Selling carbon: Risks and opportunities. Strategies and organisation of the Danish Government s sales of CO2 allowances

Transcription

1 Selling carbon: Risks and opportunities Strategies and organisation of the Danish Government s sales of CO2 allowances A report for the Danish Energy Authority by Point Carbon and Joule as 19 December

2 Table of contents 1. Executive Summary: Recommended actions Introduction Price formation in EU ETS Development of prices and traded volumes Identification of key price drivers Price risk and future prices Objectives and significance of risk Objectives Risk policy - High-level risks Trade off between risk and profit Static and dynamic sales strategies Description of static sales strategies Analysis of static sales strategies using the PaR frame Dynamic sales strategies Analysis of dynamic sales strategies using the PaR frame Dynamic or static sales strategies conclusions Bidding strategies - Markets, contracts and liquidity Carbon contracts - How are Emission Allowances traded? Carbon contracts - Where are Emission Allowances traded? Exchange trading The OTC market Clearing of contracts The importance of liquidity Auctions Transaction risks Implementation of sales strategies Team of government officials Trustee State-owned trading house Combination models Discussion of available organisation models Information strategy towards the marketplace and other governments Appendix

3 1. Executive Summary: Recommended actions In accordance with the Danish law on CO 2 allowances, the Danish government is faced with the task of selling million CO 2 allowances by the end of the first trading period in This asset is valued at some 100 million based on current prices for exchange traded allowances. However, the actual value that the Danish government will realise from the sale of these allowances will depend on a number of factors, including future market prices, the overall sales strategy and how the sales are managed. Price risk is the key risk factor that has the most significant impact on the revenues from the sale of the 5 million allowances. This risk relates to the fact that allowances may be sold during a time span of over 2 years, while the price development of allowances during this period is unknown. SALES STRATEGY Any strategy must originate in a clear set of objectives and the identification of constraints that may place limitations on the achievement of objectives. The Danish government has expressed that: A sales strategy has to be devised that will optimise the state revenues. As there is a positive correlation between the expected revenues and the risk exposure of the sales programme, an optimisation of revenues may entail the process of identifying the strategy with the highest revenue potential given an acceptable level of risk exposure. The carbon market is very volatile and speculating on future prices involves a significant amount of risk. We consequently recommend that Denmark employs a strategy that is robust for all price scenarios i.e. provides a reasonable trade off between possible price developments. Consequently, we advise against a strategy which assumes a certain direction of prices in the future. The Danish government should furthermore ensure that the sales method is transparent, secure from market abuse and is cost effective in relation to the revenue optimisation. Discussing a risk policy involves the identification of factors that influence the Danish governments wider view on risk e.g. level of risk aversion. The overall risk position of the government is likely to involve an assessment of both financial and political factors Financial risk is equivalent with revenue risk which relates to timing of sales, future prices as well as transaction risks. Transaction risks are defined as the probability of unexpected events that may negatively impact revenues from allowance transactions such as operational, currency, credit and liquidity risks. The financial risks for this specific project (sale of allowances) are either systematic or unsystematic depending on the correlation of the project risk exposure in relation to the overall risk exposure of the Danish government. Governments will normally require a higher rate of return when evaluating ventures with systematic risk. Transferred to the case of selling allowances, this means that strategy options involving the early sale of allowances would for the 3

4 same expected revenue be preferred to options which defer sales to later and hence involve a higher risk. Although allowance prices admittedly are influenced by levels of economic activity there is however no evidence to suggest that allowance prices and thus revenue will correlate with economic activity in Denmark throughout the allowance sales period. Other factors such as weather, relative fuel prices etc may easily mask the influence of economic activity. Following this, we are unable to substantiate that the allowance sales programme will be characterised by a significant level of systematic risk. The political approach to risk management involves the identification of the acceptable level of political embarrassment that could be caused by a poor outcome of the sales process. This is again related to the level of public transparency of the sales process and the accounting of the revenues from the sales process. Both cases of excess loss and profit need to be considered. A significant loss of revenue due to the mismanagement of the sale or disproportionately high transaction costs could be used politically against the government. Similarly, losses due to unfavourable price developments could in retrospect be construed as government misjudgement of the emissions market. On the other hand, high revenues for the government could attract attention from the public and industry who perceive they are paying the price of emissions trading through increased power prices. If revenues are allocated up front to finance specific purposes, an extra level of care should be adopted since potential losses will need to be offset by additional budget allocations. Other political risk may be related to scandals and similar events that may originate in the organisation of the sales. This could be related to counterparty losses, corruption or other events that may compromise the government and trustees. RECOMMENDATIONS The choice of a static (pre-programmed) sales or a dynamic sales (active management) strategy is based on whether sales of emission allowances should proceed according to a predetermined sales schedule or if timing of transaction decisions should be flexible and based on continuous assessments of market prices and future prospects. Using a profit-at-risk framework allows us to provide a quantitative measure of expected revenues and the risk of each of the alternative sales strategies. Four different options were analysed, which included combinations of immediate sales, continuous sales and sales deferred to the late true-up period. Selling the full volume immediately could be considered the least risky as there would be no downside risk i.e. no exposure to prices decreasing in the future. Conversely, there would be no potential for gain from higher prices in the period and the sale of 5 million tonnes would need to be conducted over a significant time period to avoid moving the market. 4

