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The CO2 Market

Experiences from the 1st PeriodWhat can we learn?What can we expect in the 2nd Period?Threat or Opportunity?

National Environment ForumBucharest, 20.11.2007

roman.stuetz@egl.ch

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Objective

• Basics• Framework, Consequences

• Factors influencing the market• Prices

• Recap to first period

• Expectations for the second period

• The Market

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Legal Framework - Obligation

• 1997 Kyoto Protocol• Reduce output of green house gases by 5% until 2010

• EU by 8%

• 2001 EU decided to comply with Kyoto targets• EU imposed a self obligation even without Kyoto in force

• Three mechanisms• Emission trading - EUA• Clean development mechanism - CER• Joint implementation - ERU

• 2003 EU established an EU-wide trading scheme (EUETS)• Trading scheme started 2005

• Two phases 2005-07 and 2008-12

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Consequences

• An unintended commodity was created by law• 4’500 companies have to engage

• A market had to emerge from the green field

• A new market with all its start up problems• Lack of: liquidity, information, legal certainty…

• National states allocate allowances to covered companies• Could be auctioned but are mainly grandfathered

• Allowances represent an asset• Allowances have a current market value and constitute an asset

• Opens door to intensive lobbying

• Emissions represent a cost factor• You have to add another commodity to the existing bulk of input factors

• This additional input factor represents costs (at least opportunity costs)

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Consequences for the Power Market

-50%

Originally fuels were compared by• Purchase prices• Political factors

EUETS

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Consequences – Power Prices

Hyd

ro

considering costs of

emissions

Rearrangement of Merit Order regarding ETS

Short run marginal costs of power stations

Win

dAt

om Coa

lLi

gnite

CCGT

Gas

/Ste

am Oil

Gas

-turb

ine

Under full consideration of EUA

• Rising power prices

• Wind fall profits for CO2-free

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CO2-Price Development in the 1st Phase

Characteristics of phase I:

• EUA are a quite volatile commodity• Above 100% annualized volatility

• Lack information and liquidity

• Over-allocation

Allocation Emitted Position

2005 2‘102 2‘006 96 long

2006 2‘090 2‘028 61 long

Too much allocated consider “asset”

Rising emissions – but in total long

0,00

5,00

10,00

15,00

20,00

25,00

30,00

35,00

Power sector and banks buy Actual emissions data released

Industry and CEE selling

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Conclusion Phase I

• Lackluster start• Emerging market

• Early buying• Utilities cover short positions

• Banks taking speculative long positions

• Release of actual emissions data• 2005 and 2006 significant long

• Drop of prices

• Late sellers• Industry discovered natural long positions

• Delayed CEE registries went online

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Outlook for the 2nd Phase – Price Drivers

• National allocation plans• Are by far stricter than in the 1st phase

• 2‘008Mt/a compared to 2‘100Mt/a

• National CER limits (7-20%)• CER are important to cover overall short position• Delays in the CER project pipeline

• Asymmetric distribution• Industry sector is balanced to long – reluctant to trading• Power and heat sector is short – trading experience

• Risk management• Power sector wants to login margins

• Fuel switching• Short term: hard coal to gas potential of 60Mt/ is by far

overestimated• Long term: lignite to gas remarkable potential, up to 100Mt/a

Reduced supply

Improved supply

But delayed supply

Delayed supply

Early demand

Early demand

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Price Forecast

0,00

5,00

10,00

15,00

20,00

25,00

30,00

35,00

40,00

45,00

UBS Research

Markedskraft

Econ

Pointcarbon

Deutsche Bank

Early and clear decision of phase III further CDM projects

Delayed decision of phase IIIDelayed decisions in court cases

Overreaction due to short term scarcity by late allocations and active players

• Phase I: 0,10€/t• Phase II: 25€/t average price

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Market Segmentation

The market makes great leaps forward from an emerging to a matured market

EUA CER

Spot

OTC

y y/n

Spot

Exchange

y n

Forward y y

Futures

Exchange

y y

Options

OTC

y/n n

Options

Exchange

y/n n

ECX

Broker PlatformRequires:Broad market accessBroad contractual basis

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Who are the major players in the Market?

• The most players are industry based• Industry is reluctant to trading• Decisions makers lack the bonus reward (opposite to banks)

• Are afraid to do something wrong, so better do nothing

• The most active players are fossil power station operators and banks• Power producers have a strict risk management

• Login the profit on the production side / speculate at the trading desk• Utilities trade actively on a daily basis

• Trading is one of the natural businesses of banks• Operate at high levels of risk by use of huge positions and VaR

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Why does EGL trade Emissions?

