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Greenhouse Gases: Reviewing the European Trade

Lessons from the EU Emissions Trading Scheme emerge after two years.

Fortnightly Magazine - February 2007

coming into the verifiers 3 rateably over time, but there was no information released until that fateful two days in April. This volatility was disruptive. To avoid a repeat, information needs to be more rapidly disseminated.

Uneven Participation

Forward markets price out quite apart from consensus expectations of future spot markets. Why? Because it takes a lot of capital to bet on future outcomes. The other side of the bet requires assurance that you will pay if you lose. Capital is expensive, so arbitrageurs rarely plan to carry a long dated bet to maturity. Instead, the balance of supply and demand sets the clearing price in a forward market just like in the spot market. Forward prices deviate from expectations of future spot prices when buyers are more motivated to transact forward than are sellers, or vice versa.

So, after the crash in EUA prices over new verification figures, and despite widespread belief that Phase 1 was oversupplied, prices crept up again. Forward prices went into the high teens and only lately have dropped despite perceived fundamental oversupply. What gives? The simplest explanation is that industrials with length are not motivated to sell forward but utilities with short positions could not sit still. Utilities run sophisticated risk-management systems modeled on those of financial speculators and market makers in financial markets. These systems demand that open exposures are covered. When EUA prices dropped, coal became a far more attractive fuel relative to gas. Coal, however, requires almost twice as many EUAs per gigajoule burned than does gas. Utility risk management required extra allowances be bought to cover this.

But industrials did not have to sell. Industrials are motivated differently. They do not consider emissions-price risk to be a core risk and simply view their allocated allowances as a means of achieving compliance. Any forward sales may indeed increase risk if their production estimates are wrong. Nor is any serious senior management time or expertise devoted to maximizing the revenue from such sales. It is simply not worth their time. To add to this, the controversy surrounding windfall profits from allowance allocations may make industrials doubly cautious about selling excess EUAs.

Structurally, we thus had in mid-2006 an excess of demand over supply in the forward market but not in the future spot market.

In 2007, as we come closer to the end of Phase 1, industrials see less risk from selling a more certain excess from known production figures. They do not likely want to see the excess expire worthless. Selling has thus pushed spot prices down. EUA prices for forward delivery thus seemed artificially, but explicably, high.

Those contemplating new rules and new trading schemes in other countries should keep this in mind. A very practical solution comes to mind from the transmission markets of New England. There, incumbents with grandfathered rights are allocated auction revenue rights (ARRs) instead of transmission itself. Certainly they could use the ARRs to fully offset the cost of buying the grandfathered transmission at auction to achieve the same result as simply giving the transmission rights in