News Articles

img_230

After the Storm: Lower Caps, More Transparency?

Steve Zwick

The April-May European carbon market crash appeared to have delivered a body blow to prices for European carbon emissions expiring this year and next, but a mid-May rally brought prices for 2006-2007 into line with those for 2008-2012. Participants, meanwhile, are demanding greater transparency and legal clarity. The Ecosystem Marketplace looks at the EU ETS in the aftermath of the recent volatility in prices.

The April-May European carbon market crash appeared to have delivered a body blow to prices for European carbon emissions expiring this year and next, but a mid-May rally brought prices for 2006-2007 into line with those for 2008-2012. Participants, meanwhile, are demanding greater transparency and legal clarity. The Ecosystem Marketplace looks at the EU ETS in the aftermath of the recent volatility in prices. COLOGNE, GERMANY— "The important thing that everyone needs to remember is that this is just a pilot phase," declared Peter Kreuzberg, Managing Director of RWE Trading, in the opening hours of the May 10-12 Carbon Expo in Cologne, Germany. By the end of the three-day event, that declaration had become an oft-repeated mantra among the more than 2,000 participants from nearly 100 countries, along with: "The market itself functioned perfectly," "Companies beat their emissions targets, and that's good," "Governments set first-round emission targets too high, and that's bad," and: "Just wait 'till next round!" At issue was the 70% plunge in the price of carbon allowances traded under the European Union Emissions Trading Scheme (EU ETS). The slide began during the last three trading days of April, and primarily impacted prices for allowances in the first phase of EU ETS, which runs until the end of 2007, recalls Garth Edwards, trading manager for Shell Trading's environmental products division. "People had been projecting a total short per year of something like 80 million allowances," he says, "but then the Dutch government released its figures, and suggested that a total short of 80 million was probably too big." Other governments quickly followed, and the market slid from over €30.00 per metric ton on the morning of Wednesday, April 26, to €13.19 per metric ton at the close of business on April 28. It traded sideways until May 12, when the EU Commission put the crowning flourish on the debacle by accidentally posting emissions figures on its web site that were scheduled for release on Monday, May 15. Those figures showed Germany had beaten its targets by 26.3 million metric tons, leading traders to conclude that the 21 member states who filed data (Cyprus, Luxembourg, Malta and Poland are not yet included) had surpassed their emissions quotas by up to 60 million metric tons, rather than missing them by 60 to 80 million as had been the expected range just three weeks earlier. On the European Climate Exchange (ECX), futures prices for allowances expiring in December 2006 and December 2007 dropped to just over €9.00 on May 15. The market drifted down to €8.50 early Monday, but when official figures were announced, it turned out that the 21 member states had beaten their quotas not by 60 million metric tons, but by 44.2 million metric tons. With environmental groups and some EU member states (notably the United Kingdom) charging that most governments had set the targets too high, Germany announced it was probably going to make a so-called "ex post correction"—essentially recalling conditional allowances it had issued for 2005. Traders quickly realized that roughly half of the allowances Germany had issued in 2005 were laden with conditions and subject to recall, and the market price for futures with December 2006 delivery more than doubled before closing at €15.10. Perhaps tellingly, Monday's high was just 25 euro-cents beneath the low of the day for futures on allowances expiring in December 2008 (the most liquid contract for the second round of EU ETS), which begins in January 2008 and continues to the end of 2012. Those prices have generally held steady in the €20.00 per metric ton range.

