Hedging carbon risk
Hedging by utilities is one of the principle drivers of carbon allowance demand, and in turn carbon market price discovery.
Utilities are one of the most active participants in the EUA spot and futures markets, balancing both their current and expected future carbon risk. However, over the next few years the hedging activity of industrial emitters is likely to become a significant factor.
The tension between the two sectors is crucial to understand. On the one hand utilities may look to reduce their hedging activity as renewable generation increases, while on the other industrial hedging demand is likely to increase as free allocations are cut.
What are the main ways emitters hedge their carbon risk?
There are five broad categories by which a utility (or an industrial emitter) might look to hedge their carbon risk:
It can buy EUAs at the same rate that it produces, buying on a spot basis based on actual emissions.
It can wait until the EUAs are needed, purchasing them in the primary auction, putting them at the mercy of the market in the weeks before compliance. This is typically what smaller, less sophisticated industrial emitters might do.
Buying EUAs/EUA futures based on expected emissions over the next 12 months.
Buying EUAs/EUA futures based on long term (2-10 years +) expected generation. This might overlap with fuel and/or power contract agreements in the case of a utility.
Strategic hedge against some part of their operation becoming a stranded asset due to climate change policies, e.g. fossil fuel generation assets.
In reality there will be a combination of strategies employed. Power generation companies will regularly re-optimise their carbon EUA purchases based on changing emissions profile, which might be influenced by changes in relative fuel and power prices, and their expectations for planned and unplanned maintenance.
How does carbon hedging work in practice?
Even if the utility has no knowledge about whether future EUA prices are going to increase or decrease, it might still choose to purchase the EUAs at the known futures cost in order to ‘lock in’ a price. This minimises its risk exposure and helps to get greater certainty over its future margins.
Obligated emitters can use a strategy that makes the most of differences between the price of EUAs and EUA futures. A ‘short carry’ involves selling an EUA and buying an EUA futures contract. The short carry enables an emitter with EU ETS compliance obligations to free up cash in the short term while still ensuring that it can secure access to EUAs when it comes to meeting compliance.
For example, consider an emitter that is currently holding 100 EUAs that it knows it will need to submit in one year’s time to cover its emissions. To complete the trade, the emitter sells its 100 EUAs for €7,500 (assumes that the EUA and futures prices are both €75 per tonne), while also purchasing 100 EUA futures expiring in one year’s time at a cost of €7,600 (assumes an indicative clearing and margin fee of €100).
In the year between undertaking the trade and the futures expiring, the emitter benefits from access to €7,500 in cash and it will receive 100 EUAs when its futures contracts expire. This may be an important cash flow management strategy for emitters that want to borrow but might otherwise be constrained by current credit conditions.
RWE’s big carbon hedge
Power companies represent the largest group participating in compliance carbon markets. Power generators sell a significant share of power one to four years ahead of delivery. To manage the price risk, they sign contracts for fuel and the associated allowances required for generating the power
Utilities need to take a view on the expected generation of their units (for which they hedge by selling their power forward) and the carbon intensity of the feedstock (more allowances need to bought if the generation mix includes more lignite than if nuclear was expected to fill the gap). Utilities typically look to hedge this carbon risk now, and adjust accordingly later, rather than wait for more information about their actual emissions.
Some European utilities have hedged their carbon exposure by buying enough carbon allowances when prices are low to cover their expected future emissions. RWE, the German utility and the largest obligated emitter in the EU ETS is perhaps the best example of this strategy.
Beginning in 2014, the company began shifting its procurement strategy to buying EUAs in advance of the year that they were required. Figures provided by the company indicate it’s average hedged carbon price during the period 2018-2021 was around €5-6 per tonne - around one-sixth of the actual average EU carbon price during that period. RWE has now reportedly hedged its carbon exposure all the way out to 2030.
Some industrials also copied RWE’s strategy. For example, German steel group Salzgitter reportedly stocked up on EUAs when the price was still just a few euros a tonne, and is now also sufficiently covered all the way through to 2030.
Futures are more likely to be used for hedging
Buying additional EUAs like RWE did, well in advance of when they will be needed, may look smart in hindsight if the price multiplies over the next few years. But in the interim it can tie up an awful lot of cash that could be more productively used elsewhere. That’s one reason why EUA futures markets are so useful.
