Emissions and the metals sector: the EU Emission Trading Scheme is now a reality and trading...

At the beginning of 2005, 2006 and 2007 the ferrous metals industry will receive an allocation of approximately 200 million carbon dioxide (C[O.sub.2]) emission allowances from the Governments of EU Member States. These allowances will be issued to the industry free of charge despite being an

The allocation of emission allowances is not being made without reason. A company that is issued with emission allowances will be placed under an obligation to contribute towards the EU effort to reduce greenhouse gas emissions. A company that has received an allocation of emission allowances will be placed under an obligation to surrender emission allowances back to the Government equal in number to its actual emissions over the corresponding period.

Companies able to reduce greenhouse gas emissions cheaply will surrender fewer of the valuable emission allowances issued free and will be at liberty to sell their surplus allowances into the market and retain the proceeds of sale. If emission reductions are capable of being made at a price below the market value of an emission allowance then a profit will result from participation in the emissions trading scheme.

Companies unable to reduce their greenhouse gas emissions in any given period may meet their obligation of contributing towards the collective effort to reduce emissions through buying emission allowances on the open market. In this way the funds from the purchase of allowances will be transferred, through the trading mechanism, to those companies able to achieve emission reductions cheaply. Both companies will then have shared the cost of the cheap emission reductions.

Having taken the political policy decision to introduce measures that reduce greenhouse gas emissions, the next decision to be taken was on the issue of how these reductions would be achieved. There were two options available to the politicians:

* The first option was the introduction of direct taxation on emissions that would be levied against industry. This would have been inequitable and unfairly prejudicial to those companies with high emission abatement costs. Furthermore, the money raised through taxation would have been added to Government Treasury funds and may not have found its way back to industry.

* The second option was the introduction of a flexible trading mechanism. This would enable the 'emission levy' to be circulated within industry for the purpose of promoting further emission reductions. The result would be to promote the required emission abatement at the lowest unit cost to all companies involved in the scheme. Fortunately for industry the latter approach was adopted.

The EU Emission Trading Scheme is now a reality and trading has already commenced. A forward thinking company will now be wise to consider the benefits that the scheme will offer and will seek to engage in market activity as soon as is practicable.

A word of warning: The scheme is designed to promote reductions in greenhouse gels emissions. For this to happen the market will have to see a net shortage of emission allowances in circulation. Consequently, there is no guarantee that emission allowances will always be available for sale on the open market. A company that anticipates a need to buy emission allowances to comply with emission reduction obligations would be wise not to procrastinate.

COMMENCEMENT DATE

The time constraints imposed on Member States by the Emission Trading Scheme (ETS) legislation has led many to question whether or not these deadlines will be met and, if not, whether the ETS will officially start on January 1, 2005 as intended.

As with all legislation, the provisions contained therein must be assigned an official date for when they will become effective. January 1 was the date specified in the legislation for commencement of the ETS. However, in reality this date has no particular significance to a company involved in the scheme.

The date of real importance is April 30, 2006. This is the first compliance date. A company will be required, on that date, to surrender emission allowances equal in number to their actual emissions during the calendar year of 2005. The compliance obligation will then continue on an annual basis until at least 2012 and almost certainly beyond.

The EU Directive is now binding law and the political will behind making the scheme work is overwhelming. The EU Commission has made its position perfectly clear. Any country that fails to meet the deadlines set in the EU Directive will be subject to infraction proceedings and the scheme will continue on schedule notwithstanding such failures by individual Member States.

Many forward thinking companies arc already looking to buy and sell EU emission allowances in preparation for the first compliance date. Companies are trading on the basis of their predicted allocation ahead of the publication of the NAP in the country in which they are situated. Trading commenced in April 2003 when the first deal for the sale and purchase of EU emission allowances was struck at a price of 5 [euro] per allowance. Since that date more than 500000 emission allowances have traded in the market and activity is picking up fast. As a result of supply and demand pressures, the price of an emission allowance first gradually increased and in February 2004 EU emission allowances were changing hands for 13 [euro] (a 160% price increase in only 10 months). However, they have since fallen to 8-9 [euro] following more generous National Allocation Plans (NAPs) than originally announced by many governments (Fig 1) following discussions with major industrial groups and the EC.

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USING THE MARKET

Before trading, a company will first need to ascertain its emission reduction liability, its emission reduction opportunities and assess its emission market related risks. The company will then adopt an Emission Trading Scheme strategy based on this information.

