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Carbon Trading and Weather Derivatives

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Title: Carbon Trading and Weather Derivatives


1
  • Carbon Trading and Weather Derivatives
  • Patrick DEDE

2
Definition
  • Emissions trading is an administrative approach
    used to control pollution by providing economic
    incentives for achieving reductions in the
    emissions of pollutants.
  • Weather derivatives are financial instruments
    that can be used by organizations or individuals
    as part of a risk management strategy to reduce
    risk associated with adverse or unexpected
    weather conditions. The difference from other
    derivatives is that the underlying asset
    (rain/temperature/snow) has no direct value to
    price the weather derivative.

3
Definition
  • The Greenhouse Effect is the process by which
    certain gases in the Earth's atmosphere to trap
    heat from the surface.  This effect creates an
    insulating blanket around the earth that keeps
    the planet warm. 

4
The Kyoto Protocol
  • The objective is to achieve "stabilization of
    greenhouse gas concentrations in the atmosphere
    at a certain level.
  • Requires EU, Canada, Japan (Annex 1 countries)
    make mandatory cuts in emissions of carbon
    dioxide and other gases.
  • By 2012 EU must reduce CO2 8 Canada 6 Japan
    6 from 1990 levels.
  • Kyoto came into force on February 16, 2005 (90
    days after Russia ratification).
  • Countries require large emitters to reduce GHG
    emissions.

5
Market of Opportunity
  • Six greenhouse gases emitted from industrial,
    agricultural and consumer sources
  • methane (CH4),
  • carbon dioxide (CO2),
  • nitrous oxide (N2O),
  • hydrofluorocarbons (HFCs),
  • perfluorocarbons (PFCs), and
  • sulphur hexafluoride (SF6)
  • will be traded in the brokerage houses and
    trading floors of the world markets.

6
Market of Opportunity
  • EUR18 billion market for CO2
  • Market opportunity has been estimated at EUR3
    trillion over 20 year horizon and may be EUR100
    billion by 2010
  • Six European exchanges are about to trade carbon
    emission and weather derivatives
  • One US exchange Chicago Climate Exchange

7
Market of Opportunity
  • UBS is trying to change weather investing by
    launching the first Global Warming Index (GWI),
    which provides a simple way to take a view on a
    wide range of weather variables.
  • Weather derivatives traded on the Chicago
    Mercantile Exchange jumped from 9.7bn in 2004-5
    to more than 45bn in 2005-6.

8
Energy Emission market
  • The polluters in the Kyoto Protocol are
    individual countries that have agreed to a
    specific reduction target which are currently set
    at an average of 5.2 per cent below 1990 levels
    of emissions.

9
Energy Emission market
  • In most respects, emissions markets are no
    different from current financial markets.
  • They are subject to the same pressures of
    capital markets, such as price volatility, boom
    and bust cycles, speculative bubbles...

10
Market Mechanism
  • Its a market-based solution to environmental
    problems which refers specifically to air
    pollution.
  • Each polluters are assigned targets for reducing
    their emissions of gases in a pre-defined time
    period.

11
Market Mechanism
  • The polluters are then given a number of
    emissions credits for the amount they are
    allowed to pollute, which is the level of their
    emissions minus their agreed target.

12
Market Mechanism
  • There are several things that can happen
  • Scenario 1
  • The polluter uses up the whole allowance in the
    allocated time period, but still pollute more. In
    order to do remain in compliance, spare credits
    must be bought from another polluter which has
    not used up the whole allotment.

13
Market Mechanism
  • Scenario 2
  • The polluter does not use the whole allowance
    and can either save the remaining credits for the
    next time period (bank them), or sell the credits
    to another polluter on the open market.

14
Market Mechanism
  • Scenario 3
  • The polluter can invest in numerous pollution
    reduction schemes in other countries or regions
    and earn credits from these projects which can
    then be sold, banked or used to make up
    shortfalls in the original allowance.

15
The Players
  • Brokers and traders
  • Oil and gas companies
  • Electricity companies
  • Industrials
  • Agricultural producers
  • Insurance and reinsurance providers
  • Financial institutions
  • Governments
  • Hedge funds venture capital funds

16
Carbon risk management for companies
  • The most important risk categories for companies
    resulting from emission reduction targets are
  • Cash flow risks, such as increased expenditure on
    measures aimed at reducing CO2 or the purchase of
    emission allowances
  • Market perception risks which may influence
    market capitalisation and
  • Capital cost risks, such as more stringent credit
    conditions as a result of altered credit risk
    ratings. The drawing up of emission inventories
    and measures taken to increase energy efficiency
    will, in future, play important roles in the
    financial rating process.
  • To understand their potential carbon risks,
    companies should have
  • in place a robust and accurate GHG inventory
    which details past,
  • current, and projected future emissions.

17
HEDGING AGAINST CARBON RISK MANAGEMENT
  • Financial services providers can assist
    companies in managing these effects, and in
    particular, reducing the transaction costs of
    trading by offering new products and services.
  • The complexity of emissions trading requires a
    wide range of products and services that
    effectively hedge against risks emerging from the
    Kyoto Protocol and the European trading scheme.

18
HEDGING AGAINST CARBON RISK MANAGEMENT
  • Various types of derivatives can be used, such
    as
  • Forwards the purchase of emission allowances to
    be supplied in the future at a fixed price.
  • Options a guarantee of the right to purchase or
    sell allowances at a fixed price within a defined
    period of time and
  • Swaps the exchange of payment obligations so
    that different allowance currencies can be
    exchanged.

19
Conclusion
  • Do not underestimate a few degrees change
    because just 8 degrees Celsius separates
    today's average temperatures from that of the
    last ice age
  • Steven Chu, Physics Nobel Prize winner
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