In practice its not always possible to use carbon futures exchanges to hedge. Liquidity may be abundant in the near term March and December contracts, but as soon as you go beyond that, liquidity tends to drops significantly. That’s why the Over-The-Counter (OTC) markets tend to be used instead. Here a utility can also more accurately hedge its carbon exposure for the same period as its contracted fuel and power offtake agreements - something that is harder to do with exchange traded futures contracts.
It’s important to note that it is only the purchase of the underlying physical EUAs that can contribute to allowance scarcity. Using futures markets to hedge does not contribute to scarcity. Carbon futures contracts represent claims to EUAs to be delivered at a specified price and at a specified date and place in the future. But remember, buying a futures contract for carbon does not reduce the quantity of EUAs that are available for compliance.
A futures contract does not necessarily result in physical delivery. It could also be satisfied by a payment based on the current market price at the agreed time of maturity. For example, only around 5% of commodity futures with a delivery mechanism result in parties actually making or taking delivery of the underlying commodity. Delivery of the actual allowance only occurs if the holder fails to offload it or roll the contract over after the futures contract expiration date.
The role of the Market Stability Reserve (MSR)
The influence of the MSR in cutting the ‘free float’ potentially available to physical hedgers could be important. With threshold levels set at 833 million and 400 million allowances (EUAs), the MSR works by reducing new supply entering the market, via government auctions, until the calculated surplus falls below 833 million. Allowances in the MSR will only be added back into the market if the calculated surplus falls below 400 million.
Some surplus was thought to be required to allow for forward hedging of physical EUAs, and the threshold levels have been set to reflect this. However, there is the fear that the threshold levels are set too low to account for the potential hedging demand that could take place.
The fear is that this could place a massive scarcity premium on allowances as obligated emitters will not want to risk being non-compliant and facing a fine. Rather than wait for the compliance year to worry about securing sufficient allowances, companies may follow the example of RWE and secure sufficient numbers well in advance.
However, although successful for some companies it is very unlikely that the majority of companies under the EU ETS will pursue a procurement strategy of purchasing several years worth of EUAs well in advance of when they will be required.
It may have been the correct one when carbon prices were well below fundamental value but it’s much less attractive at current carbon market valuations. It worked well if the company purchasing the allowances had sufficient credit worthiness that the additional EUAs were but a small line item on their balance sheet, and had the ability to also forward sell their output, as is the case with utilities.
In the absence of those factors most obligated emitters are now likely to rely on the futures markets to hedge their carbon risk. This does not contribute to allowance scarcity.
How hedging demand could evolve
As this decade evolves the importance of long-term hedging activity is likely to grow. Two factors are especially important: the gradual decarbonisation of utilities and how that affects their hedging requirements, and the growing requirement for industrial emitters to start hedging as free allocations are withdrawn.
On the other hand, utilities may need to hedge less later in the decade as 2030 approaches as the sector decarbonises. This will put more allowances back onto the market, say for example if RWE’s lignite carbon hedges are reversed.
When asked in the Q2 2021 earnings call whether RWE could monetise the carbon allowances prior to 2030 if some of its coal fleet came to an early halt, Michael Muller, the groups CFO responded with a qualified, maybe:
“The contract itself foresees coal closure by 2038, it has the option to bring that forward to 2035, that's what is in the contract. I mean, the contract doesn't say anything about our carbon certificates. So that's basically our topic. But bear in mind, I mean, the hedges we currently have in place are to match the implicit exposure we have from the fleet.
So I mean, kind of in a nutshell, what I tried to say is, yes, we are obviously internally discussing what are potential options. But it's too early to say anything here, and we just need to wait what really happens.”
Carbon hedging strategies by utilities are a crucial piece of the puzzle in being able to understand how carbon prices could evolve over time.
However, moving forward hedging activity is likely to grow from a different sector. Industrials may turn out to be the dominant hedger in the market as their free allocations are cut and the carbon price begins to bite.
That sets the market up for a volatile period where perceptions of the pace of decarbonisation across different sectors (and hence the demand for physical and futures based hedges) will come into conflict.