Over the past few months, a great deal has changed in the world’s awareness of climate change. Larry Fink, the CEO of BlackRock, the world’s largest asset manager, stirred up Wall Street in January stating in his annual letter to CEOs that the intensifying climate crisis will bring about a “fundamental reshaping of finance.” Then in February, energy giant BP pledged to cut its carbon emissions to net zero by 2050, following the lead of other oil and gas firms in setting targets amid mounting pressure from investors and climate activists. Even central banks are joining in, with leaders such as the Bank of England’s Mark Carney warning that climate change poses major risks for the safety and stability of the banking sector.
The fundamental story is that a shift from high carbon energy to clean energy is moving higher on the agenda, driven by economics, risk, and increasingly supported by political and social forces. How the world can produce abundant energy supplies while substantially reducing emissions has become one of the defining issues of our time.
Carbon Trading in Europe
The “energy transition” should not be viewed as a single, big transition; rather it is a plural, made up of many steps and stages across sectors and geographies. Some energy transitions are already taking place, such as coal to gas switching in the U.S. or the introduction of new rules mandating lower sulfur emissions from cargo ships. Others are longer-term efforts, such as government investments to support a gradual shift to electric vehicles.
One area of the financial markets that has become a key component of the energy transition is carbon emission trading, which is designed to provide an economic incentive for power utilities, airlines and manufacturers to reduce their emissions through a regulated market mechanism.
In Europe, emission trading is often seen as the flagship project of the European Union’s climate policy. It moved into greater prominence in December when European Commission president Ursula von der Leyen unveiled the EU’s “Green Deal,” a 10-year package to reduce the EU’s carbon emissions by at least 50% compared with 1990 levels, with the goal of reaching net zero carbon by mid-century.
“The Emissions Trading System is the EU’s cornerstone policy to achieve its 2030 climate goals,” said Lawson Steele, a senior utility analyst at Berenberg Bank. “The system will work, providing the [carbon] price is high enough. For the last 15 years, it hasn’t been, but that is about to change.”
Carbon emissions trading was the result of the landmark 1997 Kyoto Protocol which set emission reduction targets for 37 industrialized countries. The idea was to create a system to control emissions worldwide based on principles that are similar to other regulated commodity markets.
In 2005, the EU created the Emissions Trading System (ETS), a cap-and-trade system that became the world’s first major carbon market and remains the biggest today, accounting for almost 80% of emissions traded by volume. The EU ETS sets an overall cap or limit on the total amount of carbon emissions that can be emitted each year by sectors and companies covered by the system, including power stations, industrial plants and airlines operating in Europe. Tradable emission allowances are allocated to participants in the market via free allocation and auctions. One EU allowance represents one ton of carbon dioxide that the holder is allowed to emit.
Companies that go over their limit must buy emission allowances from auctions or the secondary markets. Companies that reduce their emissions below the target level—for example by switching to cleaner fuels—can sell those excess allowances. The goal is to create economic incentives for companies to reduce their emissions of carbon into the atmosphere, with market dynamics of supply and demand determining the price of allowances.
Leipzig-based European Energy Exchange, a subsidiary of Deutsche Börse, operates the primary market for the auctions that the EU uses to allocate the allowances, while ICE Futures Europe until last year operated the auction platform for the U.K. The U.K.’s EU carbon allowances were suspended at the start of 2019 due to Brexit uncertainty, although sales will restart this March.
EEX and ICE also operate the emissions secondary markets, offering spot and derivatives trading of ETS allowances (EUA, EUAA) and Kyoto credits (CER). The derivatives contracts allow companies to lock in the cost of these allowances, serving as an optimal hedging tool for compliance obligations.
The average carbon price in the EU ETS rose to just under €25.00 per metric ton in 2019, peaking at €29.81 in July, according to data from Refinitiv. This is a marked contrast to previous years, when the EU ETS closed 2016 at €6.57 and was still at less than €10 a tonne at the beginning of 2018.
