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Markets coming of ageUS emissions markets are changing their shape, trading in weather derivatives is growing steadily, and new renewable energy trading schemes continue to emerge. But it’s carbon trading that is poised to explode. Mark Nicholls and David Biello talk to the winners of Environmental Finance’s fifth annual market surveyIn 2004 greenhouse gas (GHG) emissions trading finally came of age. Of all the markets covered in the annual Environmental Finance survey, carbon trading saw the most dramatic growth in 2004 and, with January seeing the start of the EU Emissions Trading Scheme (ETS), and February the entry into force of the Kyoto Protocol on climate change, 2005 promises to be even more exciting.
Among the other markets we cover, the picture in 2004 was also improving, but less markedly so. The weather derivatives market managed a respectable 10% growth in volumes, according to figures covering the year to April 2004 from the Weather Risk Management Association released in June. A successful start for the new federal nitrogen oxides (NOx) programme helped offset declining volumes in US sulphur dioxide (SO2) trading. And, in renewable energy certificates, the introduction of new regimes helped compensate for the ongoing fragmentation of markets in both North America and Europe. A year ago, Russia’s continuing prevarication about ratification of the Kyoto Protocol was casting a shadow over GHG markets. The European Commission had pledged to introduce its trading scheme – and meet its Kyoto targets – come what may. But the risk of a Russian ‘nyet’ dooming the Protocol gave ammunition to those, including Loyola de Palacio, the Commission’s own energy head, arguing for a rethink on EU climate policy. To some extent, these doubters have been silenced by the October vote in Russia’s parliament in favour of ratification. But, as Benedikt von Butler notes, volumes in the forward market for European Union carbon dioxide allowances had already begun to climb in July. Von Butler, a London-based director with broker Evolution Markets, which was voted Best Broker, EU ETS, says that volumes in that month topped 500,000 tonnes of carbon dioxide (CO2).
After a lull in August, with most traders on holiday, “from September, people really got up to speed. [Regulatory] certainty increased, and more brokers got into the market, with more aggressive pricing, and they worked the phones. Deals brought deals.” “Yesterday, we saw volumes of 400,000 [tonnes] and today, we saw some real [price] volatility in the market. That attracted trading of 240,000 tonnes,” he says, speaking in late November. Such days are not uncommon, he adds, and – in a far cry from the ‘test’ trades of 5,000 tonnes that were common at the start of the year, November saw what von Butler describes as a “compliance trade” of 400,000 tonnes. He notes that the power sector – which has accounted for most trading activity so far, is likely to continue to dominate the market. “Eighty per cent of allowances have gone to the utilities, and they’ve got the skills in place to trade, with trading desks, etc. Also, trading allowances is an integral part of how they optimise their assets.” This is a point also made by Garth Edward, head of environmental products trading at Shell, which was voted best trading house in both the EU ETS, and its smaller forerunner, the UK ETS. “A lot of players in the allowance market are evolving in terms of their structure. A few months ago, there were relatively small volumes of speculative trading,” he says. “Now, there are closer links between the [allowance markets and] underlying assets, and we’re seeing trading around those assets.” This might take the form of switching generation between coal- and gas-fired plant, and either buying or selling allowances to match the changing emissions profile, he explains. As well as buying surplus allowances from other companies in the EU ETS, those with targets under the scheme are also permitted to buy carbon credits from projects that qualify under the Protocol’s two project-based flexible mechanisms – Joint Implementation (JI) and the Clean Development Mechanism (CDM). “We’re seeing strong and increasing interest in [CDM credits] from companies in Europe,” says Steve Drummond, managing director of CO2e, which was voted Best Broker, Kyoto Project Credits. “And interest is spreading beyond the large traders to medium-sized companies.” Much analysis has gone into the likely supply of credits from JI and, particularly, CDM projects, with some participants – such as the World Bank – warning that the long lead times to get emission reduction projects off the ground means that companies should move fast to ensure demand for credits is met. Drummond doesn’t share this concern. “My view is that there is a huge depth of latent supply out there. We’ll do a project, broker the credits, and their peers see that the company got cash for reducing emissions,” he says. “There are lots of good quality projects out there.” The EU ETS was always going to overshadow the UK’s emissions market – whose launch predated that of the EU scheme by three years. However, despite teething problems, it has provided UK Plc with valuable experience in how emissions markets work. Indeed, companies falling under the UK ETS are dealing with this bi-annual milestone year (when progress towards meeting targets is measured) in a more considered fashion than in 2002, says Tim Atkinson, head of European emissions markets at Natsource, which was voted the best broker in this market. Then, panic buying, and an initial lack of supply, pushed prices to more than £12/tonne of CO2, before they collapsed to below £2/tonne. This year, prices have only risen to around £4/tonne. “Companies seem better prepared – they are showing more patience, and discipline, in how they’re approaching the market,” he adds. Underpinning each emissions market, of course, are the consultants, advisors, lawyers and other service providers that help companies meet their obligations. This