5 The conclusion of how much to sell initially is based on finding the appropriate balance of limiting risk exposure of the total portfolio revenue whilst retaining some volume for potential revenue gain through both active management and potentially higher prices in the true-up period. A sale of between 2 3 million tonnes seems an appropriate balance between risk and reward based on our assumptions of Danish government s position on risk. It is possible to quantify the risks of various strategies by looking at the probability of losing a certain value compared to selling everything at the start of Selling 2.5mt would mean the risk of losing more than 30m (compared to a mean of approximately 100m) was less than 5% and the average of the lowest 10% revenue returns would be around 70m. The initial volume should be sold as early as possible in 2006 to take account of higher prices during the winter months. The upside potential is significant for the remaining 2 3 million tonnes, which can be sold selectively throughout the rest of the period. As more historic emissions data is available and more trends emerge, analysts will have a better understanding of how long/short the market is and what is the most likely scenario for the true-up period. We recommend selling throughout the rest of the period by splitting the remaining volume into two equal parts, the first part designated for sale during 2006 and the second part to be sold in By doing this, there is the potential to hold back some of the 2007 sale volume for sale during the true-up period following further analysis of the market during 2006 and early For a pre-programmed static sale, spreading the volume over a wide time span will mean the price achieved from the sales will be more indicative of the average price over the period rather than for a narrower time period. For a dynamic strategy, the longer period of time over which to sell the allowance volume, the more flexibility there is to take advantage of price movements and thus higher potential revenues. Some (or all) of this volume should be sold through active management (dynamic sales strategy) as within the EUA market there is potential for a well-chosen trustee to achieve increased revenues. Active management may involve higher profits but also a higher level of risk compared to a programmed sales schedule. A professional manager will have the competence to time transactions better within a trading day, within a week, month or among seasons and years. Market analysts and professional traders will be able to identify specific price trends and indicators that may form the basis of a profitable bidding strategy. BIDDING STRATEGIES Emission allowances are traded at five exchanges and through bilateral contracts in the OTC (Over The Counter) market. The OTC market which controls 80 percent of trading is managed by brokers. An average of 1,5 million allowances are traded each day in various contracts including immediate delivery (spot) and various forward contracts with quarterly and annual expirations. This fragmentation of the market into numerous marketplaces and contracts are causing temporary illiquidity which may impede the operation and profits of trading. 5

6 Using exchange markets represents a contribution to a liquid, efficient and transparent emission allowance market in Europe. However, if large volumes need to be placed in the market during a short period of time, the OTC market should be used as an additional sales channel. Direct sales to large trading companies may be a cost effective option, but do not offer same level of transparency and non-discriminatory availability as exchanges. The lack of liquidity in spot trading necessitates the use of forward contracts which will defer revenues from the sales. Forward contracts also introduce counterparty risk which can be mitigated by clearing. Clearing is provided by default at the exchanges. Clearing of OTC contracts has a cost and convenience factor that need to be addressed relative to general Danish risk management policies. Auctions may be a convenient option if a large amount of allowances need to be sold during a short period of time. There is however significant time, preparations and cost involved in organising dedicated auctions. For the volumes of this sales programme, we consider auctions unnecessary as they provide no upside revenue potential compared to well prepared, well timed and diversified use of existing market channels. IMPLEMENTATION The report discusses three modes of operation of the sales: (1) A (team of) Government official(s) runs the day-to-day bidding, or (2) the Government appoints a trustee to run the day-today bidding. A third path between the two modes is possible, namely (3) a state-owned trading house set up for managing the EUAs, and potentially other carbon assets to be purchased or sold by the Danish state. Trading in a volatile market such as the carbon market is a business which is unfamiliar to governments. A government run operation is best fit to manage a clearly defined transaction strategy in which there is limited scope to play the market e.g. by adopting a portfolio of market instruments and transaction models. An appropriate sales strategy for government could be to execute a pre-programmed schedule of transactions e.g. weekly volumes through one or more exchanges. We do not however recommend the use of an existing government entity for the sale of the allowances unless the Danish state relaxes the revenue objectives and the urgency of the scheme. We recommend that the Danish government utilises an external trustee for the operation of the sales programme. Trustee assignments may be structured in multiple ways. The choice of model needs to be elaborated further in negotiations with the trustee. In all likelihood, a professional trustee will be able to provide a netback (net of transaction cost) to the Danish government at or possibly above the market index. This requires that the trustee is allowed adequate flexibility and a reasonable profit sharing agreement. The choice of trustee should be made with specific caution with respect to possible conflicts of interest. A screening of prospective trustees demonstrates that some actors may be trading 6

