The Timing Impact Approach: How particularities of carbon markets influence market ?

With the current ‘back-loading’ proposal of the European Commission on the table it is essential to further examine the specialities of carbon markets to assess the implications of the proposal on the market development of the EU ETS. An emission right is a new kind of good which can be thought of as a hybrid of a commodity good and a financial product.

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While on one hand emission rights are very similar to financial products in terms of transportation and storage with no associated costs (except interest), loss of quality or volume limits; they are on the other hand related to commodities as a sort of input factor for the production of certain goods. Furthermore, an emission right has the unique characteristic that it can be consumed before it is owned or even physically available. All this leaves us with the question which consequences these features have on the market.

Emission rights do not have to be bought at the time of consumption or compliance. Hence, a market participant’s demand for carbon allowances may be satisfied any time before it is handed in for compliance or the associated CO2 is emitted. Therefore, a fundamental analysis which merely gathers the point in time when carbon is emitted falls short of analysing when exactly the market participants trade their positions. In order to correctly elaborate the length or shortage of a carbon market by factoring in the particularities of emission rights, it is crucial to model the trading behaviour and consequently the timing of trades of market participants.

When considering the EU ETS, there are three different types of market participants whose timing is driving the overall market balance: Power companies, Industrials and Offset Suppliers.
-Power companies: Power producers sell their power typically up to four years ahead of production to secure the price and eliminate retail price uncertainties. In order to manage the cost risks related to these upfront power sales, power companies also hedge their fuels and associated carbon emissions when they hedge the power production. Thus, the power sector buys its short position much earlier than it actually arises fundamentally.
-Industrials: Most industrial players are oversupplied with their free allocation and either sell part of their long position slightly after it arises, or bank it for compliance use in later years. Consequently, the accumulated trading activities of all industrial sectors in the EU ETS result in a partial selling of their long positions.
-Offset Suppliers: Like Power companies, some Offset Suppliers try to eliminate price risks of their production good which are CER or ERU credits. Therefore they also hedge their estimated issuance of credits years in advance to lock in prices. As a consequence, international credits are also traded well in advance to their submission.

We developed a market model which incorporates the behaviour of market participants to analyse carbon markets. Compared to standard models, our model is able to evaluate especially the impact of time-sensitive changes (e.g. back-loading of auctioned allowances) or changed expectations of future emissions with a considerable higher accuracy.

When analysing the current back-loading proposal of the European Commission, we find that volumes to be back-loaded of around 600 million allowances would already rebalance the market.
Philipp Ruf

When analysing the current back-loading proposal of the European Commission, we find that volumes to be back-loaded of around 600 million allowances would already rebalance the market. For withdrawn volumes in the range of more than 1,000 million allowances we foresee a rapidly changing market environment in the entire 3rd trading period. The market will be substantially short in the early phase (2013-2016) and unless the withdrawn allowances are permanently cancelled, it will be slightly long in the later phase (2018-2020).

Philipp Ruf November 2012

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