Emissions trading in recent years has become a fundamental part of international efforts to meet the goals set by the Kyoto Protocol and protect the world’s climate.
Through the protocol, industrialised countries committed themselves to an average 5.2% reduction in emissions of six greenhouse gases relative to 1990 by the first ‘commitment period’ (2008-2012). The EU took on a higher 8% reduction target.
The EU created a market mechanism to reduce emissions by its power and heavy industry sectors: the EU emissions trading scheme (EU ETS). Under this cap-and-trade approach, the amount of assigned emission allowances sets a cap on emissions. Facilities within the scheme must buy allowances to make up any shortfalls or can sell or bank to the next trading period any surplus.
The cap for 2013 is 1.927 billion allowances and will fall by 1.74% per year to 2020 and beyond, resulting in a 21% fall in emissions from 2005 to 2020. This allowance reduction, and aviation’s inclusion in the EU ETS from 2013, should lift trading volumes and prices.
Many factors affect allowance prices, including general economic developments, making it relatively difficult to forecast carbon prices. However, all forecasts published to date predict prices will rise in the medium term for both EU allowances and UN Clean Development Mechanism certified emission reduction certificates (EUAs and CERs respectively) (see table 1).
These price expectations, combined with recent economic and financial upheavals, have increased trading volumes on emission markets. For example, 15 % more EUAs were traded during the first half of 2010 than during the whole of 2008.
Within this total, derivatives market volumes rose by 20%, but spot trading fell by 60%. One reason for the fall in spot trading was that spot market volumes were unnaturally high during the first half of 2009 due to the problem of tax fraud (carousel trading).
Meanwhile, market participants are seeking more contractual security after the financial crisis. The issue of counterparty risk has become obvious to all since the collapse of Worldcom, Lehmann Brothers and GM, which declared insolvency with debts of well over US$150bn each. A result is that over-the-counter (OTC) activity, where transactions are arranged directly between two trading parties, has fallen to significantly less than 50% of all trading as interest has moved to exchange trading.
Indeed, in the light of carousel fraud and the continued threat of counterparty risk, it is worth questioning whether government-issued EUAs should even be traded OTC. At the least, and bearing in mind forecast increases in trading volumes, it focuses attention on what alternatives are open to market members.
When trading emission certificates, participants can essentially choose between three options:
Before the two parties conclude a transaction, the counterparty must be verified for possible limit violations or open lines. In this case the transaction may not be completed. After the transaction both trading partners must bear the counterparty risk (the risk of the counterparty defaulting) for the duration of the contract.
The parties usually resort to standardised European Federation of Energy Traders’ contracts, bank guarantees or comfort letters in order to clarify details and minimise the transaction’s risks.
The trading structure also shows major differences (see figure 1). The exchange operator holds a state licence to run an exchange regulated by public law. It is responsible for operating the trading platform and monitoring participants’ compliance.
An important element of an exchange regulated by public law is the market surveillance unit. This generally reports to ministries of economics or finance, and documents and supervises every trading transaction. In this way it can identify patterns and thereby detect possible tax frauds.
It also has extensive authority and can access business premises of market participants if it detects suspicious activity. If it finds irregularities, it will inform the exchange’s management and the supervisory authority.
After an assessment, they can decide to hand over the case to the sanctions committee. Sanctions can range from a simple warning to revocation of admission. And even though the market surveillance unit’s authority ends at a country’s frontiers, the institution can forward data to other exchanges.
The process of risk reduction is also different from OTC trades. In the ‘delivery versus payment’ process, cash or certificates for spot trading are transferred and held as deposits at a settlement bank, which is connected to the trading platform and the register. Cash and certificates have to be deposited before each transaction, known as ‘pre-funding’. Once matching has taken place, the settlement bank exchanges certificates and cash in the participants’ accounts (settlement).
The CCP enters the exchange business at the moment the matching occurs on the trading platform. It acts for the seller in place of the buyer and for the buyer in place of the seller. This is known as ‘novation’ or ‘open offer’. The trading rate and the trading volume of the exchange market remain the same. The CCP’s main tasks are:
- To ensure post-trade anonymity.
- To eliminate the bilateral counterparty risk of the transactions completed between the buyer and the seller from the trading deal up to settlement.