7 significant volumes in their own books or that portfolio management as a product may not have been developed to a stage that is required to initiate an operation. An incentive-based compensation model will improve the performance of the trustee. We recommend that a portion of the portfolio is subjected to dynamic management. If the Danish government anticipates a long term active involvement in sale and purchase of allowances and project credits, the establishment of a separate commercial state entity may be justified. A joint operation of sales and acquisitions may yield synergies and offer an opportunity to build competence in carbon trading. However, due to the size of the current sales programme and the lead times and cost involved in setting up a new organisation, we do not believe that selling 5 million allowances alone justifies a separate government entity and we do not recommend this option for the commencement of this programme. INFORMATION Choice of information strategy must weigh formal information requirements against the objective of maximising sales revenues. Transparency should not be pursued to the extent that the government is commercially disadvantaged. We have not identified any formal requirement that mandates the Danish government to make public details about the sales programme. It should consequently not disclose any details of the strategy beyond announcing its decision to go ahead with the sales of the allowances. 7

8 2. Introduction In accordance with the Danish law on CO 2 allowances, the Danish government is faced with the task of selling million CO 2 allowances by the end of the first trading period in This asset is valued at some 100 million based on current prices for exchange traded allowances 1. However, the actual value that the Danish government will realise from the sale of these allowances will depend on a number of factors, including future market prices, the overall sales strategy and how the sales are managed. This report by Point Carbon and Joule AS presents the findings of a study on how the selection of different strategies and operations can lead to the optimisation of state revenues from the sales of CO 2 allowances. The study has been conducted through three main steps, as illustrated in figure 2.1 below. First, the study addresses the optimisation of revenues through discussing the trade-offs between risks and rewards. The findings in this section have also been subject to discussions with the Danish government in order to identify the government s policy on risk in this regard. Second, having established a better understanding of the Danish government s position on risk, a sales strategy has been chosen that we believe should accommodate the risk that the Danish government is willing to take. Finally, with the recommended sales strategy identified, recommendations are made in terms of how the daily operation of the sales should be implemented in light of the chosen strategy. Figure 2.1. Conceptual structure of the proposed study Risk vs reward Sales strategy Daily operation STAGE Identify trade off between risk and profit Identify sales strategy that fits with recommended risk profile Identify mode of operation that fits with recommended sales strategy OUTPUT What are expected profits in relation to different levels of risk? Static or dynamic? Pros and cons of different strategies / strategy combinations Organisation (government, trustee, trading house)? Market places? Framework? Dayto-day operation? MAIN QUESTIONS 1 EUA market is volatile and asset valuation is constantly changing 8

9 3. Price formation in EU ETS In the EU ETS, as in every commodity market, the price is determined by the relationship between supply and demand. In this case, the demand for allowances is determined by the relationship between CO 2 -emissions and the cap. Greater distance between these indicates a higher demand. The supply is determined by the amounts of EU allowances (EUAs) and Certified Emission Reductions (CERs) from CDM projects brought to the market. In addition to the EUAs already allocated to existing installations through the NAP process, allowances issued to new entrants and/or through auction of NER surplus will also increase the supply. 3.1 Development of prices and traded volumes So far in 2005, prices have proven to be highly volatile as players have gotten used to dealing with this new commodity. Following a slow start at around 6/t - 8/t in January and February 2005, the EUA prices steadily increased, influenced by NAP-decisions and higher oil/gas prices, to some 20/t in mid-june. The EUA prices then rose sharply and peaked close to 30/t in early July. Since mid-july it has returned to a more stable level in the low-twenties ( 21/t 24/t), with the current EUA price at 21.65/t (19 December 2005). (See figure 3.1 for the price/volume developments so far in 2005). Figure 3.1. Volume of EUAs traded and price Jan-Dec 2005 Prices quoted for delivery Dec 2005 until 1 December 2005, where delivery Dec 2006 is quoted. Volumes for all delivery years, both OTC and exchanged markets. ktco Jan 1-Feb 2-Mar 4-Apr 3-May 1-Jun 30-Jun 29-Jul 29-Aug 27-Sep 26-Oct 24-Nov /t Source: Point Carbon's Carbon Market Trader Volume Price So far in 2005 more than 260 Mt have been transacted in the European carbon market. About 80% of this has been through the over-the-counter (OTC) market, i.e. through different 9

