Rising prices of CO2 emission rights

Rising prices of CO2 emission rights

27 October 2021Reading time: 7 minutes

Climate change, caused in particular by greenhouse gases, is keeping the world in suspense. One of the most important levers for halting global warming are CO2 emission rights and the trading of related CO2 emission certificates. These certificates grant companies the right to emit one metric ton of CO2 or an equivalent greenhouse gas for each emission certificate. Recently, intensified climate change ambitions and limited quotas for emission allowances have been a major price driver of CO2-Futures which are traded on the Futures market. There could still be potential, which could open interesting investment opportunities for investors.

Products

Climate change is taking its toll on our world. Weather extremes, drinking water shortages, hunger, or the extinction of species in flora and fauna are just some of the devastating consequences of global warming. To put an end to this, swift action is required. As a result, the Paris Agreement of 2015 agreed to reduce global warming to well below two degrees Celsius.

The main trigger for climate change is greenhouse gas emissions. To reach the climate target of the Paris Agreement, it is imperative to reduce greenhouse gases as quickly and intensely as possible. The objective is to reduce emissions worldwide to zero between 2045 and 2060.

CO2 Emission Certificates: What are they?

A means of reducing CO2 or similar greenhouse gases, are CO2 emissions rights or emission certificates – called EUA (European Union Allowance) in Europe. These give companies the right to emit one ton of CO2 or an equivalent greenhouse gas per emission certificate. In Europe, the intention is to regulate around half of the greenhouse gas emissions through these certificates. Companies that belong to particularly energy-intensive sectors, such as energy companies, industrial metal, cement and paper producers - and those that have a certain company size - are included. These companies are not allowed to emit CO2 or other greenhouse gases without the required number of CO2 emission certificates.

Cap and Trade: Emissions trading

Companies that have a greater strain on the environment by emitting or causing more CO2 than they are entitled to through their assigned emission rights, can buy additional emission certificates. More climate-friendly companies, who do not use up their quota, need less emission certificates and can sell the remaining. As a result, a price tag can be attached to CO2 Emissions. In the EU, the European Commission caps the total number of emission certificates in circulation. Furthermore, it is planned to lower this cap from year to year.

This system is termed «Cap and Trade» and should significantly contribute to achieving the goals of the Paris Agreement. The trading of emission certificates should motivate companies to invest in climate-friendly production capacity. The more expensive the emission certificates, the greater the incentives for such investment. If emission certificates become too expensive, affected EU-companies would no longer remain competitive on a global level. The concern is that such companies would move abroad, where no similar regulation exists. For this reason, a certain amount of emission certificates is handed out at no cost, all others are traded. In addition, the goods of non-affected companies will be subject to a toll on imports in the future. Other measures are also possible, so that it cannot be assumed with certainty that the planned annual limitation of quotas will also lead to a price increase in the trading of emission certificates.

However, regulation through emissions certificates has not yet been extended to all «CO2 sinners». Consequently, there are still industries or companies that are excluded from it. As long as this is still the case, there is no strong financial incentive to take measures to reduce CO2 emissions. However, in order to hold on to the climate targets, such companies would also have to be included in the foreseeable future.

Development of CO2 Emission Certificates

Just a few years ago, the prices for CO2 emission certificates were significantly lower than today – roughly 5 Euros per ton of CO2. For large corporations that had to purchase these certificates, it was very inexpensive. As a result, their effort in reducing emissions was relatively small.

In the meantime, this has changed. Climate policies have been tightened substantially and quotas reduced continuously. Subsequently, the prices for emission certificates have increased significantly. This is necessary to achieve the climate target that has been set. For example, last December, the European Union set much more ambitious climate targets: greenhouse gas emissions are to be reduced by 55% by the year 2030, instead of the previous 40%, using 1990 as a basis.

Because of political interventions, the CO2 emission certificates became significantly more expensive and reached new highs of over 60 Euros in September of this year.

With higher prices, emission certificates could finally bring about what was expected years ago: fossil fuels as an energy source would be less worthwhile because of higher certificate prices. As a result, energy production from such sources is being cut back, which increases the use of alternative energy sources.

Emissions trading in the EU and Switzerland

Emissions trading in the EU and Switzerland is having some effect, but there remains a lot of potential. It was only last year that Swiss and European emissions trading were linked. Proponents hope that other countries and regions will join.

