Emissions Research

The spread between EUA and CER implied volatility has narrowed from around 3.5vols to 0.5vol CERs over (ATM vs. ATM).

This can be attributed to more certainty surrounding the CERs post latest announcements. We expect this spread to remain tighter going forward.

The one year analysis shows implied volatility for carbon has significantly decreased, while the underlying has increased in value, this follows the trend seen across the energy complex. However the one month analysis shows the underlying for carbon decreasing whereas the other energy complex commodities have all seen increases.

If the bullish sentiment in other energy commodities persists into 2011, we would expect to see underlying carbon prices increase in line with the rest of the energy complex. We would also expect the implied volatility for carbon to be range bound in 2011 although at a lower range than seen in 2010.

Importantly the one month trend is showing a decrease in short term volatility and an increase in underlying values, while the six month trend is mixed.

With winter approaching, hence potentially entering a high demand period for the energy complex, we expect the underlying values to increase and short term volatilities to decrease.

We feel that overall carbon volatilities will ease due to onset of summer, but expect implied CER volatility to be higher than EUA volatility until the conclusion is reached on HFC 23 decision by the UN. This can be considered as a contributing factor to the narrowing of the EUA/CER spread in the last month i.e. underlying values for EUAs -0.13% vs CERs +3.75%.

This paper presents a series of clean dark spread (CDS) option strategies for hedging and/or outperforming the clean dark spread of a continental European power portfolio based on coal.

These strategies outperform a straight futures position by:

• Implementing a floor price against bearish clean dark spread movements.
• Enhancing the performance of the clean dark spread versus the futures through premium-financed cash buffers.

Carbon volatilities have continued to decrease due to the verified emissions figures for 2009 have come in close to expectation and current asset backed option trades are further putting pressure on volatilities.

Conversely a short term upward correction in volatilities may be overdue.

The aim of this paper is to present a series of option structures, for power, lignite, coal, gas, UK coal, UK gas, and EUAs. These structures hedge the UK and German clean dark, and clean spark spread prices against adverse movements.

The report details the profit and loss of the strategies if taken through until expiry, compared to an identical strategy using straight futures set at-the-money (ATM). Both the option strategy and the futures strategy include the price of buying the fuel and the carbon, and selling the power, and therefore also represent the corresponding clean dark, or clean spark spread profit and loss.

This article illustrates how combining OTC Carbon Spread Options with listed derivatives can act as a low cost CER hedge or a geared speculative structure. Four applications are detailed in this article to show how the correlation of CERs and EUAs can be used, by combining Carbon Spread Options and listed derivatives, to produce some unique performance profiles not replicable by trading listed emission products alone.

The article than goes on to discuss a number of compliance strategies, exploring the performance of alternative solutions verses merely using the futures market and new products that have begun trading in the emissions market.

The volatility embedded in any one market impacts on decision making in areas such as risk management and option pricing. Measuring this volatility can be done using historical data or option prices, as discussed in this report. On a daily basis, however, these volatility (risk) measures can change quite substantially - particularly with the current market uncertainty.

It is thus the intention of this report to focus more on the underlying structure of volatility in a given market, as this is more stable over time. In particular, the mean reversion potential that is associated with the carbon and energy markets is investigated as well as the independent drivers of returns that create volatility.

These analyses are performed over a two year sample period on chosen carbon and energy return data using robust time series tools such as GARCH, EWMA and PCA (these are defined in more detail in the report).

Implied volatilities are added to the framework for comparative purposes.

The GARCH application in particular, provides optimised model parameters that can be used to characterise the underlying volatility processes, for each asset.

Simulation, otherwise known as Monte Carlo simulation, is a useful technique in financial engineering, with a wide variety of applications in product pricing and risk management.

The fundamental approach to pricing carbon is briefly discussed and an explanation is considered as to why it is unsuitable for carbon market product development. Simulation is presented as a reasonable alternative.