year, UK-based EcoSecurities – one of the longest established boutique environmental finance consultancies – almost swept the board in the Best Advisory/Consultancy categories, only losing out to Natsource in the North American market. Pedro Moura Costa, the firm’s managing director, says the firm has put particular effort into the EU ETS where, unsurprisingly, “things are becoming more urgent” for affected companies. But he also notes “slow but steady” progress on the Kyoto project mechanisms. Indeed, EcoSecurities is in partnership, as investor and developer, with a Brazilian company on the NovaGerar landfill gas capture project – which, in November, became the first CDM project to be registered. Both the EU ETS and the project mechanisms are generating business for the verification and certification companies, who provide independent reviews of emissions baselines, monitoring and reporting systems, and current emissions. Norway’s Det Norske Veritas – or DNV – was the clear winner in this category, which we included for the first time this year. Einar Telnes, technical director of international climate change services at DNV, has seen particular demand from companies in Germany and the UK – the only two countries to mandate baseline verification before the start of the EU ETS. He warns that other countries could be working off badly flawed information: in these two countries – both of which are relatively advanced in their routine monitoring of all kinds of emissions – companies have overestimated their baselines by 900% in some cases, and underestimated them by 50% in others. Similar inaccuracies elsewhere, once the scheme is up and running, will lead to serious disputes between governments and companies. Telnes says lawsuits may follow. Such a statement should be music to the ears of Anthony Hobley, London-based senior associate in law firm Baker & McKenzie’s global renewable energy and climate change practice, which won another new category, Best Law Firm, Global GHG Emissions. But the practice, one of the largest dedicated to carbon trading, has steered clear of that type of litigation to date. Instead, it is building a business primarily based on transactions in the carbon market. Hobley says the firm is seeing a “one-off” peak in some more traditional legal issues, such as the tax impacts associated with receiving and trading allowances. “Over time, the in-house lawyers will get on top of these. But we’re beginning to see the start of structured carbon transactions,” including the imminent launch of the first exchange-listed special purpose vehicle involved in the market, about which he declines to elaborate. While the carbon market made big steps forward, the grandfather of all emissions trading schemes – the SO2 market in the US – went through some growing pains in 2004.
Prices, which had hovered in the $150 to $200 per ton range for several years, steadily climbed during the course of 2004 to an all-time high of $730 per ton by late November. This tripling in price, on significantly decreased volumes, made 2004 a difficult year for participants and brokers. “Liquidity has been a problem,” admits Pete Zaborowsky, managing director at Evolution Markets, which won the Best Broker vote for the fifth straight year. “It’s a very exciting time given the volatility in price, but also a trying time because the bid and ask [spread] has been fairly wide.” According to Zaborowsky, it has been difficult to get even those who need allowances for compliance purposes to trade. With a limited number of players – essentially power utilities covered by the programme and investment bank Morgan Stanley Dean Witter (MSDW) – trades have been few and far between. This marks a significant change from years past when SO2 was the only emissions market to trade on a regular basis. “There’s really been no dramatic shift in the number of players,” says Trevor Woods, a trader at MSDW, which shared the title of Best Trading Company in the SO2 market with electricity giant American Electric Power (AEP). “But there’s a value in being in the market on a daily basis because it can be gapping and it can be liquid.” In fact, the majority of new players have been drawn to another US emissions market – the new federal NOx Budget Trading Program, which began this past year. Covering 21 states and 1,500 utility and industrial sources, this expanded NOx programme saw active trading in both the spot market and future years, or vintages. “A big part of the popularity of the NOx market has been the degree to which people have been managing [their positions] as a long-term strategy,” says Mike Intrator, managing director at Natsource, which scooped Best Broker honours in this market. “Companies were not just looking at compliance in 2004, but at how they put in a strategy from 2004 to 2007 and even 2008.” The market has also benefited from the speculative action of new players, like hedge fund Citadel, improving liquidity. “There have been a lot of people that have been looking at emissions markets and environmental markets across the board,” Intrator adds. With a more stringent compliance season in 2005 – and the potential for an even larger programme under the Bush administration’s Clean Air Interstate Rule or Clear Skies legislative proposal – the NOx market looks primed for even more activity in future. Regional NOx markets are also poised for change. The Regional Clean Air Incentives Market (Reclaim) in California, which struggled as a result of the removal of utilities from the programme in response to the energy crisis of 2000, is now grappling with the rules setting out how these generators should be brought back in. “We’re seeing the programme being reborn under new rules and regulations,” says Josh Margolis, San Francisco-based managing director for Cantor Environmental Brokerage, which was voted best broker in this market for the fourth year running. “This has caused a number of players to take a look at their positions in a whole new light.” While trading was sporadic and prices low in 2004, the Reclaim