Carbon traders widen horizons despite bullish market forecasts

By David Walker, 23rd March 2011

A strong forecast for the €90bn carbon markets from Mercer in February and a significant boost from the UK Government today might still not convince traders to focus solely on them.

What they describe as "huge price volatility", opportunities elsewhere and links between energy markets is convincing managers to broaden activities instead.

Mercer has forecast carbon could reach €220 a tonne by 2030 if a lack of co-ordinated policy to tackle climate change persists.

Today the consultants welcomed the UK Budget announcement of a £13 floor in the price of carbon per tonne, rising to £30 per tonne by 2020.

The UK government also announced carbon capture and storage technology with £1bn funding, increasing green taxes as a proportion of total tax take, and an extra £2bn for a Green Investment Bank to support low-carbon investments "where the returns are too long-term or too risky for the market".

However, carbon managers say they will not limit themselves to carbon investments alone. Another key reason to diversify was the theft in January, suspected by organised crime, of national registries recording carbon trades.

The European Commission froze spot trading temporarily, causing negative publicity and disruption.

Despite this, managers are keeping a finger in the carbon market, eyeing predictions of sharp price rises and increasing allocations to the strategy.

Mercer said allocators will have to shift up to 40% of portfolios to environmentally-friendly areas, such as carbon, to avoid the damage global warming will do to the rest of their investments.

The dissipation of concerns of double dip recession already helped prices for EU allowances (EUA) jump 8.7% last year.

Luis Neira, head of environmental commodities at Pan Energy Markets (PEM), says some of the key features for the coming year will be the auctioning of Phase III allowances, and "emerging economies and new nations showing keen interest to participate within the market place".

While these developments take place, he says, "early movers definitely will benefit from developing sectors and markets, and eyes will also be on gold prices."

Neira adds it is important not to view carbon in isolation. "It is beginning to mirror the rest of the energy complex. Looking at the energy sector as a whole will give a good indication of how to trade carbon."

Matt Brownie, advisor to Carbon Growth Capital, says that concerns over the market thefts are another reason to diversify.

"We need to have a broader strategy, given all the political concerns. The markets became a bit stagnant after certain political events, so we need to have other things we can trade on top of carbon. I am optimistic about the future of carbon trading in general, but as part of a broader strategy."

PEM expanded its focus into global energy and environmental trading since starting focused on carbon in 2009. Neira says expanding was "a natural step moving across the energy spectrum".

PEM's business now ranges from spot trading to project financing, natural gas trading, bio-fuels, metals, and coal. "We have moved from originally day trading to working on larger, longer-term contract negotiations within global commodities."

As traders' approaches to carbon become ever more complex, embracing ever more inter-linked markets, the task of risk management becomes more complex, says Jonathan Ellenberger, founding director and chief executive of carbon risk consultants Risk 101.

Funds can also invest in clean energy firms alongside carbon, and in the listed equity of power providers, or arbitrage secondary carbon markets against primary ones.

It makes sense to view the carbon complex in a broader context, as a number of related markets have knock-on effects, says PEM's Neira.

Investors might also look at equities of key emitters, which are forced to buy credits from the open market if they belch out too many greenhouse gases.

To help them this year, the Environmental Investment Organisation and CO2Benchmark will rank Europe's 300 largest companies by their emission of greenhouse gases, as well as producing equivalent regional lists for UK, North America, and Asia Pacific companies, and the ‘Bric' nations of Brazil, Russia, India and China.

A series of tradeable indices are expected to follow later this year.

CGC's Brownie says changes in the depth of carbon markets - sometimes following political and market events - also make having a wider instrument set sensible.

"There is, at times, a lack of liquidity in the carbon market, but having says that, volumes in the options markets were up by about 70% from 2009 to 2010, and futures volumes were up, too."

Greater liquidity would attract more traders, and be a double-edged sword for existing participants, but Brownie says more banks making markets, and participants trading would be a good thing.

Without them, though Carbon Growth Capital made audited returns exceeding 200% last year.

PEM's Neira says: "Considering that Europe and Japan are the major developed countries active in the market, in the coming years as more sectors and countries implement an emissions trading scheme, more trading and investment opportunities will arise."

Brownie says CGC's primary focus is in trading market volatility using options on EUAs and certified emission reductions (CER), and hedging positions using futures contracts.

"In 2010 there was a wide gap between realized and implied volatility, which was very attractive compared to a market like the Eurostoxx, which is efficient and liquid and the volatility spread between implied and realised volatility was very small for most of the past year."

While that gap widened when European debt concerns hit in May, Brownie says the difference between implied and realized in carbon was attractive for most of that year.

Last year was primarily about short selling volatility, as it fell from about 40% to 30% with few volatility spikes in between, apart from in May, Brownie notes.

He adds, however: "Carbon can be a difficult market to analyse because there is not a lot of history to go by, to see where implied volatility has been."

Making accurate predictions about volatility, and picking the right direction of it, will be key tasks to get right for this year, he says.