The EU ETS as a cash cow

A feature of the current trading environment is that there is a significant premium for holding cash, as many firms struggle with weak order books and tight credit availability. A somewhat unforeseen and unheralded impact of the EU ETS, and the level of free allocation of EUAs provided to installations, is that the carbon market for many participants has turned out to be an important source of finance. (Source: Tendances Carbone (No 35) , by Mission Climat of the Caisse des Dépôts and BlueNext)

Increasingly many companies that have compliance liabilities under the EU ETS are looking at their allocations of EUAs as a potential source of funding.
One way of realising this funding is to sell large volumes of the current year’s allocation to raise cash, and then to close this position in the future. Under EU ETS rules, this can be done due to the presence of a free allocation, which provides value that can be monetised, and the timing of the issuance of EUAs in February of the current compliance year against the timing of submission in April of following year. Due to this staggered timing, installations have a year’s worth of allocations to use and, given the ability to borrow EUAs across time within a phase, do not have to be submitted for compliance until 2012 at the earliest. While this is a simple sell strategy, it does open up a likely future carbon position that may have to be closed when the future carbon price is much higher. A more popular trade which has been present in the market and is an effective way of managing future price risk is through a time swap, under which volumes from the current allocation are sold into the spot market and at the same time, an offsetting volume of allowances is purchased for future delivery (such as for December 2012). The firm receives a current cash-flow and locks in its future price liability. The difference between the cash received today and that paid in the future is the effective rate of interest being paid on
what is in effect a loan.

From Graph of the Month, we see that in terms of the EUA curve, the level
of contango in the market (i.e. the amount by which forward prices are higher
than spot delivery prices) for most of 2008 was below the cost of carry –
meaning that the carbon market would provide a lower cost loan than even the
inter-bank market. Since November 2008, when the majority of EUAs were
issued to installations, the EUA curve has traded above Euribor by increasing
amounts. Indeed, the implied interest rate between the Dec 09 and the Dec
12 EUA price has increased from +190 basis points above Euribor (around a
4.1% interest rate per annum) at the beginning of February to +500 basis
points by the middle of March (around a 7% interest rate per annum). Such
super contango levels in the market reflect both the current tight credit
conditions and the increasing interest that participants have in securing long-
term future delivery. The level of contango is even higher when comparing Dec
09 contracts with Dec 13 contracts, with the premium to Euribor almost +550
basis points. At these levels of super-contango, there is, however, little
appetite for undertaking the opposite trade: buying the Dec 09 contract and
selling the 2012. This reflects the premium for cash in the current operating
environment. As the market is now a less attractive source of finance for many
compliance participants, the recent interest in selling allowances for cash and
buying them back has started to dry up.