The launch of a new emissions allowance price index from London-based energy brokers could herald the beginning of more transparent derivatives markets attached to the EU Emissions Trading Scheme (EU-ETS). This -some think-could pave the way for the entry of large financial actors into the carbon market. The Ecosystem Marketplace takes a closer look. The nascent European carbon market passed another milestone on the week of May 16, 2005 with the launch, by the London Energy Brokers Association (LEBA), of the LEBA Carbon Index. Six brokers, who collectively claim to account for the vast majority of trades in the European Union Emissions Trading Scheme (EU ETS), will put together the index, which they say "will contribute to a more transparent, liquid, traded market in emissions allowances". And the following day, Barclays Capital – the investment banking arm of the UK's Barclays Bank – announced that it had transacted a financial derivative (a swap contract) based on the index. While this is not the first financially-settled swap in the EU ETS – Germany's Dresdner Bank conducted a similar swap with Finnish bank Sampo in January – it marks the first such deal referenced to a transparent, publicly-available index.
A New Benchmark
Essentially, the LEBA index – which is published by financial information provider Telerate at 9.30 am each day – is an amalgamation of the prices of all the emissions trades for physical delivery in 2005, 2006, and 2007 that the six brokers arranged the previous day, weighted by volume. The idea is it provides a benchmark 'virtual' price for the EU Allowance (EUA) market. Such indexes are common in commodity markets. Some traders in oil, or copper, or – for that matter, EU carbon dioxide (CO2) allowances – want to take or make physical delivery of the commodity in which they trade. Most, however, do not. The typical investment bank, or hedge fund, or own-account trader will want exposure to the price of a commodity, without the complications of actually having to move around barrels of oil, tonnes of copper, or even the electronic bits of data that confer ownership of an EUA. The existence of indexes such as that launched by LEBA allows market participants to trade numbers, rather than actual allowances. They provide a reference for derivatives trades – such as swaps or options – and allow for the structuring of investment products such as bonds whose interest payments are linked to the index price. "Increasingly, the contracts we are structuring in the carbon markets require the use of a reliable market standard," says Steve Drummond, managing director of broker CO2e, one of the contributors to the index. "We believe this will become the [over-the-counter] market standard for European allowances." "With the dramatic growth in the trading of the physical EU emissions allowances in the last six months, the launch of an index to encourage the growth of a derivatives market is a logical next step," says David Jenkins, director of European energy products at Tradition Financial Services (TFS), another LEBA member.
The First Swap
Barclays is giving few details away about the details of the trade. Louis Redshaw, the bank's London-based head of environmental markets, told Ecosystem Marketplace that the trade was a fixed-for-floating swap, conducted "at a market price, in 'non-token' volume", but he declined to identify the counterparty, the duration of the deal, nor which side of the swap Barclays was on. Such swaps, he explained, allowed counterparties to take a view on the price of EUAs without requiring them to hold the actual allowances. Under the terms of the trade, the party buying the floating leg would pay the counterparty on the fixed side if, when the contract matures, the LEBA index is lower than the fixed price which they agreed. If the price is higher, the fixed leg pays up. "The point is, the two counterparties don't have to pay the whole amount, as they would for physical delivery – they just pay the difference in the two prices," Redshaw says. "If you want to invest in CO2, you don't have to lock up cash in buying physical allowances, and you don't have to worry about the delivery risk and penalties involved in actually getting your hands on the allowances." The existence of such an index also makes it possible to 'short' the market – betting that the price of allowances will fall. Some banks are beginning to offer EUA 'repo' services – whereby they borrow allowances from companies for a period of time, in exchange for a fee. While repos allow players to go short allowances, trading swaps on an index is a much more straightforward proposition.
Maybe not the first, but a potential leader
But the LEBA index is not the first on the market. Consultancy Point Carbon produces a daily index price, and Ecosystem Marketplace carries a weekly index produced by Carbon Finance magazine. Exchanges that list EUA futures contracts, such as the European Climate Exchange (ECX), and Nordpool, also provide a de facto daily index, in their closing prices. As in many markets, differences of opinion exist as to which index is the most reliable indicator of prices. "There is no consistent pattern in commodity markets," says Jenkins at TFS. "In oil, some trade against exchange prices from Nymex or the International Petroleum Exchange, others use [information provider] Platts' indexes." "In emissions, however, most indexes, such as those from ECX and Nordpool, currently represent very little volume," he says. TFS, along with the other contributors, CO2e, GFI Brokers, ICAP Energy, Prebon Marshall Yamane, and Spectron Energy Services, claim 90% of the privately negotiated over-the-counter market in EUAs. "There's more than 1 million tonnes [of carbon dioxide] going through each day," he adds. "That's more plausible and credible for the market."
Waiting for the Exchanges
But other market players would rather see exchanges, rather than the OTC market, take the lead on indexes. "We haven't looked into it in great depth, so it's hard to be specific," says Garth Edward, head of environmental trading at Shell in London. "But indexes need to be very robust and exchanges would offer more transparency." While exchanges are required to track and report every trade, OTC markets are more opaque. "That's not to say that you couldn't do a [financially-settled] swap before, but both buyer and seller would have to clearly agree on what the index is," he adds. "We wanted to wait for a reliable index," says Barclays' Redshaw. "There's nothing wrong with the others, but LEBA has the commitment of its members. We can be sure that the index will be there for the long term." Mark Nicholls, a regular contributor to The Ecosystem Marketplace, is the London-based editor of Environmental Finance magazine, and consulting editor to its sister publication, Carbon Finance. He can be reached at email@example.com