10 brokerages. The remaining 20% has taken place through the 5 different exchanges serving the carbon market: Nord Pool in Norway, the European Climate Exchange in UK/Netherlands, EEX in Germany, EXAA in Austria, and Powernext in France. 3.2 Identification of key price drivers Market fundamentals in the carbon market, similar to other markets, concern demand and supply. The supply of allowances - the right to emit one tonne of CO 2 is fixed by governments through the National Allocation Plans (NAPs). In brief, governments in Member States will first determine the total quantity of allowances to be allocated (the cap ), and then allocate the allowances to installations in energy intensive industries (e.g., production of iron and steel, building materials, pulp and paper) and the power and heat generation sectors. The demand for allowances is in turn a function of the level of CO 2 produced by the companies and installations covered by the scheme. ESTIMATING AND FORECASTING CO 2 PRODUCTION In order to monitor and forecast the demand side of the EU ETS, Point Carbon has developed a unique set of models that provide continuous updates and forecasts of CO 2 production for all sectors in each of the countries covered by the EU ETS. The models draw upon a wide variety of input data and structural information, including for instance detailed information about installations in the power and heat sectors (e.g. installed capacity (MW), efficiency, and availability). In general, CO 2 production depends on a number of factors, such as weather data (temperature, rainfall, and wind speed), fuel prices, carbon prices and economic growth. Among these factors, weather has a double effect; firstly, cold weather increases energy consumption and so CO 2 emissions through power and heat generation. Secondly, rainfall and wind speeds will affect the share of power generated by non-emitting sources and thus emission levels. This is of course particularly important for countries and regions relying on hydro- and/or wind power to any significant extent. THE IMPACT OF WEATHER Consider for instance the Nordic Power Exchange area. During dry years, CO 2 emissions tend to soar along with the price of power, with Norway and Sweden drawing power from the pool at higher levels and coal-fired generation in Denmark and Finland ramping up. The Danish emissions profile is thus a good litmus test for the impact of weather. As shown in figure 3.2, annual emissions from power and heat generation in Denmark during the period fluctuated from a low of about 24 MtCO 2 in 1990 to a high of 42 MtCO 2 in 1996, an exceptionally dry year, representing a swing of about 70% from the lowest to the highest level. According to the Danish NAP, the public power and heat sector will be allocated an 10

11 average of 21.7 MtCO 2 annually in the first period This is approximately 40% less than projected emissions for the period and lower than any year during the 1990s. Hence, even under normal circumstances, not to mention what could happen if for instance 2006 proves to be another dry year like 1996, Danish power and heat producers will have to cover a potentially significant short position through the market. Figure 3.2. Danish power exports (left axis bars) and emissions from the power and heat sector (right axis line) for the period TWh Export Emissions Source: Point Carbon ( and Energistyrelsen ( Hence, the message is clear weather can cause a swing for power producers and flip their position vis-à-vis its cap from short to long and back during a season. This is similar to the case for the power markets, thus weather could become a key price driver in the short term and possibly increase volatility. For instance, the combination of a cold winter and a warm summer could cause power consumption and emissions to soar, which would provide a clear bullish signal MtCO2e The impact of weather on emissions is measured by comparing observed values to forecast data. The effects on emission levels of both temperature and precipitation are calculated across the EU25. As described above, the accumulated effect of weather on emissions is correlated to the EUA price as shown in figure

12 Figure 3.3. Chart showing relationship between weather related emissions and EUA price /02/05 22/02/05 08/03/05 22/03/05 05/04/05 19/04/05 03/05/05 17/05/05 31/05/05 14/06/05 28/06/05 12/07/05 26/07/05 09/08/05 23/08/05 06/09/05 20/09/05 04/10/05 18/10/05 01/11/05 15/11/05 EUA Price ( /t) EUA Price 2005 Accumulated weather effect Variation in emissions (mt) -5 THE ROLE OF FUEL SWITCHING While the marginal CO 2 abatement cost might in the long run direct investment towards abatement projects, fuel switching from coal to gas for power and heat production is probably the single most important measure in the short term. This is firstly because the public power and heat sector is the largest in terms of emissions for most of the current Member States. As illustrated in Figure 3.4, public power and heat represent more than 70 per cent of total emissions covered by the EU ETS in Denmark, Ireland and Greece, and about 60 per cent in Germany and the UK, representing the two single largest emitters. Figure 3.4. Share of emissions by sector covered by the EU ETS for EU 15 in year % 90 % 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % 0 % Denmark Ireland Greece Germany Finland UK Italy Other Building materials Oil and gas Metals Pulp and paper Public power and heat Netherlands Portugal Spain Belgium Austria Sweden France Luxembourg EU15 Sources: Eurostat and Point Carbon 12

