C-Cash: Carbon credits and floating rates
ET helps you join the dots between carbon credits and the sweet deals on offer.
By Nidhi Nath Srinivas, TNN |
You have a clean green factory that helps save the planet. You know there is a hot market for carbon credits. But whether or not you make big money from them depends on how trade savvy you are. ET helps you join the dots between carbon credits and the sweet deals on offer.
Suppose your factory became operational from January 1, 2008, and would save 100 tonnes (or units) of carbon dioxide annually. By 2012 (next trading cycle of the EU emissions trading scheme runs from 2008 to 2012), you would have 500 credits available for sale.
To get these credits issued, your factory will be audited and certified by designated surveyors. Based on the survey report, the UN certification body will issue credits. If credits are not issued, you have nothing to sell.
On July 1, 2008, you would have earned 50 units while remaining 450 units would accrue as you go along if your factory runs. The point to remember about CER prices is that right now they are linked to the price of European Union Allowances (EUA).
If there is a shortage of EUAs, demand for CERs rises, up to a point. CERs are currently 75% of EUA price. But this could fluctuate wildly if the supply of EUAs or CERs moves up or down sharply.
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Since EUAs are traded mainly on the European Climate Exchange, its prices and indices are the benchmark for carbon credits. You have three options for encashing your credits. One, you could sell 50 credits in the spot market, where the price is always a couple of euros higher than the forward market. Brokers say this is because nobody is too sure whether the seller, industry, or country would actually be able to supply the promised credits.Two, you could enter the CER forward market. Entering the forward market means you have decided to sell the credits you would earn till 2012 right away. You get the best price if you guarantee delivery over the contracted period.
Suppose the day you decide to trade, the EUA December 2012 contract is trading at 40 euros. Some buyers would offer you a flat guaranteed price. But very often, a buyer would offer deals such as a floor price of 10 euros and an upside of 50%.
Translated into English, that means for each CER, you will get 10 euros plus half of the remaining 30 euros. Or 25 euros in all. The floor price and upside combo varies. Since the buyer is hedging against price fluctuations, that cost is factored into the deal you are offered.
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As a seller, such a deal is attractive if you believe EUA prices will rise. It also works if you want to trade just once. Interestingly, banks too encourage companies to settle for a fixed price or at least a floor because they like to lend against collateral of fixed value.But suppose you are gutsy and prefer to go for the kill. You then go for a floating rate with no floor and a upside participation that could be as high as 90%. This works when EUA prices drop, because then CERs prices as a percentage are higher.
On a deal of, say, 90% EUA December 2010 contract, if EUA price today is 15 euros, you earn in theory 13.5 euros. If it moves to 25 euros, you get 22.5 euros. But by the time you actually deliver in 2010, EUA prices would have moved.
So you would simultaneously hedge this risk by short selling EUA futures to convert your floating price into a fixed one. What differentiates the men from the boys in the Indian market is this appetite for risk. Since hedging requires a deeper understanding, frequent trading, margin money and mark-to-market, companies get nervous. Instead, they prefer to let buyer/aggregator bear the risk, enjoy the rewards and be satisfied with a one-time deal.
While Indian companies are fence-sitting, overseas the market is deepening. Exchanges are listing secondary CER futures. Buyers and sellers of secondary credits do not deal with unfamiliar companies in developing nations. So secondary CERs fetch more than what you would ever get because risks are lower and paperwork is standardised.
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