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Traders scrutinise EU ETS oddities
 
Traders active in the EU emissions trading scheme (ETS) had a chance to put over their own views about a market that still does not seem to quite add up. 

Shell environmental trader Garth Edwards, one of the pioneers in emissions trading since even before the start of the UK ETS - and Argus Global Emissions - in 2002, spoke of a number of oddities about the EU ETS "that make me wonder".
 
One quirk is the uneven contango that exists in the market. The price spread between spot allowances and forward 2005 allowances with a delivery date of 1 December is far wider than the spread between forward 2005 allowances and 2006 or 2007 allowances. "It is a wrinkle in the market that exists today," said Edwards. "What is going on?"
 
Markus Huewener, managing director of consultants 3C Climate Change, noted that the forward curve of the EU ETS was unusual, being much flatter than the interest rate curve - "flatter than it should be", said Huewener.
 
Another uncertainty is the effect of government auctions on the EU ETS. Some countries such as Ireland , Lithuania , Denmark and Hungary have sales of allocations built into their national allocation plans. Other countries have New Entrants Reserve allowances which can also be sold if in surplus.
 
"Will a whole bunch of allowances be sold in a discrete, lumpy, supply event?" asked Edwards. He pointed out that little thought seems to have been given on how to run these auctions - if they all happened at the same time the effect on prices could be catastrophic. Edwards also noted that procedures to assess the creditworthiness of auction participants need to be put in place.

The youth of the market also brings another potential headache - the differences in delivery/settlement dates of various exchange contracts. 

In the longer term, the end of the first phase of the EU ETS in December 2007 could be potentially a confusing time. The likely outcome is unclear. As Edwards pointed out, companies could bank surpluses until the last moment "and then sell the market down." Or they could also delay action till the last minute and buy aggressively in order to secure compliance - thus bidding the market up.

Mind the gap
 
Christophe Grobbel, from consultants McKinsey, foresaw an expected gap in EU allowance needs of around 80mn t/yr between 2005-07, but this figure is uncertain, and might well change if natural gas prices change - given that the power industry, with its power generation needs, is the key sector involved. From 2008-10 this gap could be around 35mn t/yr CO2e. "Carbon dioxide is the price which makes us switch from coal to gas," said Grobbel.
 
Traders generally showed only a cautious interest in project-based emission reductions, noting that the fragmentation of the CDM/JI market and lack of a one homogeneous price was a major issue. "You don't have guarantees of volume or investment," complained Edwards.

This article has been reproduced with permission from Argus media. It first appeared in Argus Global Emissions Volume IV,6,June 2005.

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