CO2 emissions certificates made investable

For investors, interesting investment opportunities can be taken from the performance of CO2 emission certificates. In principle, it is possible to invest in emissions rights by means of futures contracts traded on futures exchanges. Enabling investors to participate in the price development, Vontobel offers various certificates on the ICE ECX EUA Future, which tracks the prices of CO2 emission certificates.

The underlying: ICE ECX EUA-Future

The ICE ECX EUA Future is a futures contract on the CO2 emission rights traded on the ICE Endex futures exchange, which is part of the Intercontinental Exchange (ICE) and based in the Netherlands. A defining characteristic of futures trading is an agreement to buy or sell an asset (in this case, the CO2 emissions rights) at a specified price on a specified date in the future. This agreement allows buyers to lock in the price of emitting a specific amount of greenhouse gases (CO2) on a specific date in the future. Because the expiration dates of the contracts are fixed in advance on a monthly basis, if the position is to be maintained in the market, the position in the expiring futures contract must be regularly switched to a contract with a later expiration date.

Since a future is a forward transaction, the performance of the future may differ from the performance of the relevant CO2 emission rights to which the future relates. For example, this is the case, if the future is traded on the futures exchange at a premium or discount compared to the CO2 emission rights because certain market factors are valued differently in the futures market than in the spot market for CO2 emission rights.

Products

The products on the ICE ECX EUA Future are illustrative examples of how «exotic» underlyings or markets can be made accessible through structured products.

Tracker-Certificate

With a Tracker-Certificate on the ICE ECX EUA Future, interested investors receive an investment product to participate from the performance of CO2 emission allowances. The Tracker-Certificate enables investors – under consideration of the management fee – a 1:1 participation of the performance of the ICE ECX EUA Future. Investors can determine their own investment horizon thanks to the «open end» structure of the tracker certificate. However, the issuer of the tracker certificate has the option to terminate the term of the product by terminating the certificate.

Mini-Futures

Mini Futures offer an alternative way to participate in the performance of CO2 Futures. Whatever your market expectations, with Long or Short Mini Futures on the ICE ECX EUA Future you can bet on both rising and falling prices.

Mini Futures offer the opportunity to participate in the performance of the underlying with low capital investment – leveraged and in both directions. The products are open end, provided that the product is not terminated by reaching the stop-loss level. If the price of the underlying reaches or falls below the applicable barrier during the observation period (barrier-event), the Mini Futures expire immediately and are redeemed on the basis of the so-called Stop-Loss reference price. Further information can be found in the prospectuses available on the product page (Termsheet and basic information sheet).

Constant Leverage-Certificates

The Constant Leverage Certificate tracks the performance of an underlying factor index on the ICE ECX EUA Future. In this way, investors can participate in stable - rising or falling - price trends. Depending on market expectations, investors can participate disproportionately in the performance of the reference value in the form of daily returns. The factor (leverage) is constant over the entire term, which is why the investment is similar to a reinvestment on a daily basis. Further information can be found in the prospectuses available on the product page (Termsheet and basic information sheet).

Warrants

Investors can participate disproportionately (leveraged) in the performance of the ICE ECX EUA Future through warrants with low capital investment. Call warrants allow investors to participate in rising prices, while put warrants are used to bet on falling prices. While the standard form of a warrant has an expiration date, there are other types of warrants, for example, equipped with a (so-called) knock-out barrier or warrants with a knock-out barrier and without a predetermined expiration date (open end). In the case of knock-out products, when the underlying reaches the knock-out level, the warrant immediately expires worthless. Further information can be found in the prospectuses available on the product page (Termsheet and basic information sheet).

As all mentioned products refer to Futures, the so-called rollover mechanism should be considered: Futures have a specific expiration date, therefore the front month future as a reference value of a product without a fixed maturity must regularly be replaced by a longer-term future. Regarding the rollover, it is relevant whether the price of the longer-dated future into which the product is «rolled» is above or below the price of the expiring future. Depending on the price deviation, the execution of the rollover may adversely affect the performance of a product with a future as underlying or reference value, although the rollover is usually carried out in a price-neutral manner while adjusting the product features.

For further details, please refer to our publication "CO2 emissions allowances information", which is available via the product page.

Products

Investors bear the issuer's default risk for all products.

18/01/2022 13:33:23

 

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