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Thursday, 19 October 2017

Growing pains

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After a spectacular collapse in 2007 the carbon market has made an impressive comeback this year. Liquidity is up and prices are trading within a range of fair value, though there is considerable volatility. The market is growing up, reports Solomon Teague.

For those on the inside, the carbon market is functioning pretty well. Lionel Fretz, chief executive of broker and fund manager Carbon Capital Markets, likens the growth of the market – in terms of liquidity and the emergence of risk management products – to the early growth of the electricity market.

The EU ETS was divided into three chronological phases, allowing the project to be expanded over time and giving the Commission the opportunity to modify regulations between phases where appropriate.

Since the onset of phase II of the EU ETS on January 1 2008, the price of carbon has remained within a band between €20 and €30 per tonne of CO2, meaning EU technocrats can claim success on their goal of maintaining a fair price for carbon. “It is a good price for carbon at this stage,” said Trevor Sikorski, a carbon analyst at Barclays Capital in London.

There is some debate as to exactly how much correlation carbon – represented by EU Allowances (EUA) and Carbon Emission Reductions (CER) – displays with other asset classes. According to Emmanuel Fages, senior carbon and coal analyst at SG, research conducted by SG demonstrates the constantly changing nature of carbon’s relationship with other asset classes: at times it displays some limited correlation with oil, for example, while at others there is no correlation at all. “We were looking to see if it could be an effective hedge for our gas or other exposures but we couldn’t find any correlations that held up for any period of time – and they were certainly insufficient for cross hedging,” said Fages.

This, he said, is a product of the diverse influences on, and the enormous complexity of, the price of carbon. In the short term – and influencing daily price movements, are oil and gas prices, and the weather. Over longer periods of time, economic growth clearly has an impact, implying companies are emitting more carbon, though GDP figures seem to have no impact on daily movements, said Fages.

For Sikorski, carbon’s correlation with oil is a little closer. “Oil is a lead indicator for carbon,” he said, citing a definite positive correlation between EUAs and gas – being the preferable source of energy, relative to coal.

Either way, its distinct properties make carbon very attractive at a time when other asset classes – for example, equities and oil – are becoming increasingly linked, with major indexes like the FTSE hosting a large number of oil companies.

Not a baby anymore

The market has shown fairly significant volatility this year, though this is in itself a symptom of a normal market. With the market short EUAs, traders started the summer buying the spread between EUAs and selling CERs – which pushed up the price of EUAs. Direction was given from both the Commission policy proposals and the upward trend in oil at the time. Yet a mild summer has ensured demand for carbon credits has been muted, which has facilitated some selling, as has the recent dip in oil prices. “Over the summer there has not been much compliance buying, but quite a lot of position taking,” said Sikorski.

Just as significant a victory for carbon-philles has been the rapid expansion of liquidity in the market. Orbeo, a joint venture between SG and Rhodia which helps companies manage their carbon exposures, traded around 2m–3m tonnes of CO2 a day in 2006, said Fages, compared to around 12m a day now. Carbon Capital Markets (CCM), another significant carbon trading institution, trades 0.5m tonnes of CO2 a day now, up from a mere 10,000 tonnes in 2005.

The carbon market has displayed other symptoms of its maturity. A broad range of structured products has emerged in recent months tracking EUAs and CER markets, including capital guarantee products, barrier options and investable indexes.

It is all so different to a year ago, when prohibition of bankability – the ability to carry credits between ETS phases – caused the value of credits to tank. But according to Fages the chances of that reoccurring are remote-to-nonexistent.

In 2007, even as the price of carbon was falling through the floor there was a tendency among the industry’s bankers and policymakers to make excuses. It is clearly a unique situation to be creating a market from scratch, with regulation in place of the demand that would usually drive development. There was much talk of phase I being an educational phase, where the main objective was to identify, and then rectify, potential problems, before phase II – when the market would begin to function like an ordinary market.

“Some learning by doing was there in the first phase but overall I think the EU Commission did a tremendous job,” said Fages.

It was no secret there were too many allowances in the system, and it was predictable that there would be a crash in the market, but the timing of that happening was not, he explained. Once the price started falling, many predicted it would fall to zero within days; in the event, it took months.

“Phase I was not about achieving a meaningful price for carbon,” Fages said. “It would have been good to achieve it, but the main objective was to get the infrastructure in place. Nobody had experienced an emissions market before and there was a lot of guesswork involved.”

Industry wanted to give themselves room to manoeuvre, and in many instances maybe overstated their future carbon output, in order to give themselves that room.

Regardless, having gone through phase I it will be harder – if not impossible – for industry to dupe the Commission this way again. There is now a wealth of data regarding carbon output, so it was easier to issue an appropriate number of EUAs, to provide the moderate net short overall carbon environment needed to make the system work.

But not an adult either

Not all the problems in the market have been ironed out. One particularly dark cloud hanging over the market is the Commission’s failure to offer clarity on the issue of transaction logs, which electronically track and transfer EUAs when traded. Within the EU ETS the system is called the Community Independent Transaction Log (CITL), while outside it, where CERs are generated, the UN’s International Transaction Log is used. Over the summer the Commission conducted tests to ensure the compatibility between the two systems, and while the tests were reported successful no official announcement has been made of when the interface will be completed, prompting the UK and German governments – among others – to delay the issuance of EUAs. There are therefore only around 25% the overall European allocation of EUAs in circulation. The formal interface between the CITL and the ITL was due to go live in October, but market participants were originally expecting three months notice to prepare for this. With a month to go, no confirmation has been given yet.

Currently the market is trading December 2008 EUAs, but if there is no confirmation on this issue before 1 December there risks being another crisis, with the market being hugely short of EUAs, risking a massive spike in the price and possible defaults. The credibility of the market, still recovering from last year’s crash, would be a significant casualty, said Sikorski.

Looking to the future, it is hard to predict how the global carbon market will evolve. While it is tempting to envisage a single, global carbon market – especially with both US presidential candidates showing themselves to be more receptive to a cap and trade system than the current Bush administration – it will not necessarily go this way. The US would have to ensure the system it builds imposes the same costs of compliance on its own business as Europeans have, to allow carbon credits to trade in the same range. And there is a good chance it will, instead, opt for something with less cost to the economy, for example introducing price caps on carbon credits.

Because it will have the advantage of learning from Europe’s experience in establishing the world’s first carbon market, "the US will probably come in and improve on what the Europeans did,” said Fretz. “But the US has other problems, and the economy always comes first.”

But a single market is not necessary to make the system effective. There is no single, global market for gas, but the gas market functions very well.

Even within the EU ETS, behaviour is likely to change once institutions are forced to pay for their EUAs, when auctioning becomes the predominant form of EUA distribution, currently expected from 2013: “It is a very different psychology when there is an actual financial cost,” said Fretz. “It makes you pay more attention to risk management, and it promotes innovative thinking.”

Expect a flood of new derivatives and structured products to arrive alongside the introduction of EUA auctioning.

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