- To carry out settlement netting (settlement of purchases and sales).
- To carry out some risk management.
As soon as the exchange transaction is carried out, the CCP has fulfilled its task.
Like exchange trading without a CCP, the settlement bank is responsible for settlement and custody of the emission certificates. But in this model only the netted certificate and cash positions are exchanged. The settlement bank also sets up the connection to national and international registers.
Membership of the CCP requires, for example, that a market member must be subordinate to a regulatory authority or have the status of a financial service institution. Thus, general clearing members (GCMs) act as intermediaries between institutions that do not meet requirements of the CCP.
GCMs are financial institutions that collateralise every transaction via the margin model of the CCP and carry out bank services for the market member in its role as ‘non-clearing member’. This includes carrying out all transactions, position management of certificates, automatic transaction confirmations and position information, arrangement of collateral or online supervision of positions and risks.
Though exchange trading with a CCP is more complex than either OTC trading or exchange trading without a CCP, it has inherent advantages for individual market members and for the market as a whole:
If one of the counterparties does not fulfil its payment or drops out, a default has occurred. In OTC trading the buyer and seller bear the entire risk of non-fulfilment. In this case the company must carry out the entire dunning process (actions to ensure the collection of accounts receivable) and, if necessary, the realisation of collateral. In exchange trading without a CCP, pre-funding helps to reduce risks.
In exchange trading with a CCP, the GCM and CCP share risk reduction in a two-stage model. To minimise the damage in case a member defaults, the GCMs set conditions for the trading participants, which may involve the participant’s equity capital, the type of securities to be deposited or the level of the margins.
Fundamental elements of the CCP risk model are margining, a default fund, the equity capital strength of the CCP and rating of the clearing member. These components are known as ‘defence lines’ (see figure 3).
If a GCM drops out, its securities are used to cover debts first before its contribution to the default fund is accessed. Starting from the next level, the CCP must contribute part of its provisions. If this does not cover the open transactions, the default fund is used. The first two stages concern solely the level of the defaulting member, whereas the subsequent defence lines can be regarded as services to solidarity.
Ultimately, the CCP would cover the full loss with its reserve fund if need be.
This complex risk management system significantly reduces the impact of a possible default on members and on the market as a whole. Even in the event of default by a major player such as Lehmann Brothers, the large-scale CCPs defence lines were only used up to the first stage; the securities of the defaulting member proved sufficient.
Besides the reduction of the default risk itself, an important factor for market members is whether market, credit and operational risks can be backed with equity capital. Thus, the reduction of risks via exchange trading with a CCP can be accompanied by lower capital contribution requirements made by the market members.
In this context, major advantages of exchange trading with a CCP are the possibility of netting (clearing of purchases and sales) and cross-margining (clearing of securities and bonds across different markets). Both reduce the amount of securities that have to be deposited.
Additionally, cash efficiency is increased through the process of netting and by the provision of credit lines for the NCM by the GCM. The market member is able to trade more frequently with a given amount of money and certificates, as purchases and sales are offset against each other and the NCM can make use of the GCM’s credit lines.
This impact is even stronger if the booking is carried out in real-time. In exchange trading without a CCP the market members deposit money or certificates and have the possibility of buying or selling once a day, as transactions are mostly settled the day after. For OTC trading, settlement takes even longer.
In the event of a default the market participant does not have to be concerned about how the default will be covered or about realising securities: the CCP undertakes these services. Furthermore, the member has concluded a single contract with the GCM instead of innumerable contracts and credit lines with several counterparties, reducing the transaction’s complexity.
Market members can achieve significant efficiency gains by using the same processes and bank accounts for both spot and derivatives trading on a platform with a CCP. This is not possible in exchange trading without a CCP, since the applications of derivatives trading are considerably limited through pre-funding.
All in all it is clear that exchange trading with a CCP offers a number of major advantages for market members in both the spot and derivatives markets. A higher degree of security, increased capital efficiency and enhanced convenience are likely to boost the popularity of this system, especially as volumes rise and market members want to conduct hedging and trading strategies on a single platform.
Biography: Dr Robert Ertl is head of greenmarket, operated by Bayerische Börse AG. He has held leading positions in consulting firms and banks, is a trained banker and has a doctorate in business administration.