Watching Brussels

"Under the current regime, allowances not used in the first round expire when the second round begins," said Duncan Shiels of the Reuters Foundation on May 12. "This will become more and more of an issue as the end of the first phase approaches." Or will it? Peter Zapfel, an official from the European Commission's Environment Directorate, confirmed last week that Poland and France had been granted the right to bank a restricted number of excess allowances from the first phase and apply them to the second phase. Since other EU member states are not likely to sit idly by as two of their competitors receive preferential treatment, Monday's move may be evidence of spread traders betting that the Commission will allow more member states to roll excess allowances from phase one into phase two, and perhaps with fewer restrictions than those currently imposed on Poland and France. After all, once a political ball gets rolling, it tends to move well beyond the equilibrium point. Whatever the ultimate cause of the last rally, Laurent Segalen, Investment Manager for the European Carbon Fund, attributes much of the volatility to inexperience. "You had a lot of people who understood nothing about anything, and they tried to come in and make some quick gains," he says. "They got bashed." "If you really believed those prices as they were climbing and climbing and climbing, you had to believe there was nothing anyone could do anywhere in Europe for under €25 per metric ton," says Dirk Forrister, managing director of Natsource. "That simply was never the case." Perhaps, but most market participants have laid blame for the volatility on the lack of transparency regarding emissions numbers and the lack of regulatory certainty regarding the long-term structure of the markets. "There should, at the very least, be a code of conduct on how the individual member states as well as the EU releases sensitive information," says ECX CEO Peter Koster. " It's very important that it is done in a structured and a professional way, as if it is a publicly-quoted company releasing earnings information." "Business has done its part by creating a market which works," said Andrei Marcu, president and CEO of the International Emissions Trading Association (IETA). "But markets are driven by supply and demand, and demand in this market is driven by government policy." Accordingly, traders will be focusing on Brussels as it hammers out the ground rules for the second phase. Some in the Commission want to see quotas reduced 6% across the board, while others are calling for a complete restructuring of the way allowances are granted—perhaps shifting to a formula that ties quotas to output rather than to previous emission levels.

Coming Out Ahead

The exchanges, at least, came out ahead after the recent market activity. Open interest, or the number of open contracts, on the ECX actually rose as the slide continued—finishing at 42,649 on May 15, more than double the 21,000 after the March expiry. That indicates a slew of new positions were taken even as the market slid and after it had fallen. The fact that open interest did not drop after Monday's rally indicates that more than simple short-covering is behind the move. "You read in the press about carnage and whatnot, but generally our customers have been happy through all of this," says a broker with Fortis Banque. "All the time this was going on, if they wanted to execute, they could, and many were happy about lower prices. We were doing two to four deals per day on average last year, but now we're doing multiples of that." Albert de Haan, ECX's commercial director, says 30 companies that had never before traded directly, suddenly became active the day after the crash. "These were companies who had prepared themselves ahead of time, and were just waiting for the right time to buy," he says, adding that the exchange executed its first intra-day margin call that day—bad news for the recipient, but at least a demonstration of the market's efficacy. And the composition of the market is also encouraging. On the day the slide began, 4.2 million metric tons (4,200 contracts) were traded in 467 individual transactions, 394 of which were traded through the screen as opposed to Exchange For Physicals (EFPs), indicating a large number of small transactions rather than a small number of large ones. "The bulk of trading is coming from utilities, with banks becoming more and more active as carbon becomes part of the energy complex," de Haan says.

Global Fallout

While the rebound has brought prices on first-phase EU ETS allowances into line with phase-two allowances, it's interesting to note that the plunge brought them into line with prices of voluntary markets and project-based Certified Emissions Reductions (CERs). Such moves do, however, have a knock-on effect in prices paid for CERs. "More and more CER contracts are linked to the price of European Union Allowances (EUAs)," says Segalen, whose fund does not trade futures but instead invests in CERs. "Although the projects we are involved in tend to have long-term horizons, these kinds of moves often force short-term contracts to be re-negotiated, and they can be quite disruptive to negotiations." Heuberger agrees. "When market prices are down, it is easier to source projects, because the people offering them are afraid of being undercut," he says. "But most of the CERs we are involved in will be delivered between 2008 and 2012, and by then we should have the kinks hammered out of this system." Judging by the relative stability of phase two prices, the market seems to agree—but let's not forget that hammers can create kinks as well as straighten them out. Steve Zwick is a free-lance journalist and Editor-at-Large of Futures Magazine. He can be reached at Steve.Zwick@gmail.com. First published: May 16, 2006 Please see our Reprint Guidelines for details on republishing our articles.

Please see our Reprint Guidelines for details on republishing our articles.