For settlement transactions (both immediate and forward) allowances are usually being exchanged for cash. This is the simplest form of allowance transfer and the most common in emissions trading markets. However, swaps have also become another popular type of transaction. At its most basic, swaps allow one party to exchange allowances of one vintage year for allowances of another vintage year from a second party.
Viewed in the context of compliance for the U.S. Acid Rain Program, swaps have the ability to use the market to efficiently distribute allowances. Take for example, utility A, which has plenty of SO2 allowances for the year 2000, but is short 10,000 vintage 2002 allowances. On the other hand, utility B is short on vintage 2000 allowances yet is long by at least 10,000 allowances for the year 2002. Through a swap transaction, utility A could exchange its surplus vintage 2000 allowances for utility B's surplus 2002 allowances.
Immediate Vintage Year Swap: In the above example, we can assume the two utilities will transact this swap concurrently. Still, the swap generally would not be made on a one-for-one basis. If the transaction were done on a cash basis, the value of the vintage 2000 allowances would be higher than those vintages further out, reflecting the price differences in the market between earlier and later vintages. A ratio is used to calculate this difference, and it is usually given in terms of the earlier vintage and how it relates to the inherent value of the later vintage.
Vintage Year Swap Formula {[ratio between vintage years x (later vintage year - earlier vintage year)] x amount of earlier vintage year allowances} + amount of earlier vintage year allowances = vintage year swap amount
For example, again, using the above illustration, utility A would give utility B 10,000 vintage 2000 allowances in return for 10,700 vintage 2002 allowances.
i.e. {[3.5% x (2002 _ 2000)] x 10,000} + 10,000 = 10,700
The premium paid by utility B reflects a ratio of 3.5% per year between vintage years, which is calculated based on the cash differential between vintages and quoted in the marketplace.
Deferred/Delayed Swaps - or Loans: In cases where the counterparties do not wish to make the swap arrangement an immediate transaction, they can enter into a deferred or delayed swap transaction, placing a several month to several year lag into the equation. Although these types of deals are less common, they can be implemented to allow the parties flexibility in delivery times.
Counterparties can structure transactions in which one party delivers allowances the day the transaction is closed and the other transfers back allowances within 175 days. Despite this transaction taking on the form of a loan, the returned allowances often will be different from those originally transferred. This deferred allowance swap is specifically constructed to close within 180 days. Swaps that settle in less than 180 days are generally considered a nontaxable transaction.
These 175 day deferred swaps are what amount to a short-term loan of allowances, and like any loan, the borrower is charged an "interest" rate. The market ratio for this type of transaction currently is 0.75% to 1% every 175 days for vintage swaps of the same year. The ratio would increase as vintages differ.
Deferred or delayed swaps extending beyond 180 days are calculated slightly differently, and they actually take on an appearance much more akin to a loan. In this type of a transaction, one party loans allowances to another for a period of one to five years. The current "interest" or loan rate falls within the 1.5% to 2.0%-range per annum for quantities of 25,000 allowances or greater.
Deferred Swap Loan Rate Formula [interest or loan rate x number of allowances] + number of allowances = 180 day deferred swap allowance amount
For example, if party A transfers 100,000 vintage year 2000 allowances it will receive 102,000 vintage 2002 allowances from party B one year later.
i.e. [2.0% x 100,000] + 100,000 = 102,000
The interest is compounded yearly. The extra 2,000 allowances provided by party B is the equivalent of loan interest. There is a specific credit risk associated by this transaction, and one that is born by the lender. The lender can certainly take measures to alleviate this risk, such as requiring the posting of security or establishing specific recourse positions.
The motivation for these types of transactions, of course, depends on the perspective of the parties. The borrower, most often, is trying to immediately cover a short-term need for allowances and is willing to trade later vintage years to cover their current year allowance needs for compliance purposes. On the other side, a utility with excess allowances may look to maximize the value of its portfolio of allowances with the interest accrued in a loan-type structure. Because trades are not submitted to the EPA's ATS until they are transacted, loans often do not appear in the system. It is up to the counterparties to keep track of the allowances owed or under obligation to another party. Delayed swaps or loans are becoming increasingly less common. In large part, the objective of these vehicles is easier-and some times more effectively-met with options.