At their most basic, options are a means to hedge the risk of a rise or fall in price, but they can also be used to maximize revenue on a portfolio of allowances. Options provide the option buyer the right but not the obligation to buy a commodity (in this case, emissions allowances) at a specified price by a certain date. They can best be related to insurance policies in which an individual pays out a premium to the seller or "insurer." The insurer provides a "policy" to cover the buyer's risk of prices going up or down, depending on where the buyer sees their exposure.
Call
Put into practice, options can be useful to a party that may need to buy allowances in the future and is hoping the price for these allowances will fall over time. Without options, the buyer faces a risk: If the price falls, they save money, but if the price actually rises they will have lost money by hesitating to purchase allowances earlier. The option used to manage this risk is known as a call option. To hedge the risk that prices will increase (known as the upside risk), the party can enter into an option transaction with a counterparty. The option allows the option buyer to buy allowances at a specific point in the future (the option exercise date) and at a specific price (the strike price). In return, the option buyer pays the option seller a premium.
As the exercise date approaches, the option buyer needs to decide how to act. If the market price for allowances is higher than the option strike price, the option buyer will exercise the option and buy the allowances for the strike price. If the market price for allowances is equal to or lower than the strike price, the option buyer will simply enter the market and purchase the allowances over-the-counter. In this case, the penalty associated with rising prices is limited to the premium paid by the option buyer.
Put
The contrast to the above example would be a situation where a party knows it has surplus allowances, but does not want to sell them right away. The party hopes that in the future the price for allowances will increase, allowing them to realize more profit from the sale than if they had sold immediately. The risk is that the market price for allowances will actually drop in the future. To hedge this risk, the party can purchase an option to sell its allowances at a given point in the future for an agreed upon price. The option buyer pays a premium to the counterparty providing the option. Should the exercise date arrive and the market price is lower than the strike price set in the option, the option buyer will take advantage of the transaction and sell allowances to the option seller for the agreed upon strike price. If the market price is above the strike price, the option buyer will forgo exercising the option and take its allowances to the over-the-counter market to garner a larger sale price. This is type of option is known as a put option, and the option buyer's risk of decreasing prices (known as the downside risk) is limited to the cost of the option premium.
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.