Growing in fits and starts

The continuing recovery of the US energy sector has helped boost activity in weather derivatives and US emissions markets in 2003. But, while environmental markets globally are moving in the right direction, they remain dogged by uncertainty. Mark Nicholls and David Biello talk to the winners of Environmental Finance’s fourth annual market survey

Across the markets covered in Environmental Finance’s annual survey, 2003 has been a happier year than last. The US energy sector is emerging from the doldrums precipitated by Enron’s collapse in 2001, supported by a strengthening US economy. This has proved a boon to weather derivatives teams, as well as to brokers in environmental markets, for whom energy companies are the biggest clients.

Generally speaking, 2003 saw environmental traded markets – barring a few hiccups – continue to grow. This year’s survey has subdivided the markets in greenhouse gas emissions and renewable energy certificates, and includes two new categories for US pollution credits – covering the Houston/Galveston nitrogen oxides market, and emission reduction credits.

However, despite the growing acceptance of trading schemes as viable environmental policy tools, Russia’s attitude towards the Kyoto Protocol is casting a shadow over greenhouse gas (GHG) markets. Even if it refuses to ratify – dooming the Protocol to destruction – the European Union will press ahead with its planned GHG emissions trading scheme, which is due to start in 2005. But a truly global market in carbon – not to mention the future of Kyoto’s ‘project-based mechanisms’ (Joint Implementation and the Clean Development Mechanism) – will be in grave doubt.

The weather derivatives markets, fortunately, are immune to Russian prevarication. In North America, dealers and brokers report a steady influx of new participants during 2003 – with hedge funds becoming increasingly important as speculative players. They add that the volume of business, in both primary and secondary markets, is up on the previous 12 months.

The 2003 survey produced something of an upset in this region – still the biggest market for weather derivatives. Swiss Re narrowly beat XL Weather & Energy – the winner for the previous two years – to the Best Dealer title. The reinsurer has long been active in the weather markets, but moved up a gear in April 2002 with the hire of Mark Tawney and Bill Windle from Enron’s weather desk. The two brought a more active trading element to Swiss Re’s existing weather team.

“We’ve been quite successful in developing distribution channels, and our success in the end-user market has helped drive our secondary market activity,” says New York-based Tawney, noting that holding end-user risk enables the desk to make markets in most major US cities.

He believes that the set-up of the weather operation at Swiss Re – which combines the risk structuring expertise of the Zurich-based arm, led by Juerg Trueb, with the trading and origination specialists on the New York desk, has contributed to the firm’s success in this year’s poll.

Tawney adds that his team is hoping to make a bigger splash next year in the European markets but, in 2003, Entergy-Koch Trading (EKT) remained firmly in the driving seat, winning (or sharing the top spot) for the third year in a row. David Pethick, its head of European weather derivatives, cites the firm’s long-standing presence in both European energy and weather markets as a reason for its success.

The growth of weather risk management in Europe has been patchy, with many continental energy companies still holding back. But, compared to its more mature US equivalent, the European market has been characterised by more ‘balance’ between demand for hedges against warm winter weather, and for those against cold. This is largely due to the repeated placing of hundreds of millions of euros of construction- linked ‘frost day’ risk, arranged by ABN Amro (see Dutch builders re-enter weather market).

Pethick is bullish on the future of the European market, which has so far developed in fits and starts. He cites the hoped-for fruition of several years of end-user education, and “the greater volume of requests for very large deals, of over €10 million of risk transfer”.He adds that, as in the US, interest in hedging weather exposure is increasing among agricultural companies. And last summer’s European heat-wave alerted power companies to their hot-weather exposures, he adds. “I think we’ll see a dramatic increase in hedging next summer.”

This year’s survey saw a new name make an appearance, with GuaranteedWeather – comprising the bulk of US energy firm Aquila’s former weather team – coming in second in the Best Dealer category in Europe. Brian O’Hearne, president and CEO of the Kansas City-based group, says the new company – which began operating in April – was able to leverage off the relationships the team had established at Aquila, which pulled out of the market in 2002. “We’re pleased to have got into the top three – that was always our position at Aquila”.

He adds that GuaranteedWeather has seen “explosive growth” in the Japanese market. Unfortunately, however, the region is not represented in this year’s survey results as we received insufficient votes from the Asian market to justify its inclusion.