13 Secondly, and even though burning any fossil fuel creates CO 2 emissions, coal causes about two times that of natural gas per consumed unit. Figure 3.5 shows that solid fuels (hard coal, lignite) accounted for about 70 per cent of total CO 2 emissions from public heat and power stations in EU15 (less Luxembourg) in year The figure also shows that the share of emissions by fuel varies between countries, depending on factors like resource endowments, fuel prices and state subsidies/taxation. For instance, solid fuels accounted for almost 90 per cent of emissions from thermal power stations in Germany, but only about 26 per cent in Italy. In comparison, natural gas is an important fuel in countries like the Netherlands, Austria, Belgium and the UK. There is a considerable scope for switching from coal to natural gas and other liquefied fuels in several Member States, most notably Germany and Spain. Hence, in order to forecast CO 2 emissions into the future, it is also important to monitor developments in fuel prices and assess its potential impact on fuel switching. Figure 3.5. CO 2 emissions from public heat and power generation in year 2001 by fuel 100 % 80 % 60 % 40 % 20 % 0 % Austria Belgium Germany Denmark Gaseous fuels Liquid fuels Solid fuels Spain Finland France United Kingdom Greece Ireland Italy Netherlands Portugal Sweden EU14 Source: European Environmental Agency ( EXOGENOUS SUPPLY (CER CREDITS AND NEW ENTRANT RESERVES) CER credits from CDM projects and supply through the new entrant reserves are the other potential sources of supply into the scheme and together these are termed exogenous supply within Point Carbon s price forecasting tool. For the new entrant reserves, some countries have stated in their NAPs what they will do with any surplus whilst others haven t decided whether to cancel or sell any surplus allowances. In terms of the overall supply into the scheme, it doesn t matter whether allowances come into the 13

14 market through new entrant allocations or through an auction or other sales channels. Our view of new entrant reserve supply into the market is currently between 158 and 168mt in total throughout the first phase. The volume of CER credits entering the market in phase 1 is dependent on regulatory issues surrounding project registration and approval processes, the demand from non-eu ETS countries and companies, and the speed of development of the CDM market. Our current view of CER inflow into the EU ETS is some 35mt in total during the first phase although recent changes to CDM regulations (early credits) may increase supply throughout the period. Even with this potential inflow, the volume of credits used for compliance within phase 1 may be less than this as credits can be banked between phases so the volume used within the first phase will depend on the prices in phase 2. Whilst the phase 2 price is currently trading below the phase 1 price, it is likely that the phase 2 equilibrium price will eventually be higher than for phase 1 given the requirements to meet Kyoto commitments. 3.3 Price risk and future prices Price risk is the key risk factor that has the most significant impact on the revenues from the sale of the 5 million allowances. This risk relates to the fact that allowances may be sold during a time span of over 2 years, while the price development of allowances during this period is unknown. One effect of price risk to the Danish government is that they sell allowances at a certain price and the price in some future period is higher than the price received. Conversely, if prices were to fall, the same transaction would look more favourable. Taking a view on the market and speculating on future prices involves a significant amount of risk if prices move in the opposite direction than expected. It is therefore advisable to take a view of the market by considering many possible price paths, and adopt a sales strategy which entails a reasonable trade off between possible price developments. Consequently we advise against a strategy which assumes a specific direction of prices in the future. A framework for managing price risk needs to incorporate analysis of the market to determine how future prices may develop, and a quantification of the effect of these prices on a position/portfolio. Understanding price developments becomes an art of understanding the effects of observable and predictable factors and weighing these against the possible impacts of events that may be difficult to forecast. Price risk may be controlled by acquiring the best skills and best available sources of information about market fundamentals. The future price level is likely to be set by the price drivers, described in the previous section, but the only certainty about future prices is that there is a variability associated with future prices. It is therefore of interest to examine the variability of price drivers to get a feel for the future level of variation of carbon prices. Figure 3.6 is a schematic of possible price paths during phase 1 that underpins the modelling used within this report. There are three main periods with different ranges of price outcomes early 2006 (narrow range), rest of 2006 to 2007 (central assumption of price outcome range) and 14

15 true-up period (wide range of price outcomes). The vertical blue lines reflect periods of potential price shifts when allowances need to be submitted. This comes about because whilst emissions can be monitored and estimated throughout the period, there is no certainty until allowances are submitted in registries. This could cause a price shock depending on how different actual emissions outturn compared to market expectations. Early 2006 Prices have remained relatively static over the last few months, hovering around the low twenties, and not dropping below 20/tonne for more than a few days before rising again. This is known as a support level and is often a psychological effect rather than being based on any fundamentals. It seems likely that, unless there are any important political signals or significant movements in the fundamentals, prices will remain at this level into early Main period (remainder of 2006 and 2007) Further out into 2006 there are several factors that could give rise to a wider range of price outcomes. The first submission of allowances at the end of April 2006 will be a real test of the market, not only to see how accurate emission forecasts have been, but also how the market reacts to any discrepancy. Political events that could affect the supply side include decisions on the revised UK NAP, decisions on what to do with NER surpluses and the development of the CDM market. The longer-term volatilities of the fuel prices, used as input parameters in the model, are higher than volatilities over a shorter time period. The distribution of carbon prices in the period from 2006 to 2007 is driven by the annual volatilities of the model input parameters, which have been set at levels seen in the market today. True-up period early 2008 The range of carbon prices at the end of 2007 and early 2008 is expected to be wider as phase 1 allowances have no value in phase 2 and the price will either surge or collapse depending on how short or long the market is. CERs could provide a price bridge between phase 1 and phase 2 as these can be used in either phase. Figure 3.6. Schematic of potential price paths during phase 1 Wider range of price outcomes 40 /t Possible price path Average price 10 Central range of price outcomes

