The arc of carbon’s curve
What does the carbon futures curve tell us and why is it important?
The carbon market has the potential to become the world’s largest and most consequential commodity market. The price at which carbon allowances and carbon credits trade could become one of the most important macroeconomic variables.
Despite appearances there isn’t one single price of carbon.
Carbon allowance prices vary significantly across regulated compliance schemes, and are influenced by the local marginal abatement cost curve, the overall emission reduction target, the relative scarcity of carbon emission allowances, and the credibility that the scheme has in the eyes of market participants.
Carbon credit prices in the voluntary carbon market are influenced by their perceived and actual success in avoiding or removing carbon from the atmosphere; for instance, whether offset projects are real, additional, measurable, and permanent and if they deliver any other social or economic benefits. All of these factors are in turn influenced by geographical, political, and technological factors coupled with often volatile demand side sentiment.
There is another variable that is often forgotten when discussing carbon - its place in time.
In the EU emissions trading scheme (ETS), the right to emit one tonne of carbon can be bought or sold for immediate delivery (i.e., the spot market via the regular daily auctions) or future delivery; next month, end of the year, or in the months thereafter. The chained prices of sequential EUA futures contracts form a curve known as the futures curve.
The EUA futures market has, except for a brief period after it launched in 2005, consistently been in contango. A futures curve is described as “in contango” when it is upward sloping and so prices in six months’ time are higher than the spot price. In the case of physical commodities, traders are typically willing to pay a premium to avoid the costs associated with transporting, storing and insuring it, and therefore the furthest-out contracts are typically higher in price.
In contrast to physical commodities, EUA storage costs are negligible. In 2020, the German administrator charged €170 to open an account and €600 as an account administration fee for the entire trading period. Transport costs are also negligible, a mere entry in an account. Finally, EUAs do not degrade over time (they are bankable between and across compliance years) and they can only be used by the purchaser for compliance purposes so don’t face a security risk, which means there are no insurance costs to contend with.
In the case of the EU carbon market, physical EUAs can be banked for future compliance needs, creating a strong link between the spot price and the futures price. The contango should equal the cost of borrowing since the storage, transport and insurance costs are nil or negligible. And so the higher the interest rate the steeper the EUA futures curve, since the opportunity cost of holding physical EUAs also rises. If the contango is higher than this then buyers would be incentivised to buy physical and sell forward, moving the market to a position where no arbitrage exists.1
Investors in the voluntary carbon market need to be aware that the spread between futures contracts straddling two or more years reflect different vintage specifications, rather than simply being a function of the cost of carry. For example, the vintage of credits included in the Nature-Based Global Emissions Offset (N-GEO) futures contracts are updated on a rolling annual basis (updated every July), and includes credits 6 years up to and including the current year. That means that one futures contract cannot be arbitraged into another since they reflect different attributes (see GEO versus N-GEO: Investing in the VCM futures market).
Forward curves are not forecasts
The futures curve of commodities and other asset prices have been used extensively in the macroeconomic models used by central banks and other official agencies, and it is very tempting to view them as a price forecast. The two terms “futures” and “forecast” both sound like they should represent the same thing. They are anything but. The futures curve shows the price at which it is possible to buy or sell contracts for a date in the future at a price agreed on today. It is not a forecast of future spot prices. Asset management firm DWS compared the benchmark December EUA contract at the start of the year with the outturn at the end of year based on the period 2010-2021. Overall, the futures curve ad an average error of 32.9% (see Weighing the value of carbon price predictions).
Remember, there are several factors that affect the futures curve, not just market expectations of where the price of a commodity will be. First, the physical characteristic of the commodity, discussed earlier. Second, longer dated contracts are often illiquid, raising doubts of whether they are an effective aggregator of information. Third, the futures curve fails to account for real interest rates, i.e. taking account of inflation. Finally, the futures price will always be discounted to the market’s expected future spot price in order to give speculators a “risk premium” to take on the risk associated with hedging. This means that even if the spot price is estimated correctly, the traded futures price will tend to understate the market’s current real price expectations.
Investors need to be cautious about how they interpret a change in the futures curve. In ‘normal’ commodity futures markets, a tightening in the futures curve (i.e. a move towards backwardation) is often a good sign that the current underlying conditions in a commodity market are getting tighter – either via gradually improving demand or supply problems, or a combination of both. The opposite of which is true when the curve moves towards contango. Given the outsized role that the interest rate has in determining the shape of the futures curve, relative movements towards backwardation do not have the same predictive insights that commodity futures markets often provide.
Overcoming contango
The difference between spot and futures prices for a commodity is known as the basis. The price of a futures contract – whether it is above or below the spot price – will converge to the spot price as the expiration date on the contract approaches, a process known as convergence. For someone holding a futures contract where the market is in backwardation, the value of their contract will rise to meet the spot price, enabling them to achieve what is known as a positive roll yield, i.e., a bit of income from selling one futures contract and buying another. The opposite applies for a trader holding a futures contract where the market is in contango.
Investors in carbon allowances, whether that is the EU ETS, Californian ETs or any other carbon market with similar attributes need to take account of the futures curve when thinking about the relative return profile. Given the widespread and prolonged contango that is evident in these markets, investors need to be clear they must overcome the negative roll yield in order to at least breakeven. For example, at the time of writing the Dec-23 EUA contract is €92.56, while the Dec-24 contract is trading almost €5 higher at €97.50 - a negative roll yield of 5.3%!
To be clear, compliance schemes typically prevent market participants from banking allowances between different phases, at least in early stages of implementation. However, as markets such as the EU’s and California’s have become more developed, banking across phases has increasingly been allowed.