We observe:

• Interaction with the whole energy complex (remember: order of merit)• Coal, oil, gas, CO2 and power interfere each other

• No transport bottlenecks / fungible commodity• Easier to handle than power

• Cross border congestions• Daily scheduling

• Potential customers• About 12`000 installations in about 4`500 companies

• About 1`000 companies from the energy sector

• Existing contacts to these 1`000

• An issue we have in common with the other 3`500 (door opener)

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EGL applies the following Strategy 20.10.03

• Start Emissions trading• Establish all procedures on the green field (done by EGL-Austria)• First trade Nov03

• Selected the Option „Active Trading“• Hedging Activities for EGL’s gas fired power stations in Italy• Active Trading

• Sales und CO2-services for customers • Speculative trading with own positions

• No Engagement in• CDM/JI and project development

• Amendments in May this year• Secondary CER trading• Speculative / hedging / customer services

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The Internal Market Place

IMPOperated by EGL-Austria

Obliged Bid and Ask

EGL Esp.loc: Spain

No account

EGL Rom.loc: RomaniaNo account

EGL Ita.loc: Italy

No account

Customer CustomerCustomer

Spot Exchanges Trading-Companies Brokers

EGL Prod.loc: Italy

Operator‘s account

EGL Pol.loc: PolandNo account

Customer

Intermediaryloc: CEE, Baltic

Account

Customer

Directional BookDietikon

Fut. Exchanges

Customerloc: EUAccount

• Advantage of EGL: Concentrate activity at one central point• Advantage of customers: Gain access to the market

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Is the EUETS a Threat or an Opportunity?

• EGL’s view• Due to interaction with energy complex an opportunity

• Rising power prices• Trading approach

• Due to service provider approach an opportunity• Broader range of products plus new counterparts

• As expanding CCGT operator• Regarding uncertainty a threat• Regarding abnormalities a (trading) opportunity

• Industry view• Due to rising power prices a threat

• Due to expected balanced total position neutral

• In case of expansion scenario (uncertainty) a threat

• Considering market abnormalities a (trading) opportunity

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Conclusion

• Due to over allocation in first period price approaches zero• Successful lobbying of industry

• Scarcity in the second period will establish average price of 25€/t• Major cuts in NAP

• Significant inflow of CER

• Early demand and late supply for/of EUA

• The market is becoming matured• EGL deems the EUETS overall an opportunity

• Due to trading and service provider approach

It would be great if you could deem it an opportunity too

Looking forward to trade with you

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The End

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Annex: Abnormalities in the Market

• Spread between spot and term• Spot: delivery within two business days

• Term: delivery at defined date in the future

• Spread between the forward vintages (forward curve)• Vintages: Dec05 – Dec12

• From time to time we observe a forward curve which is too flat (or steep)• Compared to the Euribor (erb)

• Expectation: pterm = pspot*(1+erb)^(days/365)

• Reality: often deviates from expectation

• Obviously people allocate a convenience yield on early delivery

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Annex: Abnormalities in the Market

Current forward curve for phase II*

Vintage Close IIR

2008 21,63

2009 22,16 2,5%

2010 22,71 2,5%

2011 23,26 2,3%

2012 23,86 2,7%

*) Point Carbon CMD 7.11.07 IIR…implied interest rate FV…Fair Value calculated with 4,6%pa

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Annex: Abnormalities in the Market

• Sources for such convenience yield could be• No experience with forwards (risk management)• Low credit ranking of buyers (of buyers)• Reduction (elimination) of counterpart risk• Reduction of effort for monitoring counterparts until delivery• Expectations about short term supply bottlenecks

• Delayed allocation of EUA (as we saw it in 2005)• Default of CER deliveries with replacement clause

• What could eliminate the convenience yield• Internal rates of return deviating from Euribor (IRR>Euribor)

• Our opinion: • As soon as EUA08 are allocated and industry sells, widening of spreads

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Period II

Excursus: Liquidity Analysis

Liquidity in allowances

Allocation for 2008 / 09 and 10 Required Purchase

Compliances for 2008/ 09 und 10

Liquidity in Allowances

28.2.08 28.2.09 30.4.09 28.2.10 30.4.10 28.2.11 30.4.11 28.2.12 30.4.12 30.4.13

Even in the case of a short position the purchase can be postponed

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Product: Interest Yield on CO2-Allowances

• Remember your liquidity line• You can do this even if you are short

• Transactions• You make a transfer of allowances to your counterpart on Dec08

• On Dec09 • Your counterpart returns the initially transferred allowances• And also returns excess allowances (approx 1,5% more)

• Effectively you lend your allowances to a counterpart for a premium

Period II

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Product: CO2-Loan

• Remember your liquidity line• You can do this even if you are short

• Sell x tons EUA on Dec08 at 21,63• Buy x tons EUA on Dec09 at 22,16• You repurchase something you sold cheaper earlier• But the implied interest rate is significantly below Euribor

• Effectively you borrowed money at 2,5% and placed EUA as collateral

Period II

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Product: EUA - CER - Swap

• Substitute EUA by cheaper CER• Sell expensive EUA and purchase cheap CER

• NOR 38,2% DEN 17% SWE 10% FIN 10%

• By use of a forward agreement• Sell x tons EUA on Dec 1st at 21,50€/t

• Buy x tons CER on Dec 1st at 17,50€/t

• Collect 4€/t

• Terms• EUA deal is binding

• CER deal is contingent on functional ITL• If not CER deal is postponed• In the worst case the CER deal is null and void – replacement of EUA

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Would you like to profit from EUETS?

By use of the following mechanisms

• EUA-CER-Swap• Emitting installations are allowed to substitute EUA by cheaper CER

• Sell expensive EUA and purchase cheap CER

• NOR 38,2% DEN 17% SWE 10% FIN 10%

• Interest rate products - use the flat forward curve and your EUA liquidity• CO2-loan

• Interest yield on allowances