Carbon Trading and Weather Derivatives

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• Carbon Trading and Weather Derivatives
• Patrick DEDE

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Definition

• Emissions trading is an administrative approach
  used to control pollution by providing economic
  incentives for achieving reductions in the
  emissions of pollutants.
• Weather derivatives are financial instruments
  that can be used by organizations or individuals
  as part of a risk management strategy to reduce
  risk associated with adverse or unexpected
  weather conditions. The difference from other
  derivatives is that the underlying asset
  (rain/temperature/snow) has no direct value to
  price the weather derivative.

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Definition

• The Greenhouse Effect is the process by which
  certain gases in the Earth's atmosphere to trap
  heat from the surface.  This effect creates an
  insulating blanket around the earth that keeps
  the planet warm. 

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The Kyoto Protocol

• The objective is to achieve "stabilization of
  greenhouse gas concentrations in the atmosphere
  at a certain level.
• Requires EU, Canada, Japan (Annex 1 countries)
  make mandatory cuts in emissions of carbon
  dioxide and other gases.
• By 2012 EU must reduce CO2 8 Canada 6 Japan
  6 from 1990 levels.
• Kyoto came into force on February 16, 2005 (90
  days after Russia ratification).
• Countries require large emitters to reduce GHG
  emissions.

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Market of Opportunity

• Six greenhouse gases emitted from industrial,
  agricultural and consumer sources
• methane (CH4),
• carbon dioxide (CO2),
• nitrous oxide (N2O),
• hydrofluorocarbons (HFCs),
• perfluorocarbons (PFCs), and
• sulphur hexafluoride (SF6)
• will be traded in the brokerage houses and
  trading floors of the world markets.

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Market of Opportunity

• EUR18 billion market for CO2
• Market opportunity has been estimated at EUR3
  trillion over 20 year horizon and may be EUR100
  billion by 2010
• Six European exchanges are about to trade carbon
  emission and weather derivatives
• One US exchange Chicago Climate Exchange

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Market of Opportunity

• UBS is trying to change weather investing by
  launching the first Global Warming Index (GWI),
  which provides a simple way to take a view on a
  wide range of weather variables.
• Weather derivatives traded on the Chicago
  Mercantile Exchange jumped from 9.7bn in 2004-5
  to more than 45bn in 2005-6.

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Energy Emission market

• The polluters in the Kyoto Protocol are
  individual countries that have agreed to a
  specific reduction target which are currently set
  at an average of 5.2 per cent below 1990 levels
  of emissions.

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Energy Emission market

• In most respects, emissions markets are no
  different from current financial markets.
• They are subject to the same pressures of
  capital markets, such as price volatility, boom
  and bust cycles, speculative bubbles...

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Market Mechanism

• Its a market-based solution to environmental
  problems which refers specifically to air
  pollution.
• Each polluters are assigned targets for reducing
  their emissions of gases in a pre-defined time
  period.

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Market Mechanism

• The polluters are then given a number of
  emissions credits for the amount they are
  allowed to pollute, which is the level of their
  emissions minus their agreed target.

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Market Mechanism

• There are several things that can happen
• Scenario 1
• The polluter uses up the whole allowance in the
  allocated time period, but still pollute more. In
  order to do remain in compliance, spare credits
  must be bought from another polluter which has
  not used up the whole allotment.

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Market Mechanism

• Scenario 2
• The polluter does not use the whole allowance
  and can either save the remaining credits for the
  next time period (bank them), or sell the credits
  to another polluter on the open market.

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Market Mechanism

• Scenario 3
• The polluter can invest in numerous pollution
  reduction schemes in other countries or regions
  and earn credits from these projects which can
  then be sold, banked or used to make up
  shortfalls in the original allowance.

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The Players

• Brokers and traders
• Oil and gas companies
• Electricity companies
• Industrials
• Agricultural producers
• Insurance and reinsurance providers
• Financial institutions
• Governments
• Hedge funds venture capital funds

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Carbon risk management for companies

• The most important risk categories for companies
  resulting from emission reduction targets are
• Cash flow risks, such as increased expenditure on
  measures aimed at reducing CO2 or the purchase of
  emission allowances
• Market perception risks which may influence
  market capitalisation and
• Capital cost risks, such as more stringent credit
  conditions as a result of altered credit risk
  ratings. The drawing up of emission inventories
  and measures taken to increase energy efficiency
  will, in future, play important roles in the
  financial rating process.
• To understand their potential carbon risks,
  companies should have
• in place a robust and accurate GHG inventory
  which details past,
• current, and projected future emissions.

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HEDGING AGAINST CARBON RISK MANAGEMENT

• Financial services providers can assist
  companies in managing these effects, and in
  particular, reducing the transaction costs of
  trading by offering new products and services.
• The complexity of emissions trading requires a
  wide range of products and services that
  effectively hedge against risks emerging from the
  Kyoto Protocol and the European trading scheme.

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HEDGING AGAINST CARBON RISK MANAGEMENT

• Various types of derivatives can be used, such
  as
• Forwards the purchase of emission allowances to
  be supplied in the future at a fixed price.
• Options a guarantee of the right to purchase or
  sell allowances at a fixed price within a defined
  period of time and
• Swaps the exchange of payment obligations so
  that different allowance currencies can be
  exchanged.

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Conclusion

• Do not underestimate a few degrees change
  because just 8 degrees Celsius separates
  today's average temperatures from that of the
  last ice age
• Steven Chu, Physics Nobel Prize winner