Hot, volatile CO2 market spawns derivatives trade

Reuters: The booming carbon market, heading for a $70 billion value, is spinning off a flourishing network of new derivative instruments, from options and swaps to bond-style repos. The multi-million dollar derivatives are thriving under the European Union's emissions trading scheme (EU ETS), Europe's flagship programme to tackle greenhouse gases blamed for global warming, allowing companies to hedge positions, aggregate risk exposure, or speculate on underlying price movements.

"With a stable regulatory regime and a liquid physical market comes the ability to have derivatives," said Greg Dunne, a director at carbon project developer ICECAP. Intercontinental Exchange's European Climate Exchange (ECX), Europe's largest carbon exchange, reported option volumes for European Union Allowances (EUAs) at 26.4 million tonnes of CO2 in the third quarter of 2007, more than twice the total traded in the six months before. The exchange's third quarter options transactions accounts for eight percent of the ECX's total volume of almost 330 million EUAs traded during that period.

Underlying price volatility, an important prerequisite for derivatives trading, is not new to the expanding carbon market, which the International Emissions Trading Association said this week would more than double in value this year. EUA futures for Phase I (2005-07) of the EU ETS hit 32 euros a tonne before crashing in April 2006 on news of an over-allocation of credits by the European Commission. Phase II EUAs, looking comparatively stable due to stricter emissions quotas set for member states in 2008-12, still hit a 5-month high of 24.20 euros early Wednesday.

The benchmark Dec-08 contracts have fluctuated between 12 and 26 euros this year, with Swiss bank UBS last week forecasting EUA prices as high as 40 euros by 2013. Certified emissions reductions (CERs), the $5 billion carbon offsets market under the UN's Kyoto Protocol, are also seeing a derivatives market develop around them. The first exchange-traded CER options contracts were launched Friday on the Chicago Climate Exchange, though only a single contract has traded.

This summer, Norway's Nord Pool started settling CER-EUA swap trades, another derivative instrument which allow counterparties to exchange, or swap, credits before an agreed future date. Since September, the Nordic energy exchange said it has settled almost 5.5 million CER-EUA swaps, or 75 percent of its CER trading activity, at a total value of almost 30 million euros ($44 million). Repurchase agreements, or repos, are another trading instrument companies are considering.

"Companies buy EUAs, which then just sit there not yielding anything, so a repo market is a natural development," Dunne said. A repo, normally associated with the bond market, is an agreement between two counterparties whereby one sells the other a security at a specified price with a commitment to buy it back at a later date for another specified price.

"The carbon market is starting to look like a government bond market," Richard Wilson, head of emissions at brokers Tullett Prebon, told Reuters. "Carbon offsets are similar in that there are both high quality credits and junk credits, and you'll be able track them all once the International Transaction Log is running," Wilson added, referring to the UN's new carbon-trading link slated to be fully operational in 2008. Even the unregulated voluntary offset market has the potential to breed a healthy derivatives market, Dunne added.

"There's an unlimited amount of things that can be done with derivatives. We're only at the beginning, we've barely even started."