By Chris Gillick
Betting on the recovery of a regional economy can take many forms: buying stock indices, stocking up on the native currency or playing the back end of the yield curve. Recently some hedge funds have found another way to make the same bet in a more obscure market with a greater risk/reward ratio: pollution credits.
One such fund is RNK Capital, founded by former energy broker Robert Koltun. RNK, a leader in trading environmental markets, is betting on a European recovery with a spread trade between two forms of carbon emissions credits. The fund is buying government-issued European Union Allowances (EUAs) and selling nonprofit-sponsored Certified Emissions Reductions (CERs). Under the European Union Emissions Trading System (EU ETS), polluters can keep a portfolio of CERs and EUAs, but a polluter’s credit portfolio is limited in the amount of CERs it can use. Once those are exhausted, a polluter must pay up to buy EUAs.
“In times of economic growth, demand for power and electricity and big-ticket items such as cars and steel will increase pollution, thereby driving up the price of these contracts, with EUAs more so,” says Koltun. His firm manages about $1 billion, the bulk in the flagship Grey K Environmental Fund. But, he adds: “In times of economic retrenchment, the opposite is true. Carbon prices decline, and the spread between the two contracts compresses.”
The price history of the December 2009 contracts for CERs and EUAs confirm this trend. In April 2008, months before the global economy would grind to a halt, EUAs traded at €26 per ton of carbon dioxide, or CO2, vs. €16 for CERs—a 60% premium. Expecting the European economy to contract in early 2008, Koltun sold EUAs and bought CERs when the spread was more than €10, profiting handsomely as the spread compressed to €2. By February of this year, the margin was nearly negligible, at which point Koltun reversed and went net long, a position he has maintained since April. He is also net long on the 2010, 2011 and 2012 contracts.
The carbon emissions market—created to help polluting companies comply with government cap-and-trade schemes in the European Union and select regions of the U.S.—is growing as fast as steam rises from a power plant smokestack. Cap-and-trade schemes aim to limit the amount of greenhouse gases each polluter can emit into the atmosphere, including nitrous oxide, or NOx in industry speak; sulfur dioxide, known to traders as SOx; and CO2. If a company pollutes more than its cap, it must buy credits to offset the difference. Trading volume on the European Climate Exchange was up 36% year over year in August with 283,400 contracts (one contract equals a ton of CO2) traded, according to an exchange report. Open interest as of August 31 stood at 750 million contracts, an increase of 125% year over year.
“Not only are we seeing increased volume on exchanges, but over the counter as well,” says Mark Stugart, product manager for commodity derivatives at Calypso Technology, a software provider to trading desks. “We are also seeing more interest from existing customers seeking to enter this market in anticipation of cap-and-trade legislation being passed in the U.S. and Australia.”
The U.S. this summer took a big step toward developing its own nationwide system to reduce emissions. On June 26, the House of Representatives passed the American Clean Energy and Security Act. Debate is still pending in the Senate. In Australia, progress stalled in May when political bickering led Prime Minister Kevin Rudd to postpone debate for that country’s carbon pollution reduction scheme.
As in any commodity futures market, the speculators are as important as the commercial hedgers—utilities and manufacturers, in this case—as speculators put up the opposite side of the trades. Multistrategy powerhouses Tudor Investment and D.E. Shaw have emissions desks embedded in their operations, while RNK Capital has been up and running since 2004. John Arnold’s Centaurus Advisors also trades environmental contracts.
The EU ETS allows three types of credits, but only two are traded on an exchange: EUAs and CERs. EUAs are isued by national governments through a mix of grants and auctions, whereas CERs are credits created by projects known as Clean Development Mechanisms, which are eventually certified by the United Nations. CDM projects include methane capture from landfills, wind farms, biomass plants, hydroelectric power plants and land preserved by avoided deforestation. EUAs trade at a premium price to CERs because the supply outstanding is fixed by governments, while new CERs, assuming they are approved, can be created at any time. Launched in 2005, the EU ETS is based upon principles of the landmark Kyoto Protocol and is in its second phase of emissions reduction. In the U.S., local cap-and-trade already exists through the Regional Greenhouse Gas Initiative in 10 northeastern states and California.
Over time, the theory goes, governments will lower emissions caps, and credits will be used as offsets in the interim as new technology comes on line to reduce emissions, a process known as internal abatement.
Just as undervalued equities can have catalysts to propel stocks to a higher value, so does the CER/EUA spread. For example, should Luxembourg-based steelmaker ArcelorMittal resume running its plants at full capacity, carbon emissions will increase, along with the price of carbon offsets, with EUAs increasing more than CERs on a relative basis. (ArcelorMittal has cut production globally by 45% in the past year after producing more than 100 million tons of crude steel in 2008.)
As of press time, the December 2009 CER contract was trading at about €12.50, while the December 2009 EUA contract was changing hands at the slightly higher price of €13.75. This €1.25 spread is near the all-time low of €1, and barring an outright depression, it is unlikely that fixed EUAs will trade at a discount to the more flexible CERs. As such, Koltun says, the trade represents an almost free call option on the European economy.“Right now I’m long from a spread of about €1.50, and the downside risk is roughly €0.50,” explains Koltun. “The spread has historically blown out into double digits, so I’m risking €0.50 to make €10, a 1:20 risk/reward ratio. I like those odds.”