market should revive at least somewhat under the new rules. New participants may help increase the flow of deals. “The speculators provide liquidity but also create new challenges,” Margolis says. “More traditional participants may see opportunities disappear before they can get approval through their budgeting process.” Rule changes are also expected to have a major impact on the regional NOx trading programme in the Houston-Galveston Area (HGA). The Texas Commission on Environmental Quality now plans to allocate all allowances for future years at the same time, and this will free up participation in the market. “There is a better understanding in the marketplace of what’s expected with this programme,” says Tom Gibson, vice president at broker United Power, which finished runner-up to Natsource for Best Broker in HGA NOx. “With the advent of this rule change,we will potentially see more trades.” But it is in the market for Emission Reduction Credits (ERCs) that the most hopeful signs for the future have already emerged. “There was a lull in the offset business last year,” says Andy Kruger, vice president at Cantor Environmental Brokerage, which won Best Broker, ERCs. “But we started to see more trades this year. It’s a sign of the overall economy turning around.” And such a turnaround is also good news for the weather market. But, as Mark Tawney, Swiss Re’s head of weather and energy products, points out, bad weather is even better news. Two cool summers in a row – depressing air-conditioning usage, and thus power company profits – promise to bring the sector to the market in hitherto unforeseen size.
“2004 has been even colder, and we’re already getting unsolicited calls for next summer,” says Tawney, whose firm won Best Dealer honours in both Europe and North America, bettering last year’s performance, when it won only in North America. “The size of stuff we’re being asked to price dwarfs things we’re seeing in the winter. For example, one large utility has asked for a price on $100 million of cover.” Fortunately, the market is getting better at absorbing large deals, says Kendall Johnson, who heads up the weather desk at TFS, which this year swept the weather brokerage category, winning in all regions. In November, the brokerage organised a ‘Dutch auction’ for $30 million of daily temperature options referenced to Boston. The auction was designed to ensure that the client got the best price, while trying to ensure the maximum number of participants, Johnson says. Because all the successful participants are paid the same price to take the exposure, it avoids the “winner’s curse” whereby a single winner often finds itself some way off the mid-market price. “This was atypical market risk,” Johnson says, “given that the options close on a daily basis. I expect to see more of these types of events, as people find out that we can get such large risks placed in the market.” According to Brian O’Hearne, president of GuaranteedWeather, voted Best Dealer in Asia, and runner-up in Europe and North America, such atypical risks are becoming more common. “In the US, we’re seeing interest spreading out from the utilities, and we’re getting inquiries for precipitation, snowfall and critical day structures.” And in Asia – where GuaranteedWeather shared the honours with its partner, Mitsui Sumitomo Insurance – O’Hearne says that, in Japan at least, weather hedging is moving into the ‘middle market’. “Up to now, it’s been the large utilities and small companies hedging. There’s now more penetration into medium-sized companies,” he says. But the biggest change in the market is the increase in activity among the hedge funds, according to Nick Ernst, weather broker at Evolution Markets, which once more was runner-up in the North American weather broker category. “This started last year, but it’s getting much bigger – the weather market has been getting a lot of publicity in relation to other commodities. This is adding liquidity, and helping the market get a lot smoother.” On the other hand, there has been no change from last year in either the Best Exchange or the Best Advisory/Data Service categories. The Chicago Mercantile Exchange (CME) remains largely unrivalled in terms of its weather derivatives offering – and, as the Weather Risk Management Association survey showed, the CME enjoyed a substantial increase in volumes between 2002–03 and 2003–04. However, it faces competition in its Japanese contracts, which it launched in July, and which have, thus far, seen limited interest from the market. Both TIFFE, the Tokyo derivatives exchange, and the Tokyo Commodity Exchange have promised to list their own weather contracts, and it remains to be seen whether they can exploit the advantages of offering a product to their domestic markets. California-based Risk Management Solutions, similarly, remains the dominant provider of data and advisory services to the weather market. Steve Jewson, London-based director of business development, reports a strong year, driven by new entrants from the hedge fund community, “nearly all of whom have bought data from us”. RMS provides a useful barometer of trends in end-user activity, as dealers who are asked to price hedges in unusual locations, or for non-typical weather variables, often approach the company to provide the data. “We’re seeing huge interest in precipitation data, on both a daily and hourly basis, and an up-tick in requests for ‘off-the-wall’ data-sets, that can only be related to end-user deals. For example, there is lots of talk about airlines,” he says. “What we can’t say is whether the deals close or not.” Another useful barometer is Claude Brown at Clifford Chance, which won the new category of Best Law Firm, Weather Derivatives. Brown – a familiar face to many in the weather risk industry, partly due to his role as WRMA’s European director – is cohead of Clifford Chance’s environmental and climatic trading group, a unit that was created at the start of 2004 to bring together the firm’s weather, renewable energy and emissions trading practices.