Among the brokers, this year saw little change. TFS held on to first place in North America, and won the new runner-up category in Europe. Its head of weather,Kendall Johnson, noted that the company had adopted a new approach. “This year, we’ve taken more of an integrated approach”, with closer co-ordination between its London and Connecticut weather desks, he said. “That’s important with so many US players active in the European markets,” he added.

Johnson notes his team hung on to its position despite his short-lived departure to evaluate TFS’ involvement in the credit derivatives market. He praises his colleague Eric Anderson for ably managing the weather operation during his absence, enabling the firm to retain its market share in a cut-throat broking environment.

But TFS might do well to keep an eye on Evolution Markets. The New York-based environmental and energy brokerage only established its weather desk in August 2002 but, as in most of the markets in which it is active, it has managed to grab a significant slice of the business from existing players.

In Europe, GFI retained its top position. However, Olivia Goldsmith, who has headed the weather desk for three years, is moving on within the company. She is replaced by Gaynor Allen, a former gas options broker who has been working with Goldsmith on weather for the past six months.

Nor was there any change in the Best Advisory/Data Service and Exchange categories in the 2003 poll. California-based weather and catastrophe risk modelling firm RMS again won most votes for its data quality, while the Chicago Mercantile Exchange remains unchallenged in terms of exchange-traded weather derivatives. Its only real rival, the London International Financial Futures and Options Exchange, saw no trades at all in its weather contracts last year. The Helsinki Exchange’s Helsinki temperature contracts also failed to trade.

The CME is likely to further consolidate its position next year, thanks to its October launch of contracts referenced to European cities – complementing its suite of weather futures and options on temperatures in 15 US cities.

Emissions markets recover

Much like the weather market, US emissions markets benefited significantly in 2003 from the recovery of the formerly moribund energy sector. Prices of sulphur dioxide (SO₂) allowances soared from $135 per ton at the beginning of the year to historic highs above $220 in early December.

But Pete Zaborowsky,managing director of Evolution Markets – which retained its title of Best SO₂ Broker – notes that the price surge came on smaller volumes than have been standard in the past. Another factor was that the market had been suffering for several years from the financial woes of many energy companies. “There was a lot of selling of surplus allowances in the last two years because of cash needs,” Zaborowsky explains. “People who would not have sold allowances had been selling because they needed to prop up their balance sheets.” As a result, many found themselves with a dwindling inventory of SO₂ allowances.

“I think it’s been a year of recuperation, as in many of the energy markets, as people are getting through the credit crunch,” adds David Oppenheimer, a principal at Natsource, which was runner-up to Evolution in the SO₂ broker category for the second year in a row.

While the diminishing bank of allowances, along with high gas prices, helped drive allowance prices upwards, new entrants to the market helped facilitate trading. “This is our first full year of trading,” says Trevor Woods, an emissions trader at Morgan Stanley, which won the title of Best Trading Company in the SO₂ market. “The general market perception is that we’re a company that is willing to go out and make markets and we honour all trades.”

The same bank also topped the poll in the national market for nitrogen oxides (NOx) allowances. But prices in this market have moved quite differently from those of SO₂

allowances. After spiking to record highs of $8,000/ton in May, they have headed south ever since. “The reductions simply were not available,” explains Andy Kruger, vice president at second-placed NOx broker Cantor Environmental Brokerage. “That’s what caused the panic [in May].”

Then Mother Nature intervened. After one of the coolest Mays on record, followed by a cool start to June, the heat started to come out of NOx prices, brokers noted, falling as low as $2,000/ton before rebounding slightly to $2,600 by 3 December.

Nor did future vintages add any strength to the market. Despite the fact that 11 new states in the Midwest will join the market in 2004, a shortened season has left sources confident that they can meet the cap on their NOx emissions. In addition, continued economic woes forced some companies to sell their allowances. “States with big budgets in 2004 finally put allowances in the hands of sources,” says Zaborowsky of Evolution, which also held on to its title in the NOx category. “As soon as distressed companies got them, they sold. So you had a wave of that type of selling on the heels of weather and gas fundamentals.”

