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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

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

The cost of the repurchase agreement, Emanuel says, would probably be around
2.5% of the total value. In other words, the company would be getting E150m in
financing for 2.5% without dipping into its existing bank facilities. Most
finance directors would snap your hand off for this. Emanuel adds that the
repurchase option is only one of a series of financially rewarding opportunities
being missed by companies caught by the ETS.

Risk averse
However, Emanuel says it is often very difficult to get anywhere near finance
directors to appraise them of the fact that their company is sitting on this
possibility and has, in fact, been sitting on it and doing nothing since the ETS
was introduced in 2005.

Instead, all too often, they find themselves talking to a variety of people ­
including health and safety officers ­ none of whom have the slightest incentive
to generate any profit for the company from compliance and all of whom are, both
by temperament and job description, wildly risk-averse.

“You can’t blame compliance people for turning down these opportunities. They
stand to gain nothing from any upside we can generate, since they are not
personally rewarded in any way for a positive outcome from such a contract.
Moreover, in their eyes, entering into the contract looks like a risk that, if
it goes sour, could terminate their career,” Emanuel says.

We come back again to the point that if the responsibility for carbon trading
is allocated to the wrong slot in the organisation, significant revenue loss,
viewed from a financial perspective, is the inevitable outcome.

Emanuel has a classic story which illustrates the kind of closed-loop
thinking that a pure compliance focus generates. EUAs are multi-year
certificates, but they are not ‘eternal’. They are issued for a ‘phase’. The
first phase of EUAs, issued in 2005 and 2006 expired in 2007. The present phase
of certificates expire in 2012. For the first phase, this meant anyone sitting
on 2007 vintage EUAs in 2006 was sitting on an asset that was going to have zero
value at a point in 2007.

“We went round Europe explaining to companies that they needed to monetise
any spare certificates before they became valueless. Time and again we were
told, “So what? They cost us nothing, so we lose nothing.” he says.

Underdeveloped market
Lizzy Ooi, a consultant at Deloitte specialising in advising clients on issues
around carbon trading, says the reason companies are not monetising their carbon
allowances as a routine feature is the perception that the market is not well
developed yet ­ a conclusion that Emanuel vigorously refutes. Ooi’s point,
however, is that there is a distinct lag between perception and reality.

“There is no doubt that the spot market has really taken off over the past
year, but the message still has to filter through,” she says. According to Ooi,
it is now fairly straightforward for companies to sell spot and buy back futures
on exchange, effectively creating an expensive repo market to parallel the
securities lending market. However, this market is still in its infancy.

Ooi also says that placing carbon trading under the auspices of a company’s
compliance or risk management team risks putting it in the hands of staff who
have little understanding of how to hedge any trading strategies they might
employ. “Compliance people would always rather be long and have a buffer against
the time when they have to submit the certificates rather than looking to
optimise their assets more efficiently,” she says.

However, Ooi suggests that the problem goes deeper than this. Even if a
compliance team was to outsource dealing to an experienced carbon broker, there
are problems that need to be resolved. “The results would still have to hit the
general ledger and they need to know how to account for it in their books and
records.” If they start trading, then IAS39 will apply and fair value accounting
raises its head.

Doubtless, the carbon market will sort itself out as it develops in the years
ahead. But the sums involved are already far from trivial and any finance
director looking back on the formation of a market which, in the eyes of many
experts, is set to be as big as the foreign exchange market ($1 trillion traded
daily), could hardly help suffering a pang at the wasted opportunities along the

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