He says a big part of the firm’s work in weather has been concerned with the regulatory treatment of weather derivatives across Europe, from the point of view of the institutions looking to trade them. But he adds that he is seeing increasing interest in the accession countries of Eastern Europe that joined the European Union in May – suggesting dealers are exploring the potential of new markets to the East. He also confirms the growing interest in weather risk as an investment opportunity, noting that he’s received inquiries on how to develop structured products that include weather risk – including from institutions not currently involved in the market. In the renewable energy markets, the popularity of renewable energy certificate (REC) schemes to encourage growth in green generation continues to increase. A number of US states introduced renewable portfolio standards (RPSs) in 2004 and Norwegian officials are in discussions with their Swedish colleagues about setting up a green certificate market linked to the existing Swedish Elcert scheme. Such schemes typically mandate electricity suppliers to source a rising percentage of their power from renewables, with compliance demonstrated by them delivering green certificates. These certificates are awarded to renewable generators, for each MWh of power they produce. They can then be sold on to the suppliers, providing green generators with an additional revenue stream. The future is certainly looking bright from the point of view of Anna Giovinetto, director of environmental markets at Evolution Markets, which won the vote for Best Broker, North American RECs, for the second year in a row. “2004 saw some potentially significant compliance markets added in the US,” she notes, pointing to New York State, Pennsylvania and Maryland, all of which passed legislation introducing RPSs last year.
And on the supply side, the reintroduction in October of the US federal Production Tax Credit, a tax-break for wind farms that expired at the end of 2003, and had been caught up in the disputed Energy Bill, is likely to provide a huge boost to wind farm development. "There will be an enormous surge in the number of wind credits – everyone who can will be setting up a wind farm next year.” But she notes that it can still be difficult to use green certificates to finance wind farms. Under some compliance schemes, the obligation on electricity suppliers is short-term – meaning that wind farm developers find it difficult to use certificates to underpin the longer-term borrowing they need. In the UK’s Renewable Obligation Certificate (ROC) market, meanwhile, some confidence is returning, following the shock caused by the bankruptcy of TXU Europe in 2002. Market players had not realised that, due to the design of the scheme, the bankruptcy of a major supplier could hit the price of all certificates outstanding in the market. The TXU Europe affair caused spot trading to grind to a halt, and made buyers of ROCs reluctant to pay fixed prices, instead insisting that generators assume some of the risk of possible future bankruptcies. “Buyers are beginning to take credit risk in the short-term market again,” says Fiona Santokie, head of European renewables at Natsouce, which took the title of Best Broker, UK RECs, “but for anything longer term, it’s very much broken down, with the risks being shared by buyer and seller.” She adds that trading in ROCs on a standalone basis (that is, not bundled up with physical power) remains sporadic, with trades occurring typically every couple of weeks. “It’s still a question of working hard with developers to close long-term structured deals to bring projects to fruition, but measures still need to be taken if we are to see the more expensive emerging renewables technologies coming online,” she adds. The European markets have also seen some changes over the past 12 months, says Jussi Nykanen, executive vice-president at GreenStream Networks, the Helsinki-based broker and consultancy that won the Europe ex-UK RECs category. “Volumes are going up all the time, but we’ve seen some big changes in the market.” The biggest of these is a change in the tax benefits that Dutch power consumers could exploit by importing green certificates. Certificates from Scandinavian biomass plants had been attractive, but the loss of the tax benefit on imported certificates has had a downward impact on prices. Dutch companies are keen to continue to green their electricity supply on a voluntary basis with certificates, says Nykanen, but the loss of the tax break means they now demand the cheapest available, which typically come from hydro plant. “Europe’s markets remain very fragmented,” he comments. “There are opportunities at different times, in different countries. But the European market is becoming more international. A year ago, the Netherlands was the only international market, but now customers in many countries are buying certificates from abroad.” EF BOX How the survey was conducted More than 1,500 companies were approached in October and November and asked to nominate the leading brokers, dealers, and advisors in emissions allowances, weather derivatives and renewable energy certificates, via an online survey. 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 500 completed responses were received. Only one vote per company was allowed and those firms that nominated themselves had their votes disregarded. Data compiled by Iris Koehne |
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