Money to burn: carbon trading and a profit-making opportunity

Illustration: David Lyttleton

Companies are missing out on hundreds of millions of euros because they fail to realise that carbon trading is a profit-making opportunity, not just a ‘green compliance’ exercise. In fact, according to the World Bank, it was a $126bn market in 2008.

For companies caught by the EU Emissions Trading Scheme (ETS) ­ which means all heavy emitters in traditional, hefty pollutant industries such as power generation, automobile manufacture, steel and cement ­ carbon trading is a legal necessity, not a piece of ‘greenwash’. The need for companies to present an audited report on carbon emissions and prove they hold sufficient certificates each year to cover their total emissions is a legal requirement. In fact, the EU ETS covers 12,000 sites across the EU.

Failure to register as an emitter is a criminal offence and failure to hand back the requisite number of certificates attracts a penalty of E100 per certificate, plus the need to buy the missing certificates in the open market. Unfortunately, for many of the larger companies in the UK and Europe, the fact that carbon allowances, and hence carbon trading, is enforced by legislation and penalties, has shaped a mindset in companies that sees carbon emissions and carbon trading as wholly and exclusively a compliance issue.

Ready to comply
Focusing on compliance inevitably leads to placing the responsibility for carbon trading into the hands of the company’s regulatory and compliance team, which understands rule following, as opposed to placing it under the direct aegis of the finance director, who understands trading and profit.

In fact, profit ­ and the idea of making efficient use of a new asset class, in this case carbon certificates, is all too often being left out of the picture ­ but the money involved can be substantial. Consider the following example: Company A is given 10 million free certificates ­ its annual allowance ­ entitling it to produce 10 million tons of CO2 as part of its production process. These certificates currently have a face value of E15 euros, but they also have a daily value that varies in the spot market according to demand.

As with all commodity spot markets, the price can show impressive volatility. According to the World Bank, the spot price for ETS European Union Allowances (EUAs) saw a record high of E28.73 in July 2008 and a record low of E7.96 on 12 February 2009.

A number of points follow from this. Depending on your perspective, these ‘free’ certificates are (a) something you hold on to safely in a drawer then give back to the government as part of a compliance exercise, or (b) an asset class with a face value of E15 euros times 10 million (in our example) and an impressively volatile trading price accessible from a number of exchanges, as well as from over-the-counter (OTC) spot-market dealers.

At this juncture we need to add in the fact that irrespective of whether companies opt to keep and hold their certificates (the compliance approach) or opt to exploit their certificates (the profit approach), they all have to trade. This is because the idea behind ‘cap-and-trade’ emissions markets (pioneered by the US two decades ago with acid rain and air pollutant certificates) is to award fewer certificates than companies require under ‘unregenerate’ production methods.

Producers are deliberately given fewer certificates than they need each year, in order to put a price penalty on standing still and not investing in carbon abatement technology. In other words, their options are to invest in carbon emission abatement technology, so they need fewer certificates, or to go out to the market and buy additional certificates to meet their obligations. If they need fewer than their allocated number, they are free to sell them to other emitters which need more certificates.

What follows from this is that a compliance-orientated approach will seek to ‘go long’ on carbon certificates to ensure the company can comply with its obligations. A profit-centred approach will trade to maximise profit, while still having an eye on the need to deliver X certificates on Y date.

Cash alternative
Now let us return to our example. As James Emanuel, commercial director at carbon broker Cantor CO2e, explains, the logical thing for any commercially-minded person to do when they get their allocation of free certificates is to turn those certificates into cash.

To understand the mechanics behind this process you need to take into account another unique feature of the carbon market: certificates are handed out in February each year.

Companies have until April the following year to complete their carbon audit and hand in the certificates. Since unused certificates can be carried forward to the next year’s allocation, it follows that each February companies which have not sold off either their prior year’s allocation or the new allocation, are extremely long in certificates.

Emanuel’s point is that this is extremely odd commercial behaviour. “Why would you do this?” he asks. “The obvious thing to do is to sell the certificates for the best price you can get as fast as you get them and, at the same time, to buy a forward contract against an implied 2.5% annualised yield on the forward curve that will ensure you have sufficient capacity to meet your obligation the following April.” This is known as a repurchase agreement and, in our example, this would immediately generate around E150m in cash for the company.