Simulation is a technique whereby asset price movements are randomly sampled over time, from a universe of possible outcomes. For multiple carbon assets, it is necessary to impose a correlation structure on the relevant asset price movements. This constraint enables the simulated prices to more realistically represent the dependencies that exist amongst similar carbon assets over time (for example: CER futures prices across Phase II). The analysis that follows considers these correlated price paths for listed EUA and CER futures contracts

The results show that simulation can be used as an alternative to Black-Scholes type models, to accurately price carbon options (including spread options and swap options). The report concludes with an application of simulation to modelling Phase II Carbon futures term structures. These simulated term structures can be used, amongst other things, to measure carbon portfolio risks that are sensitive to the spread between different carbon contract maturities

Swapping out of CER Carbon into the higher priced EUA is often transacted by holders of large portfolios of Secondary Market CERs, with a view to managing their price and liquidity risk. Exchanging Carbon assets in this way suggests a certain confidence and robustness in the EUA instrument relative to its CER equivalent. It is unlikely therefore that the 'Buy EUA, Sell CER' Swap will be transacted if there is an expectation that both Carbon assets will collapse in price. If anything, Swaps are transacted with an expectation that the price differential (or relative price) between two correlated assets will change i.e. the price spread between CER and EUA Carbon will increase or decrease. For example, if CER prices drift lower and EUAs are stable, the Spread will increase. Swapping out of CERs into EUAs then represents a lower risk trade. Relative price risk management is thus a strong motivating factor for swapping one Carbon asset for another. Spread Options, by construction, mitigate such risk. It is the intention of this report to investigate the effectiveness of combining a portfolio of CERs with a long position in Spread Call Options, as an alternative to the abovementioned 'EUA- CER' Swap.

Asset managers investing in commodities such as Oil, Gas, Coal, Electricity and Carbon typically rely on market fundamentals in their investment decision making process. That is, they monitor macro-economic and industry specific variables that impact on commodity prices. A complementary approach to this process would be to examine the underlying commodity price data itself in an attempt to isolate information or structure that exists between commodity returns that is not necessarily apparent in a fundamental setting. There are several quantitative or 'Time Series' models that can be used to analyse historical data in this way - this report chooses to use Principal Component Analysis (PCA) and Correlation Analysis. These diagnostic tools are applied to weekly Futures returns (in USD) on Oil, Coal, Gas, Electricity and Carbon over the period: June 06 to Dec 07. Discussing the return relationships between USD based Electricity Futures and Futures that reference German Power and related European Energy Markets, is left as a separate research report. The report also compares the weekly valuation of equal USD investments in Carbon, Coal, Gas, Oil and Electricity over the chosen sample period.

EUA and CER futures trade at noticeably different price levels over Phase II despite the fact that they both reference 1 tonne of deliverable Carbon (currently, for a chosen expiry, the price differential ranges between €5 and €7 a tonne).

These price differences or ’Äòprice Spreads’Äô are partly explained by the uncertainty associated with CER's (i.e. bankability issues beyond Phase II, ITL delays, NAP purchase restrictions etc.). In short, they are deemed to be higher risk Carbon instruments. Views on such spreads are typically implemented using the Carbon Swaps market.

It is the intention of this report to introduce Spread Options either as a lower risk alternative to trading Carbon Spreads/Swaps directly or as a tool for mitigating specific price risk in existing Spread exposures.

Long positions in deliverable Phase II Carbon can be achieved through the purchase of sufficiently low strike Carbon Call Options (as discussed in our September Report) and/or through the sale of higher Strike Carbon Puts. In general, the use of Options in the Carbon markets has implications for compliance risk, price risk and cash flow management (with particular reference to Over-The-Counter (OTC) Option markets). This report discusses the relevant risk and cash flow profiles of Long Carbon exposures achievable through the use of Short Put and 'Short Put, Long Call' combinations.

Installations with legislated Carbon exposures can achieve Phase II compliance using either the 'Listed' or 'Over the Counter' (OTC) Carbon markets. Mitigating compliance risk, however, is often done at the expense of increased Carbon price risk - particularly given the underlying price volatility that exists in both the EUA and CER Carbon markets. Amongst others, Carbon Funds are equally vulnerable to such price variability. This report investigates the management of Emissions price risk using Carbon options. CER Calls are of particular interest as they trade at lower implied volatilities than EUA equivalents and unlike Carbon Puts, deliver 1 tonne of Carbon when exercised. This can be used for compliance if necessary.

With continued uncertainty regarding the bankability and future oversupply of Certified Emission Reduction Units post 2012 some carbon market participants are swapping out of CER's into the more robust EUA, despite the cost. This partly explains the continued CER discount to EUA's. As a result, the swap approach leaves no room for possible CER price recovery. The option structure presented in this report, however, allows for flexibility in both CER and EUA price movement - outperforming the swap if these instruments trade within a neighborhood of each other, regardless of which one is higher or lower on expiry.