The witching hour approaches

The increasing role that options play in the EU carbon market

Derivatives play an important role in carbon markets as they enable market participants to hedge their risk. Futures and options also enable financial market participants to speculate on the future direction of carbon prices and related spreads.

Options were first introduced into the EU carbon market in October 2006, and have become increasingly important over time. In early 2016 for example, 0.1 million lots were traded (accounting for 7% of total carbon derivative volume), but by Q2 2021 this had increased 11-fold (representing 44% of volume). In contrast, futures market volume has merely increased by 80% over the same time period.

Options market activity has been one of the factors supporting the EU carbon price in recent months. Earlier in the year participants (both financial and compliance) bought call options that would pay out if the EU futures price of carbon reach certain thresholds - €60 per tonne for example and beyond all the way up to €100 per tonne.

The most heavily traded futures contract in the carbon market is the December contract. Tomorrow (15th December) the Dec-21 contract expires, and with it significant call option volume betting that the carbon price would hit €100 per tonne. Big call option open interest incentivise market participants to purchase the underlying futures contract (either speculatively or to hedge) so that the calls expire in the money.

The options expiry helped fuel the rise to around €90 per tonne, but as the time to expiry counted down, traders closed their positions in the Dec-21 contract. Carbon prices quickly returned to the €80 per tonne level as the 15th approached. The past week might have been particularly painful for many retail investors who, after seeing prices first breach the €80 per tonne level, may have FOMO’d into chasing the brief ‘exponential’ rally that followed.

The impact of options expiry isn’t likely to be felt again in any meaningful way until next December when the Dec-22 contract comes up for expiry. It’s worth watching out for.