Based on historic emission data the company will have a good idea of what its actual emissions are likely to be over the forthcoming compliance period. It will also be able to assess the number of emission allowances that it is likely to be issued in the NAP of the country in which it is based. The company will then be faced with a range of alternatives:

* If it anticipates being short of allowances; then it may buy emission allowances on the open market to bridge the gap between its allocation and its actual emissions; or

* It may invest in emission abatement such that its actual emissions fall to the level of its emission allowance: or

* It may reduce its actual emission beyond the level of its emission allowance with a view to selling surplus emission allowances into the market.

In determining whether to invest in emission abatement or to buy emission allowances from the market an operator may plot a Marginal Abatement Curve (MAC) relating to the installation in question.

In Fig 2, an operator that emits a quantity 'A' of emissions above his emission cap will find the price of an emission allowance on the open market is X. If all other factors are equal, the operator will invest in emission abatement to the point where his marginal cost of abatement equals the open market price of an emission allowance (where the MAC intersects with the price line (XY)). The initial cost of the emission abatement to the operator is represented by the yellow plus blue areas under the MAC. Conversely, the operator who has reduced emissions beyond A (the obligation) will have the additional abatement Y-A as a surplus allowance to sell in the market. The surplus can be sold at the market price of X, realising the financial value represented by the blue plus the green areas below and above the MAC between A and Y. The net cost to fine operator (yellow minus the green) will, therefore, be a far lower cost to the operator than had the company not invested in emission abatement but instead bought emission allowances direct from the market (yellow plus red).

[FIGURE 2 OMITTED]

In Fig 3, the price of an emission allowance on the open market has risen causing the operator to invest in further emission abatement to the point where his marginal cost of abatement equals the open market price. The initial investment will be more costly (yellow plus blue), however; the net cost to the operator (yellow minus green) has turned in to a net gain, since the green area is now much greater than the yellow area. The operator will have generated more money in selling the surplus emission reductions than he has had to spend in reducing his own emissions in line with his cap. In Fig 4, the market price of an emission allowance has fallen to the point where investing in emission abatement is no longer viable for the operator. Instead the additional emission allowances required should be purchased from the market at a cost represented by the red area.

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In this way the Emission Trading Scheme affords a company maximum flexibility in meeting its emission reduction obligation.

Whether a company decides to buy allowances to comply or to invest in emission abatement: it will have to deal with the associated market risks of its chosen strategy. The primary risks will be price risk and volumetric risk. The former relating to the price volatility of an emission allowance on the open market and the latter relating to the ease at which it will be possible to trade a quantity of allowances. These risks apply to both buyers and sellers of emission allowances in equal measures.

RISKS APPLYING TO THE SELLER

There is always a risk that a decision is made to invest in emission abatement based on the market price of an emission allowance but soon after the investment is made, the price falls and the investment is no longer viable. Alternatively: the market price of an emission allowance may remain at the requisite level for the investment to remain viable, but it may prove difficult to find a buyer for the volume of allowances needed to be sold when required.

RISKS APPLYING TO THE BUYER

A company may need to buy allowances to comply but, prior to the company being ready and able to purchase, the price of emissions allowances may rise sharply. Consequently the compliance cost will increase dramatically. Alternatively, due to the fact that there are only a finite number of emission allowances in circulation, it may be the case that when a company is ready to buy there are insufficient allowances in the market and the company is unable to buy the number required to comply.

Some companies are happy to accept risk and to manage risk themselves. Most companies, however, are risk averse and are far happier removing unfamiliar risk from their business model. In this way the company may avoid playing the market and instead focus their efforts on their core business. Such risk offsets are possible through businesses that specialise in risk management and who are happy to accept the risks of others. It will formulate bespoke structured financial products to meet the needs of a company looking to offset its risk.

A RISK MANAGEMENT PRODUCT

A company estimates that it will need to buy between 100 000 and 150 000 allowances in a year to comply. The company would be able to source a structured product that would guarantee a supply of the requisite number of allowances (within the specified tolerance band): being delivered at a pre-determined price and on predetermined delivery, dates. A risk averse company will then be confident that it will comply and it will not have to concern itself with market price fluctuations of emission allowances or with shortages in supply. The company knows exactly what its cost of compliance will be and it will be able to plan its cash flows more efficiently. Such a deal can be struck on an annual basis or over a longer time frame depending on the needs of the company. Fig 5 shows: in red: the possible price volatility of tin emission allowance over time. The green horizontal line shows the price volatility is zero for a company that has offset its risk.

