The Forward Settlement transaction is much like the immediate settlement example. The delivery of allowances and payment, however, happen some time in the future, as the name indicates. These types of transactions allow market participants to lock in future purchases at prices that meet their individual needs. It is also a sound tool for managing cash flow, as the buyer is able to book the definitive price of the future purchase well in advance.
Short-Term Forward, Long-Term Forward: The market has derived a few innovations to the forward settlement structure in order to satisfy varying needs. Buyers who are looking to lock in prices through a forward deal-but want to do so within a year-can transact a short-term forward. Usually, delivery and payment are scheduled for December, when utilities true up their emissions balance sheets.
The long-term forward typically extends settlement date by several years, and this type of settlement is contracted by adding on the seller's cost of carry. The cost of carry calculation essentially means the buyer will pay the seller a premium over the actual cost of the allowances in return for the delay in payment and delivery. In mature commodity markets, forward transactions are quoted prices much like spot transactions. However, the forward emissions market is too thin to have standing bids and asks, so a carry forward calculation is used instead.
Carry Forward Calculation Formula [(current allowance price) x (allowance loan rate)] + current allowance price = forward contracting price
For example, if SO2 vintage 2001 allowance prices are quoted at $100 dollars in July 1999, but a utility is interested in purchasing allowances for delivery in July 2001, the contract price would be $122.50.
i.e. [($100/allowance) x (7%)] + $100/allowance = $107.00/allowance (compounded yearly for three years: $122.50)
This premium reflects how the market prices future deliveries and payments, which usually incorporates the seller's cost of carry interest rate plus a premium assessed by the market to create a calculation known as the allowance loan rate. The market assumes prices will escalate between 6% to 8% every year, going out seven years. The rate is compounded yearly. In the above example, the rate used was 7%, but in reality this rate will reflect whatever the market will bear. Therefore the difference in terms of cost to the seller of holding on to the vintage 2001 allowances for delivery in July 2001, rather than selling them immediately, is around $22.50 for each allowance. As the contract term extends past the year 2004, this cost decreases due to regulatory uncertainty.