16 Price risk in the context of the forward curve Buying allowances through the spot market means that payment and exchange of allowances will take place immediately. When selling forward contracts, delivery and payment don t occur until the time of delivery e.g. December 06 or December 07. Whilst EUAs are equivalent throughout the first period, there is a price differential between the different yearly vintages (06 and 07) to reflect the future value of money. Theoretically, the forward curve for EUAs should be priced so as to reflect the current interest rates. Occasionally, the curve may not trade in this idealistic way and there may consequently be an opportunity to take advantage of this. 16

17 4. Objectives and significance of risk MAIN FINDINGS The government needs to consider the full range of risks when assessing strategies - We are unable to substantiate that the allowance sales programme will be characterised by a significant level of systematic risk - Emphasis needs to be placed on political and price risks 4.1 Objectives The main objective of the sale of allowances is made explicit in the terms of reference: A sales strategy has to be devised that will optimise the state revenues Optimising the state revenues involves maximising profits within certain constraints, which constitute limitations on profits, such as the level of risk which is acceptable to the Danish state. There are a variety of different risks that the Danish government is exposed to and these are detailed throughout this report in the relevant sections. The conclusions of this report have been derived from choosing the most appropriate strategy based on the perceived revenues and risks of a variety of different strategies and from a dialogue with the Danish government as to their view of acceptable risk levels. In addition to the main objective of the Danish government, we would like to add the following important considerations: Employ a strategy that is robust for all price scenarios given the dynamic nature of the EUA market The EUA market has historically been very volatile and there is significant price risk for the remainder of the period. Whilst we have developed a good understanding of the fundamental drivers of the market which can be used to model future price scenarios, the future prices will never be certain. The use of price distributions for the evaluation of the sales strategies allows us to model a range of possible price paths rather than one fixed path. The strategy that is chosen should also be flexible to incorporate changes during the course of 2006 and 2007 based on market developments. Ensure the sale is handled in an efficient and transparent manner The Danish government needs to ensure that the sales method is transparent, secure from market abuse and is cost effective in relation to the revenue optimisation. The allowances need to be made generally available to participants within the EU ETS by employing a reasonable 17

18 number of liquid marketplaces. A successful disposal method will further add confidence to the organisation and running of the EU ETS. Publicise sale without giving any details of timings and methodology until after sale As part of the transparent sales process, the Danish government should make public its decision to sell allowances. Transparency should however not be pursued to the extent that the government is commercially disadvantaged e.g. by informing the market of every planned transaction. It should consequently not disclose any details of the strategy beyond announcing its decision to go ahead with the sale of allowances. RISK FRAMEWORK Discussing a risk policy initially involves the identification of factors that influence the Danish governments wider view on risk. The overall risk position of the government is likely to involve an assessment of both financial and political factors. The risks for this specific project (sale of allowances) are either systematic or unsystematic depending on the correlation of the project risk exposure in relation to the overall risk exposure of the Danish government. These issues are described further in the following section. Project risk is the risk of revenue variations throughout the sales period. This risk is equivalent with revenue risk (already discussed in the previous chapter) which relates to timing of sales and projected revenues. Transaction risks are defined as the probability of unexpected events that may negatively impact revenues from allowance transactions. These include operational, currency, credit and liquidity risks. These are described in chapter 6.8. Figure 4.1 shows the risk of the sale of allowances in the context of a wider risk perspective: Figure 4.1. Risks for sale project in relation to wider perspective of Danish government Government risk policy Political risk Financial risk Sale of allowances (Unsystematic risks) Other government projects Transaction Systematic risks risks Revenue risk 18

