EU ETS risk and climate risk

Vertis now has more than 800 active clients across all sectors and in over 50 countries, and has recently started trading electricity in Romania. It has a team of 25 people, most of whom are based in Budapest and recently opened offices in Bucharest and Madrid.

Much of the company’s work has been about helping firms manage the risks of being in the EU ETS. In the early years, we had to spend a lot of time in teaching mode – helping clients understand the EU ETS, putting in place the capabilities for trading and compliance, as well as making the best of the opportunities afforded, such as the ‘risk-free’ use of low-cost Kyoto credits for compliance purposes.

More recently, Vertis has done a lot of work helping clients use allowances for financing or as collateral in funding, lending units to other clients, and so on. Managing the risks of these more elaborate deals while keeping things simple is vital, particularly in central Europe, where many of our clients are based.

We work with a number of clients in determining their policies for the EU ETS, so they can manage the risks in a systematic way, and we recently conducted a piece of quite revealing research. During a discussion with a friend at the London School of Economics (LSE) on hedging behaviour of companies in the EU ETS, it became clear that his assumptions were ‘classical’ – that companies in the EU ETS act as rational agents in a market, in the way more sophisticated power companies that sell power forward and purchase the corresponding fuel and carbon do in order to lock in their margins. We set out to see how valid this assumption was.

Together with the LSE and Energy Aspects, at the end of 2014, we canvassed more than 50 companies of different sizes across a range of industries and in several regions – western Europe, the Mediterranean and central Europe – on their hedging practices and attitudes to EU ETS risk. It transpired that most companies do not have formal policies for managing EU ETS risk, and most don’t have a systematic approach to hedging exposure to the carbon market. The use of sophisticated or derivative products is very limited. In effect, they accept price swings as part of the burden of being in the EU ETS and don’t worry a great deal about the financial impact of those fluctuations.

This seemingly laissez-faire approach to risk makes more sense when you consider the circumstances of the EU ETS. Prices are struggling to stay above €7 for one EU Allowance (EUA) – the right to emit one ton of CO₂. Many companies – especially industrial manufacturers – are sitting on large surpluses of allowances, some amounting to several years’ worth of emissions, meaning they won’t need to spend cash on compliance for some time. Again, in the industrial sectors, the free allocation of allowances granted by governments reduces significantly the average cost of carbon, even if it does not affect the marginal cost. If it does not hurt, it does not matter.

James Atkins, Vertis

There is, however, a perception that things will change. The companies surveyed don’t see a lot of risk in the EU ETS at the moment but they do expect an increase in prices – from today’s EUA price of €7 to an average of €15 by 2020 and €20 by 2030, although they are still less bullish than analysts in the market. At time of writing, there is a (surprising) convergence among European parliamentarians of the right and the left, which could mean we soon have an agreement on reform of the EU ETS, which should, indeed, bolster prices.

If the EUA price eventually exceeds €10, then the work done on EU ETS risk policy and trading strategies should start to pay off.

Beyond the EU ETS, there is a broader question of climate risk. It would be a mistake to perceive the EU ETS as being a proxy for climate risk – the attitude that “as long as we comply with the EU ETS, we will be OK” won’t work. The gap between the emissions targets in the EU ETS and those recommended by scientists is too great.

Aviation is a case in point. While much of the aviation industry kicked and screamed at the introduction of the EU ETS, less noise was made about the $5 billion cost to airline passengers due to delays caused by the snow and storms of winter 2013/2014 in the US, a possible sign of things to come as climate change brings more extremes of weather. Vertis is trying to raise co-funding for a data mining study on the impact of climate change on the aviation industry.

We are not confident that the price will shoot up one day. As long as entrepreneurs are investing in renewables, energy efficiency and coming up with new technologies, there is a chance that they will keep pace with the declining cap in the market. Despite what people seem to think, the level of the price is not a reflection of whether or not the market is working, nor is it a signal of climate risk.

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