Regional NOx markets had their own share of problems. The California Regional Clean Air Incentives Market (Reclaim) soldiered through the continued lack of participation from electricity generators in the state, removed following the California energy crisis in 2000. Cantor Environmental Brokerage triumphed as Best Broker for the third straight year but prices and trading remained moribund. “The market was not very volatile,” says Josh Margolis, San Francisco-based managing director for Cantor. “It had folks participating in no small part simply because they were under compliance deadlines.”

But there is hope as the Reclaim overseer, the South Coast Air Quality Management District, has decided to bring the electricity generating units (EGUs) back into the market next year. They will face stricter emission limits and a modified trading regime, at least initially.

Another regional NOx market, covering the Houston-Galveston area, also saw prices fall, but fairly modestly. There allowances began 2003 at around $34,000 per ton in perpetuity and rose to a high of $43,000 before settling back to around $40,000 per ton. Amerex was voted Best Broker in this category and the company’s Kelly Covington expects prices to resume their climb in the future. “As we move further along, there’s going to be a shortage in the amount of tons and, as we all know, rules are never eased, they’re only tightened in this type of market,” she says.

Carbon poised for growth

Outside the US, of course, it is GHG emissions – rather than SO₂ or NOx – that have been the main focus of policy-makers, corporate planners and environmental traders. While the Kyoto Protocol remains in limbo – with Russia still prevaricating over the use of its casting vote – progress has been made in developing its ‘project-based mechanisms’, Joint Implementation (JI) and the Clean Development Mechanism (CDM).

But the real breakthrough in 2003 was the adoption by the European Union of a directive establishing a multinational emissions trading scheme (the EU ETS). From 2005, more than 14,000 installations will fall under this ambitious system, which is designed to help the EU meet its Kyoto Protocol targets – and which, EU officials insist, will go ahead whether or not the Protocol enters into force.

Forward trading in EU allowances has begun, although most trades have been relatively small transactions, designed to test contracts, procedures and trading systems. Companies are awaiting decisions from their governments on targets and allocation of allowances – due next year – before trading in earnest, say brokers.

But Evolution Markets has made an early start at penetrating this new market, winning the Best Broker category. Evolution president Andy Ertel predicts dramatic growth for 2004, with many more participants and overall traded volumes soaring by as much as 100-fold. He expects bids and offers for 50,000 tonnes of carbon dioxide equivalent (CO₂e, the unit of trading in most GHG markets) to become common, against less than 10,000 tonnes now. Option contracts may also appear in 2004, he suggests, whereas all trades thus far have been forwards.

The company is planning to consolidate its strong position in this and other environmental markets, by increasing its presence in Europe.

Rival broker Natsource took the Best Advisory Service award in the EU GHG category which, its London-based managing director Dirk Forrister argues, reflects the immaturity of the market. Natsource boasts both consulting and broking arms, but “because no-one knows their allocations yet, it’s provided us with more of a consulting opportunity,” he says. “As it gets more serious, some of our clients will be trading more,” he adds.

Natsource also won the Best Advisory title in the UK ETS category. That market experienced extremely thin trading for most of the year, because compliance is only measured every other year. Companies had until February 2003 to ensure they held sufficient allowances to meet their targets for the first two-year period of the scheme, and the first few months of the year saw a flurry of trading – with prices hitting £12/tonne of CO₂e in November 2002, before crashing back to around £2.50 this year.

CO2e took the award for Best Broker, UK ETS. Its managing director, Steve Drummond, says that the scheme – which is essentially voluntary – “has been an important learning exercise for everyone involved”. While most attention is now directed towards the European scheme, Drummond points out that most of the participants in the UK ETS will fall outside the ambit of the European directive.

“The government has said only six installations fall under both schemes, and it will give them the opportunity to opt for one or the other,” he says.

Both the UK and the EU trading schemes were designed with one eye on the Kyoto Protocol, which – if it enters into force – will introduce a international GHG market, as well as its project-based mechanisms, JI and the CDM.

Only one trade has been reported under the Kyoto Protocol’s international emissions trading rules, but efforts are accelerating to develop JI and CDM projects – largely driven by the World Bank’s suite of carbon funds, and purchase programmes established by a number of European governments.