To those who have been following carbon markets, this is quite a turnaround. For years, a glut of allowances built up in the system depressed prices, leading some to question the market’s relevance as a tool to fight climate change. In January 2019, the EU introduced a Market Stability Reserve to withhold a significant volume of allowances and to tighten the supply side, sending prices on an upward trajectory ever since. Policy makers are now looking to tighten the rules in the market reserve even further to pull more allowances out of the system.
“Carbon has been one of the strongest performing commodity products of the past few years,” said Brett Hillis, a partner at law firm Reed Smith who focuses on energy trading and derivatives. “One cause of this has been the measures taken by the EU to reduce the number of surplus allowances. We are also seeing more interest in carbon markets among our clients, with some financial institutions that reduced activities several years ago returning to these markets.”
Many analysts and industry experts expect the price of carbon to rise even further this year, breaking through the psychologically important threshold of €30.
“While the addition of supply from the U.K. will add some bearish pressure in the short term, we are coming to the end of the third phase of EU ETS and this will see increased demand from industrials, especially those that in the past borrowed future free allowances. This will not be possible for the compliance year 2020 and therefore these participants will need to be active, which will support prices,” said Nicolas Girod, managing director of markets at carbon consultancy ClearBlue Markets. “We forecast that prices will end the year above €30.”
Berenberg’s Steele expects the price of carbon to more than double to reach €65/mt by the end of the year as the market begins to price in the “enormous multi-year deficits faced by the system.”
Now that the rules have been tightened and the oversupply problem is being addressed, an increasing number of companies are entering the emissions derivatives market to lock in the cost of these allowances, market participants told MarketVoice.
The biggest participants have been the region’s utilities who sell their power many years in advance and hedge their exposure to rising carbon prices by buying enough permits when the price is lower to cover their future emissions output. For instance, German utility RWE, one of Europe’s biggest power generators which last year pledged to become carbon neutral by 2040, has said it has hedged its carbon exposure until the middle of this decade.
Financial and hedge fund activity has also helped lift prices, according to market participants. EEX, for example, said the number of financial participants active in its emissions futures order book has increased significantly.
“EEX has experienced a significant increase in interest in emissions since 2018. An overall scarcity of supply of emission allowances due to reduced auction volumes resulted in a rapid price increase and a rise in volatility,” said Steffen Löbner, an expert in EEX’s environmental markets team. “We have noted a rising interest by financials, including hedge funds.”
EEX’s portfolio of trading participants comprises utilities, industrials, financials and brokers directly admitted to the exchange or providing access to third parties. “In 2019, 26 new clients started to trade in our emissions futures order book including five big international banks,” Löbner said.
Globally Inspired Plans
Europe’s success in establishing the world’s biggest carbon market has inspired similarly designed schemes around the world. In North America, in the absence of federal adoption of climate change policy, states and municipalities across the U.S. and Canada have been taking action on their own, creating carbon cap-and-trade markets primarily in the northeastern and western regions.
The biggest carbon market is the linked California and Quebec program, which forms the Western Climate Initiative, covering the power and transportation sectors. The second, in the northeastern U.S., is the Regional Greenhouse Gas Initiative (RGGI), which was recently buoyed by the re-entry of New Jersey into the scheme this year, and perhaps even more notably by Pennsylvania, the US’s third biggest coal producing state, agreeing to join in October 2019.
While RGGI covers the power sector only, it may soon have a transportation-focused companion. Most of the RGGI jurisdictions announced plans in December 2018 to design a market to address carbon emissions from the combustion of transportation fuels under the Transportation and Climate Initiative, which could be operational by 2022.
According to Refinitiv data, WCI and RGGI saw an increase in traded volume and value in 2019, with traded volume gaining 49% YoY and value jumping 74% to €22 billion to make up a 12% share of the global total.
“Both the WCI and RGGI are operating under expectations of a significantly tighter market next year, as they enter a new trading period with more ambitious caps from 2021,” Refinitiv said.