The benefits of offsetting risk in this way are clear but often there is one further concern on the part of a risk averse company. The concern centres on the price at which the supply is fixed. A financial director of a risk averse company may not want to take the risk of fixing the price at a peak in the market and then having to justify such a decision to the board or to the share holders.

Such concerns may be eliminated by structuring an averaged financial product. This would be a structure, similar to that described above but not at a fixed price. Instead, the average of the prices on the last day of every month over the period is used to set the final price paid. In this way the company would comply at a price, which represents the average price over the compliance year, a defensible strategy.

Such structures are not limited to buyers of emission allowances either. A company that will have to sell allowances to finance its investment in emission abatement may use similar structures. Such a company may have a surplus of, say, 100 000 allowances per year over a five-year period. The company will be concerned that the price of these emission allowances may drop over the five-year period. Structured financial products would allow the company to ensure that it is able to sell all its surplus emission allowances at a fixed price. This would create certainty for the company and simplify the investment decision.

THE MARKET

Although National Allocation Plans were published in 2004; emission allowances will not be issued until early 2005. This will make it impossible to take delivery of emission allowances prior to 2005. Trading is taking place on the basis of an agreed price for a fixed quantity of emission allowances to be delivered on or after March 1, 2005. This is referred to as 'forward trading'.

Once issued, emission allowances will begin to trade on the basis of immediate delivery and this is referred to as 'spot trading'.

The company now knows the number of allowances that it wishes to trade and it knows the payment and delivery terms of the trade. The final issue is the question of price.

The valuation of an emission allowance is not quite as simple as it may first seem. In attempting to answer this question it is necessary to consider the factors that will influence the price.

The price will be a product of a number of elements. Drivers of price will include the volume of allowances being transacted, the price volatility in the market and the settlement terms of the deal. However, in summary, it is fair to conclude the primary driver of price will be the amount of risk involved in the transaction.

There is no hard and fast method of measuring risk. Consequently, different companies will have differing measures of risk and in this way the same commodity may have a number of different prices at any given time.

To find the best deal in the market at any given time, a company is advised to use the services of a specialist broker. The broker will provide the company with access to a network of thousands of other companies involved in emission allowance trading. In this way the company will be presented with a number of alternative counterparties and the broker will negotiate mutually agreeable terms and price between the buyer and the seller.

VARIABLE PRICING

As an example, take a company looking to sell 100000 allowances in the market and it would like to deliver those allowances one year from today. The terms of such a deal will be payment upon delivery. The broker tells the company that there are two interested buyers, one willing to pay 13 [euro] per allowance, while the other is only willing to pay 12 [euro]. At first instance it would appear that the best price is 13 [euro]. However, the company offering to pay 13 [euro] is a small company with a weak balance sheet that has only been in business for a few months. Conversely, the company willing to pay 12 [euro] is a multinational with 'AAA' credit rating and a solid balance sheet. It is now necessary to make a subjective valuation of the risk involved in accepting the 13 [euro] price. It is quite possible that the deal will be concluded at 12 [euro] since the risk involved in dealing with the small company is too great and is not sufficiently compensated by the 1 [euro] price differential.

The company may then look to sell another 100 000 allowances to the same 'AAA' credit rated buyer but for cash flow purposes would like to be paid 50% today and the balance on delivery. To encourage the buyer to agree to these less favourable terms the company offers the allowances for sale tit a price of 11.50 [euro] and a deal is struck.

Meanwhile, the small company that was unsuccessful in its attempt to buy allowances at a price of 13 [euro] has been forced to revise its bid upward In order to encourage a seller to accept the additional default risk involved in dealing with it. It is now prepared to buy emission allowances at a price of 14 [euro].

From this example, it can be seen that the price of an emission allowance has ranged from 11.50 [euro] to 14.00 [euro] at the same point in time and it is fair to conclude that there is no definitive answer to the question of 'What is the price of an emission allowance?'

The use of a broker will once again be invaluable in allowing a company to evaluate the various routes to market an the various prices available at any given time.

BROKERAGE SERVICES

A broker will serve a number of functions, many of which will be offered at no charge. For the company looking to transact, the broker will be a source of market information and a means of networking with other companies involved in the market. A brokerage service is about matching buyers and sellers and providing financial products and structures that best suit the needs of the company looking to manage its risk.

A company gearing up to participate in the market would be best advised to make contact with an emission allowance broker who will help guide it through the process.

J EMANUEL, Director at specialist emission allowance broker Evolution Markets LLC, London Tel +44 (0) 20 7621 1609 email London@evomarkets.com www.evomarkets.com