19 4.2 Risk policy - High-level risks The revenue risk that the Danish government is willing to assume could be dependent on the question whether the outcome of the allowance sales should be judged individually on their own merits (a political approach) or as part of the overall Danish state risk exposure in which case an assessment needs to be made to what extent the revenue risk is considered predominantly systematic (a macro economic approach). Political risk The political approach to risk management involves the identification of the acceptable level of political embarrassment that could be caused by a poor outcome of the sales process. This is again related to the level of public transparency of the sales process and the accounting of the revenues from the sales process. Both cases of excess loss and profit need to be considered. A significant loss of revenue due to the mismanagement of the sale or disproportionately high transaction costs could be used politically against the government. Similarly, losses due to unfavourable price developments could in retrospect be construed as government misjudgement of the emissions market. On the other hand, high revenues for the government could attract attention from the public and industry who perceive they are paying the price of emissions trading through increased power prices. If revenues are allocated up front to finance specific purposes, an extra level of care should be adopted since potential losses will need to be offset by additional budget allocations. Other political risk may be related to scandals and similar events that may originate in the organisation of the sales. This could be related to counterparty losses, corruption or other events that may compromise the government and trustees. Financial risk The impact of revenue risk and reward on the Danish government is associated with the question whether the sales project will add to the financial risk exposure of the Danish government or if the project is considered neutral, in which case a high return strategy may be preferred. Such an assessment requires a discussion of systematic and unsystematic risk. Systematic risk is the risk that revenues from an economic venture are correlated with the general level of economic activity or the economic cycles of the Danish economy, which in turn is strongly linked to the European economy. The term systematic risk is adopted because the project risk is positively or systematically correlated with a number of other economic ventures, all of them performing in phase with the overall level of economic activity. Unsystematic risk originates in uncertainties that are specific to each individual venture. For a government that is involved in a large number of projects, it is likely that unsystematic risk will be 19

20 neutralised in the sense that some ventures will incur gains and others will incur losses. Unsystematic risk may therefore be disregarded, whilst systematic risk should be accounted for. Consequently, governments will normally require a higher rate of return when evaluating ventures with systematic risk. Transferred to the case of selling allowances, this means that strategy options involving the early sale of allowances will for the same expected revenue be preferred to options which defer sales to later and hence involve a higher risk. The question then remains if there is systematic risk in the project of selling 5 million allowances during the course of two years. Fundamentally, there is a clear causal relationship between levels of economic activity and emissions of greenhouse gases. This is based on the observation that energy generation and industrial production and their emission levels are historically positively correlated with economic growth. To which extent such a relationship will be maintained into the future becomes an issue of belief in the effectiveness of climate change policy. Having established a positive correlation between economic activity and emissions and thereby demand for allowances, it needs to be recognised that other factors such as weather and relative fuel prices may have a significantly stronger impact on allowance prices in the short run. The key price drivers for the EU ETS are discussed in chapter 3.2. The effects of these price drivers may consequently mask the influence of economic cycles on prices during a two-year period. Economic activity, and hence emissions, in each country within the EU25 may vary considerably, but it is the total emissions and demand for allowances across all countries that dictate carbon prices. Whilst there may be a degree of correlation between the economic cycles of countries in Europe, it is possible that Danish economic cycles and emissions will not be correlated with overall emissions. Although allowance prices admittedly are influenced by levels of economic activity there is consequently no evidence to suggest that allowance prices will correlate with economic activity in Denmark or the EU throughout the allowance sales period. Following this, we are unable to substantiate that the allowance sales programme will be characterised by a significant level of systematic risk. The consequence of this result, if no consideration should be given to other objectives, would therefore be to select the sales strategy with the highest expected return. 4.3 Trade off between risk and profit Harry Markowitz, in his 1952 dissertation Portfolio Selection, believed and mathematically proved that there is a direct relationship between an investment's risk and its reward. He saw risk as an equal partner with expected gain. With any reward, such as a well-performing stock or mutual fund, there's always some element of risk. And the greater the potential reward, the greater the potential risk. Markowitz also argued that investors should be measuring, monitoring, and controlling risk at a portfolio level. 20

21 Most individuals measure risk as their chance of loss, however, risk can also be viewed as a chance of gain. The relationship between risk and reward is a fundamental concept of portfolio planning. Each portfolio composition has some level of risk associated with it. Although there are no guarantees of the success of any strategy, there is generally a correlation between the potential reward an investment offers and the risk associated with it. Consequently, in terms of selling allowances it can be argued that the risk associated with selling allowances immediately is the risk of foregone profits (i.e. the increased profit if prices would go higher), while the risk of allowances remaining unsold may entail losses or gains. The relationship in investing between risk and reward is generally measured by volatility, calculated from the variability of returns within a period of time. A careful consideration of volatility is, therefore, crucial to the analysis of any investment or sales strategy. Generally, when returns increase, volatility increases. An investor should decide his or her "risk/reward comfort zone" and, most importantly, stay within it. In general, a person/organisation that is risk averse will choose the trading strategy which is seen to have the lowest risk, and consequently a lower profit potential. A person that is less risk averse will choose a strategy that might entail higher risks and potentially higher rewards. Our assumption is that governments in practice demonstrate some level of risk aversion. In practical terms, this means that the focus predominantly will be directed towards the loss potential of sales strategies. This can be translated into a discussion of what would be an acceptable loss compared to the revenue level that would accrue from an immediate sale of all allowances. This is discussed further in section 5.2 following the analysis of various static sales strategies. One useful way of looking at the relationship between risk and reward is through the efficient frontier 2, which shows all the possible combinations in which the expected return is maximised for each given level of risk. In figure 4.2, from each point on the frontier curve it is possible to move in a direction of either reducing risk and hence the expected return. But from anywhere under the curve, it is possible to increase expected return without increasing risk. The objective is to identify the optimal strategy that places the investor at the frontier and at the maximum level of risk acceptable to the investor. Finding the optimal sales strategy is the main objective of the Danish government for the sale of allowances. 2 The Efficient Frontier concept was first defined by Harry Markowitz and used to find an optimal portfolio based on selecting certain investments from a universe of risk investments. It is also known as the risk reward frontier. 21