With internal improvements and participation from additional states and provinces, there is now more optimism about the North American emissions markets, which, similar to Europe, are attracting a range of participants, from utilities to speculators, proprietary trading firms and hedge funds.
“The sentiment in North American carbon markets is definitively positive. Financial players have started being increasingly active in North American carbon markets since the start of 2019,” said ClearBlue Markets’ Girod.
“Publicly available CFTC data shows that they have never been so long in the WCI market for example. This is mainly driven by hedge funds that are expecting prices to increase. While prices have increased fivefold in the EU, North American markets prices have stayed more stable and the expectation is that prices could witness similar trends to the EU market,” Girod added.
With the market showing greater signs of growth, one company that aims to catch that trend is Nodal Exchange, a derivatives exchange in the North American energy markets owned by EEX. Nodal Exchange made its move in the emissions market in 2018 when it launched a range of emissions and renewable energy certificate futures and options contracts, including futures on WCI and RGGI allowances. The derivatives are listed alongside Nodal’s existing portfolio of power and gas derivatives and cleared through Nodal Clear.
The contracts were developed in partnership with IncubEx, a consulting firm set up by former Climate Exchange executives that specializes in product and business development for environmental markets. IncubEx had already worked with EEX in Europe to promote its environmental market segment there.
In January this year, Nodal expanded its environmental offering with IncubEx with the first physically delivered California Low Carbon Fuel Standard futures and options contracts, allowing commercial firms in the transportation fuels space to hedge their forward production and meet compliance obligations under the LCFS program.
“Nodal Exchange had record environmental futures trading volume in January 2020 with 115% year over year growth. California Carbon Allowances have been particularly strong recently,” said Paul Cusenza, CEO of Nodal Exchange. “Our environmental traders are diverse representing both physical and financial traders and closely mirror the participants who trade in the power markets,” he added.
ICE also lists futures on both WCI and RGGI carbon allowances. Volume in its California Carbon Allowance futures and options jumped to 124,778 contracts in December 2019, compared to 34,565 the year before. Volume in RGGI futures and options reached 81,824 contracts, compared to 56,688 in December 2018.
“The US environmental markets are a lot bigger than people expect,” said Gordon Bennett, managing director of utility markets at ICE.
Moving Mainstream
Overall, the total value of global carbon markets grew by 34% in 2019 to hit €194 billion, according to the Refinitiv analysis. This marks a third straight year of growth and a fivefold increase in two years. In all markets, including those in South Korea and New Zealand and an emerging market in Mexico, carbon prices have risen or are predicted to rise in the near future as market rules are tightened.
And this growth looks set to continue further, when China, the world’s biggest producer of greenhouse gases, launches a nationwide emission trading scheme later this year. This will initially cover the power generation sector, with non-power elements of China’s regional pilot programs continuing in parallel. China’s ETS will cover an estimated total allocation of 4 billion-4.4 billion mt of CO2 equivalent, more than twice the size of the EU ETS.
“The emissions markets are becoming more mainstream and these are likely to get bigger, whether through new emissions trading schemes being introduced in new geographies or by adding new energy intensive sectors to existing emission trading schemes or jurisdictions,” said Bennett. “WCI covers about 85% of all emissions in California and the direction of travel is that more schemes will go this way too. It’s not just about emissions from one particular sector. Besides electricity generation, more schemes will start to include the transportation sector.”
This can be seen in Europe, where the European Commission is considering the expansion of the EU ETS to other sectors of the economy, including maritime and transport. Presently, about 50% of the EU’s output of carbon is regulated by the ETS. In a response published in February to the Commission’s Climate Law Roadmap consultation, EEX said, “The expansion of the ETS to other sectors of the economy…will provide market actors with an integrated price signal across industry, energy and transport, to guide their economic activity and decarbonisation efforts.”
EEX added that the expansion is also necessary “to ensure global connectivity across national carbon markets across the world and pave the way for a global market.”
Linking emissions trading systems is a long-term goal for the EU and will create deep liquidity in the secondary ETS market, said ICE's Bennett, adding that market-based mechanisms are crucial to help quantify the cost of polluting.