This year has seen significant progress in setting up the market infrastructure underpinning the CDM. The Executive Board, its overseeing authority, has begun assessing and, in some cases, approving methodologies that can be used for calculating and monitoring emissions reductions generated by CDM projects.

The relatively low cost of reductions from such projects – at around $5/tonne of CO₂e compared to €12/tonne in the EU scheme – is encouraging companies to enter into large CDM trades, says Forrister, whose company was voted Best Broker in the Kyoto Project Credits category. “Some of our clients see value [in CDM trades] given where they expect to see carbon prices over the coming decade,” he says.

“We’ve been able to meet interest on both sides and get ‘compliance-orientated’ trades in place,” he adds.

UK-based carbon finance consultancy EcoSecurities scooped the Best Advisory Service award in this category. Its managing director, Pedro Moura Costa, agrees that “the private sector is getting organised – but they’re waiting for the right signals”.

Aside from the uncertainty caused by Russia’s position, corporate buyers are looking to the EU’s Linking Directive, which will set out the extent to which CDM and JI credits are admissible in the EU ETS, he says. This directive is currently working its way through the EU policy-making process, with a first reading by the European Parliament due in March.

One area where the EU has failed to intervene decisively – in common with the federal government in the US – is in mandating the growth of renewable power generation. Instead, a number of European governments and US states have taken the initiative, setting rising targets for the percentage of power that electricity suppliers must source from renewable energy generators.

Compliance with these targets is typically demonstrated via tradable renewable energy certificate (REC) schemes. Last year,we included only one general category for REC broking, which was won by Natsource, followed by Evolution Markets. This year, we have expanded our survey to cover the RECs markets in the US, UK and Europe (ex-UK) separately.

In the US, where 13 states have introduced renewables targets, REC markets remain fairly small and trading is infrequent. “There’s still not that much speculative activity,” says Zaborowsky of Evolution Markets, which was voted Best Broker, US Recs. “That only started to happen this year and it will hopefully provide a more continuous market.” Even in the Texas market, which remains the largest and most actively traded, at the time of writing in early December, the last trade took place at the beginning of November.

The UK Renewables Obligation Certificate (ROC) market, which was hitherto the most actively traded REC scheme, ground to a halt last year. Over the summer, it emerged that the bankruptcy in 2002 of TXU Europe, which had a major electricity supply business in the UK, would hit the value of 2001–02 vintage ROCs. Furthermore, it illustrated that any future bankruptcies would also be reflected in the value of ROCs.

“This is a risk that can’t be valued,” argues Chris Matthews, London-based renewables trader at Cinergy Global Trading, the trading arm of US energy company Cinergy, which was declared Best Trading Company in UK Recs. “Volumes for trading in the prompt [short-term] market are down, but the appetite for long-term risk has totally evaporated.”

Cinergy, alongside CO2e and Natsource, which shared the Best Broker honours in the UK category, has been active with others in lobbying the government to re-write the rules governing the market. “There won’t be a market unless the government fixes the problem,” Matthews adds.

European markets, too, have been hampered by regulatory uncertainties, according to John Molloy, head of the environmental products desk at TFS, which was voted Best Broker, RECs Europe (ex-UK). “Markets have generally been illiquid across the board this year,” he says but he notes growing interest from utilities with operations across Europe in trading in a range of REC markets. The Netherlands, Belgium, Austria and Italy all have REC schemes, and Sweden introduced its Elcert market in April.

“Our approach has been to maintain a continual uninterrupted presence in not just the established certificate markets, but also the newer ones – such as Swedish Elcerts,” says Molloy. Such utilities “want to be able to gauge developments across the whole of Europe, not just at the national level,” he adds.

BOX - HOW THE SURVEY WAS CONDUCTED

More than 1,000 companies were sent a questionnaire or e-mail in November inviting them to nominate the leading brokers, dealers and advisers in weather derivatives, emissions allowances and green certificates.

Voters were asked to vote only in those categories in which they had direct experience and to make their judgements on the basis of: efficiency and speed of transaction; reliability; innovation; quality of information and service provided and influence on the market, not just the volume of transactions handled. More than 250 completed responses were received.

Only one vote per company was allowed and those firms that nominated themselves had their votes disregarded.

Data compiled by Alex Mathias