22 Figure 4.2. Efficient Frontier showing maximum returns for each given level of risk Expected return Expected return is maximised for a given level of risk Return varies without increasing risk Maximum level of risk an investor is willing to take Risk (Return volatility) 22

23 5. Static and dynamic sales strategies MAIN FINDINGS Sell significant volume upfront to lock-in profit - Sell between 2 and 3 million tonnes - This seems an appropriate balance of limiting risk whilst retaining some potential for gain - Selling 2.5mt would mean the risk of losing more than 30m (compared to a mean of approximately 100m) was less than 5% Sell as early as possible in Higher carbon prices during cold spells - Avoid risk of potential price shift in May 2006 if reported 2005 emissions are different to current expectations Sell the remaining volume in 2006 and Split the remaining volume for sale into yearly volumes - Potential to hold back some sale volume for sale during the true-up period Sell some (or all) of remaining volume through active management - Active management combined with careful selection of advisors is likely to increase expected revenues beyond what can be achieved by static sales strategies - Dynamic strategies can be used in combination with static sales strategies INTRODUCTION The choice of a static or dynamic sales strategy is based on whether sales of emission allowances should proceed according to a predetermined sales schedule or if timing of transaction decisions should be flexible and based on continuous assessments of market prices and future prospects. These options, which are fundamentally different approaches to risk management, do not preclude combined strategies in which the 5 million allowances are split into both a dynamic and static portfolio. Figure 5.1 gives a summary of both types of strategy. A quantitative assessment of optional sales strategies can be facilitated by the use of Point Carbon s framework for Profit-at-Risk (PaR) evaluation. The PaR model will be used for evaluating at least four conceptually different static sales strategies in order to see how they will affect the Danish government s simulated revenues in terms of mean value and risk/ revenue distribution. Finally, a PaR simulation will be performed to estimate how a supplementary dynamic sales strategy may improve the best static sales options. Bidding strategies encompass the choice of market channels taking into consideration available outlets and contract options in the current market for CO 2 allowances. Special consideration will 23

24 be given to a discussion of dedicated auctions, liquidity constraints, available exchanges / marketplaces and of transaction risk factors inherent in allowance trading. Figure 5.1. Summary of static and dynamic sales strategies Description Cost Revenue Sale Channel Static Sale of fixed volume of allowances at specific time intervals Generally low Fixed fee payable to enter markets Exposed to full volatility of market but numerous sales assumed to achieve average market price Exchanges / OTC (Brokers) Dynamic Sale is dependent on market conditions to maximise profit High Either fixed fee for someone to manage portfolio or fee as percentage of profits Dynamic trading may be able to achieve higher revenues over a period of time Exchanges / OTC (Brokers) 5.1 Description of static sales strategies The Danish government is faced with the task of selling 5,025 million CO 2 allowances from now until 30 April 2008, at which time any unsold allowances will be worthless. Based on current allowance prices, this asset may be valued at some 100 million. The future value of the portfolio will depend on developments in the international market for allowances, which is characterised by a significant level of uncertainty. Consequently, there is both a risk of significant loss and a potential for additional profit for the Danish state associated with the way in which the portfolio of allowances will be managed throughout the coming two years. This report will explore different static and dynamic sales strategies. A static sales strategy is characterised by a high level of pre-programming and automatic execution of sales and bidding strategies. A static strategy does not leave much discretion to the executioner of the strategy in terms of adapting to long term or even short term price fluctuations. Since the portfolio is dividable, there is always the option of adopting partly static and partly dynamic strategies. Another important option is for the Danish government to maintain flexibility to be able to revise the strategy throughout the trading period. A strategy that may be judged as robust and optimal at this time may not necessarily turn out to be equally sound one year from now. What may have been designed as a static strategy at the outset may have to be changed and consequently the strategy becomes more dynamic. We recommend that a static sales strategy involving an 24