“As business leaders and policy makers grapple with the consequences of climate change, the effective use of these tools will ultimately dictate the success of the energy transition,” he said.
Focus on Renewables
Meanwhile, higher carbon prices are tilting the economics of electricity generation away from fossil fuels and towards cleaner power, making lower-cost renewables—such as wind and solar—and natural gas more competitive than coal and lignite.
In Germany, renewable energy has overtaken coal as the country’s main power source, while in the U.K., renewable energy has moved narrowly ahead of gas-fired power as the primary source of power. In the U.S., coal-burning power plants are shutting down at a rapid pace as the domestic shale boom has resulted in a decline in natural gas prices. Around the world utilities face the next big climate question: embrace natural gas or shift aggressively to renewable energy.
For power producers and other companies in the real economy that are keeping a watchful eye on primary energy sources, it is vital to have access to liquid venues with a healthy balance of commercial users, financial players and speculators to manage price risks related to the energy transition.
“The relationship between the primary fuels is changing and the merit order in each pillar of energy—whether that’s heating, electricity, transportation or manufacturing—is going to look different in five, 10- or 20-years’ time,” said Bennett. “Being able to provide deep, liquid venues to manage the risk of these spread relationships evolving is important, not only to help with the transfer of risk but also to provide price signals for what companies should be putting through their power plant.”
“The challenge is to keep on top of new primary fuels and on top of new emission trading schemes that come into play,” Bennett said. “ICE is positioned well, and energy transition has been embedded within the strategy of the team for the last few years. It is a complex, global challenge but we are firm believers that markets can help to enable the energy transition.”
Derivatives markets help hedge risk in long-term renewable power agreements
It's not just utility companies that are replacing legacy fossil fuel generation with renewable sources. Around the world, heavy hitters such as Amazon, Microsoft, Apple and Google have arranged bespoke agreements with renewable power producers to provide clean electricity directly to their data centres and buildings.
Google, for example, made the biggest corporate power purchase agreement (PPA) in its history with the purchase of 1.6GW in renewable energy globally last year. That took the company's renewable energy portfolio to almost 5.5GW, more than the renewable energy capacity of countries such as Lithuania and Uruguay.
According to BloombergNEF, a record amount of clean energy was bought by corporations globally through PPAs in 2019, up more than 40% from the previous year's record. This came as governments in Europe scaled back subsidies that kept the renewables business growing for years.
PPAs are long-term contracts under which a business agrees to purchase electricity directly from a renewable energy generator. Purchasers of PPAs are attracted by lower prices and the "green credentials" from having their power supply come from 100% renewable sources. On the developer side, PPAs are necessary to finance renewable energy projects. Google, for example, said its PPAs would help towards the construction of $2 billion in energy infrastructure, including millions of solar panels and hundreds of wind turbines.
This means that PPAs are often fixed for long periods, up to 10 years or even more, to ensure revenue security for the developer.
These long-term agreements bear certain risks, however, which is where the futures market comes in. Most PPAs are financially settled, which means the price is fixed between the generator and the purchaser. However, the actual power produced is sold on the spot market, which creates price risk.
"Because of the ever-increasing trend towards long-term power purchase agreements, we see a strong demand from the market to hedge against the price and counterparty risk of the PPA agreements for the entire 2020 decade," said Steffen Riediger, director of European power derivatives at EEX.
EEX already offers cleared cash-settled futures contracts up to six years ahead in all major European power markets. Later this year it will be introducing 10-year base year futures in some of its European power markets to help members hedge a greater portion of their PPA risk.
"We will initially focus on extending the expiries in Spain, Germany and Italy to give our clients the opportunity to hedge the full 2020 decade," said Riediger, adding that the U.K. and Nordics may follow later.
"We are still watching developments concerning the future design of the U.K. power market after Brexit and potential bidding reconfigurations in the Nordic market area closely," he said. "We always strive to bring innovative products to the market, particularly to support further renewable energy investments and the market-based integration of renewables."
