Credit Risk
Contracting procedures for emissions trades are surprisingly standardized and simple. Liability concerns for emissions trades under the U.S. Acid Rain Program are low. Nonetheless, there are liabilities you should consider.
The emissions trading system dictates that, while allowances are granted by the government, there is no guarantee provided by regulators as to the ability of the seller to provide these credits. Therefore, the onus is on the buyer to determine the credit worthiness of the seller. Credit worthiness can be measured by credit rating agencies, such as Standard & Poor's, DCR, or Fitch IBCA. Often this is determined before choosing a counterparty for a bilateral trade, and an emissions trading practitioner working through a broker can stipulate that bids and asks should only be considered for counterparties meeting its pre-established credit criteria.
Standard Contracts
In the SO2 market, the contracting process is a relatively standard affair. In fact, the contracts used in almost all emissions trades these days bear a striking resemblance to each other. The Emissions Marketing Association (EMA) has even produced a sample contract which is just a few pages long, which can be downloaded from its Web site for use in transacting trades (http://www.emissions.org).
Despite the standard nature of the documentation, contracting parties must still keep an eye out for basic trading issues. Foremost is the ability of your counterparty to come through with their end of the deal, whether it be providing cash for your allowances or allowances for your cash.
In most cases, contracts will contain provisions protecting against the default of either counterparty. Their ability to pay is often measured by credit rating agencies. These independent assessments are often incorporated into the contracting process. Contracts commonly use protections, such as: setting up lines of credit (LOCs) to back the transaction; gathering guarantees from a counterparty's parent company; or securing recourse to the parent company.
Once the contract has been executed, it is time to let the allowances and the cash change hands. Typically the seller of allowances will deliver an Allowance Transfer Form (ATF) to the buyer. This is a standard EPA document that confirms the movement of allowances from one account to another. The buyer will then fill out the ATF and forward it to the EPA, which will input the information in its tracking system. Cash or other payment for an immediate settlement transaction is usually made within three business days of an electronic or written confirmation by the EPA that the contracted allowances have been transferred in the ATS. EPA is moving toward electronic transactions rather than paper transactions.
With regard to the administration requirements for an allowance trading system, the Handbook has focused on the mechanics of opening allowance accounts and transferring allowances. These requirements apply to everyone participating in the market, not just the regulated industry. Of course, companies with compliance obligations under the U.S. Acid Rain Program are also responsible for filing other forms and reports with EPA.
For more information check these Web addresses:
http://www.epa.gov/acidrain
http://www.emissions.org/
Advanced Structures
Financial markets have been dealing in the trade of commodities for more than a century, and over that time increasingly complex vehicles have been developed. As structures gain market acceptance, they are often modified to create new ones, ever innovating to satisfy the demands of increasingly sophisticated market participants. The motivating factor behind the genesis of advanced structures in commodity markets is always to create new and better ways to manage risk.
Risk Management
Risk can come in many forms, but it almost always boils down to one issue: price. It is impossible to always accurately predict what the price of a commodity will be in the future, whether it is years or even months ahead. Therefore, financial markets have designed tools to enable market participants to lessen or hedge their risk that the price of a certain commodity will rise or fall. This also applies in managing and minimizing long-term compliance costs.
Dollar Cost Averaging
All emissions market participants would have to agree that, although everyone has their own view of the direction of allowance prices, no one really knows for sure. In a sense, this puts even the most seasoned emissions marketing participant on an equal footing with the greenest emissions trader. What really sets the two apart is how they use the tools available in the marketplace to offset what they cannot accurately predict in price.
Since it is almost impossible to consistently buy at the bottom of the market and sell at the top, a strategy can be employed that averages out the highest of the highs and the lowest of the lows to produce consistent results. This strategy, known as dollar cost averaging, enables a utility to achieve consistent results by spreading out the buying or selling of allowances over a period of time. Doing so hedges the risk that prices will move aggressively against one by buying or selling in small increments at the current best available price. Under this strategy, the average price will be near to the annual average price.
Rise of Advanced Structures
These circumstances have given rise to the use of sophisticated structures, which have become commonplace in other commodities markets in emissions trading.
The rise of advanced structures can also be pegged to the growing experience of the average emissions trading participant. An increasing amount of the activity in the market today contributes to liquidity and hinges on financial plays. Most trades take place in order to ensure compliance, but an increasing number of transactions are structured to capture value in the market's movement much like the transactions in commodities markets.