.defra.gov.uk/etr.

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Natsource’s Role in an Emissions Trading Market

The broker plays a crucial role in emissions markets. The service Natsource provides includes firstly helping potential participants understand the market and serving as a source of market and policy development information. Further we provide price discovery, assist in developing trading structures and finally matching of buyers and sellers. The broker provides the avenue for a well-placed business to seize opportunities in the UK Emissions Trading Scheme and capture new sources of revenue to complement core business activities. Clients can be confident that they are always seeing the best market pricing available and in addition, all terms and conditions of transactions are kept strictly confidential.

There are a number of different trading strategies participants can use to add value and it is important to understand which structure is most appropriate. Natsource’s experience in emissions trading markets and our first hand experience of brokering over 60% of trades under the UK ETS allow us to confidently advise participants on different transaction structures. We find out what structures buyers are looking for and help sellers create marketable offers that generate the most value in the market. For example the best prices in the current spot market and forward market or the use of the most appropriate option structure to hedge exposure against price fluctuations.

For further information on the UK Emissions Trading market (including access to price information on Natsource’s UK Allowance Notice Board) as well as information on all other Global Environmental Markets please contact the Natsource London Desk on +44 (0)20 7827 2942, or email london@natsource.com.

Natsource is a leading institutional energy and environmental brokerage, facilitating physical and derivatives transactions of electricity, natural gas, coal, emissions permits, emissions reductions, and renewable energy certificates.

Natsource’s Greenhouse Gas (GHG), Renewable Energy, Strategic Services, and Brokerage Unit utilizes the company’s first-hand knowledge of energy and environmental markets, and its domestic and international public policy expertise on global climate change and related environmental issues, to provide consulting and strategic services to corporations, international financial institutions, and governments seeking the most recent information on markets and policy trends to shape their strategies.

Links

Natsource Tullett

http://www.natsource.com

Emissions Trading Registry

http://www.defra.gov.uk/etr