Last-minute power plant hedging will push up carbon prices

Prices for European Union carbon allowances (EUAs) will rise sharply in 2012 as companies hurry to hedge their emissions compliance requirements by the end of that year.

EUAs are predicted to cost €22 per tonne of carbon dioxide (t/CO2e) in 2011 and €25 t/CO2e in 2012 as the market expects an increase in demand from power companies that have not hedged additional supply before the second half of 2012, says carbon advisory firm Point Carbon.

"Hedging profiles within the power sector vary significantly across European companies and regions," says Kjersti Ulset, head of European carbon analysis at Point Carbon. "Typically, large companies in north-western Europe have the most extensive hedging policy. Companies in the southern part of Europe appear to have a far less extensive hedging profile, while eastern European power companies seem to have quite limited hedging activity. So while some companies look three to four years into the future, others focus mostly on the current year."

Utility power companies usually hedge part of their future power production by selling power and simultaneously securing their direct production costs for fuel and carbon allowances needed for this production.

The December 2011 contract on the European Climate Exchange/IntercontinentalExchange (ECX ICE) futures platform is €15.07 t/CO2e as of December 8. It stands at €15.51 t/CO2e on the December 2012 contract and has the lowest level of volumes.

Point Carbon's price estimates are based to a large extent on the predicted demand for allowances from the participants in the EU Emissions Trading Scheme (ETS).

As a result of the recession, most industry sector companies will have a surplus of allowances in phase 2 (2008–2012) of the EU ETS, where the contracts are used to offset the amount of carbon emissions companies produce. The advisory firm estimated the surplus to be close to 1 gigatonne (Gt) or 25% of the industry sectors' forecasted emissions during the same period and expects 60% of this surplus to be banked into phase 3 of the EU ETS.

Risk managers for power plants have outlined that the carbon price is a significant factor in their hedging programmes and is one of the reasons hedging strategies need to be revised.

"Change and improvement is a continuous process that should always be faced and pursued," says Stefano Fiorenzani, head of risk and research at energy supply and trading company EGL. "We can state that today's market conditions push energy generators to improve their optimisation and hedging approaches even more with respect to the past," he says.

"These new market conditions have pushed the generation 'option' more at the money, increasing its higher order sensitivities with respect to small changes in underlying asset prices such as power, gas, coal or CO2. The risk for the asset's optimiser using the static approach is to be consistently under- or over-hedged, while theoretical perfect dynamic hedging cannot always be performed due to scarce liquidity and market incompleteness. Now is the proper time to revise critically traditional hedging approaches or if you prefer it can be tremendously risky not to do it."