Whether a company is struggling to make ends meet or are in the enviable position of increasing production through the crisis, a solid understanding of exposure to the EU Emissions Trading Scheme (EU ETS) can either unlock precious capital or help preserve it in preparation for future price shocks.
Due to the way that the EU ETS works, most companies are sat on an asset that can be readily turned into cash: their free allocation of EUAs. Several companies are already turning to this source of off-balance sheet financing to weather the economic downturn. While it is tempting to dip into that reserve to raise cash, unless the need is urgent companies should fully consider their overall carbon risk management strategy before doing so. We set out below the main considerations to be taken into account.
The price of an EU Allowance has bounced back strongly from its COVID-19 induced lows, the analysts all point to even higher prices in 2021 and companies across Europe face possibly more uncertainty about their finances than they did during the financial crisis of 2008/9. While EUA prices have been resilient, due to the long-term expectation that supply will be stripped back more than demand, the short-term fundamentals point to lower prices. Low gas price, lower EUA and electricity demand, high auction volumes, low power prices, hedging caution and a number of other factors are all conspiring to keep a lid on things. It is fair to say that while EUA prices might fall lower they are still expected to be higher in the next few years.
Are you long or short?
As we are on the cusp of a new Phase, Phase IV (2021-2030), this is a more nuanced consideration than it might at first appear. Companies typically know their current position well, but what the future holds in terms of free allocation and physical emissions is more complicated. Some will get more generous free allocations in Phase IV, some will get less and others will have reduced emissions due to the Coronavirus and other rule changes.
Nonetheless there are 3 broad categories of EU ETS participant: long EUAs, short EUAs and very short EUAs.
Some companies are long because they have ‘seen the future’ and bought EUAs early in the expectation of higher prices over time. Others are long through a quirk in the free allocation system and some are long because their processes are more efficient than the benchmark. Companies that are long can choose to stay that way or, if it is needed, they can optimise their position and raise cash at short notice by selling EUAs. To be comfortable doing this they need to have a good idea of what the future holds. In most cases it is possible to comfortably conclude that EUA demand will be reduced due to the Coronavirus (see our Coronavirus and the EU ETS webinar summary) and it is possible to produce a good forecast of the free allocation that can be expected in Phase IV of the EU ETS (2021-2030). With this information, long companies can confidently decide whether they should be selling or holding on to their EUAs.
Some companies that expect to be short have bought ahead of expected price increases and are thus over-hedged, some will become less short in Phase IV and others are short in all sensible scenarios. Most companies nonetheless have EUAs sat doing nothing in their registry accounts that they may be tempted to monetise thanks to the way that free allocation occurs 14 months ahead of the need to submit EUAs for that year’s emissions. One strategy historically employed by companies short of cash is to sell the current year’s free allocation and use next year’s free allocation for compliance. This can free-up much needed cash and while, from a risk management point of view, we would never encourage so-called ‘borrowing’ it’s a bit like borrowing money: you are using something now that you must pay back later. The ‘interest’ on this borrowing is the risk and cost that EUAs are more expensive when you buy them back. It used to be the case that such borrowing could be done indefinitely, but due to rule changes 2021’s free allocation can’t be used for compliance with 2020 emissions requirements. However, it is easy to work around this restriction with a little help.
The very shorts
The electricity producers don’t get a free allocation unless they are lucky recipients of derogation allowances, designed to assist power producers in the less well-off European Union member states with the transition away from fossil-fuel. As such, unless a power producer has pre-hedged, they will not have an inventory of EUAs to dip into. We typically encourage power producers to buy-as-they-go because the commodity that they sell often includes a live carbon price component and thus they are hedged if they do so. This means that some will already have bought EUAs for 2020, and in an emergency could lean on this EUA inventory to raise cash. Another approach could be borrowing money using the EUAs as collateral, see Repos below.
Can I take advantage of a ‘Repo’ transaction?
A ‘Repo’ (sale and re-purchase) entails the sale of spot allowances and a simultaneous purchase at a higher fixed price on a delivery and settlement date in the future. By selling spot, cash is released and by buying forward, price risk is managed. The difference in price between the spot and forward leg is the ‘interest’ that is paid on the cash. Any EUA can be used for this purpose, whether already bought or from free allocation. There are a variety of repo structures available. Repo-ing very large volumes of EUAs can attract the investment banks that can provide more sophisticated structures. However, typically, a repo-like structure and forward trading with a credit line is only available to larger companies.
What are other companies doing?
So far during the Coronavirus crisis we have seen 2 tactics employed across Europe by companies covered by the EU ETS, selling EUAs and EUAAs to raise immediate cash and borrowing from 2020’s free allocation to preserve existing cash. There are also several companies that expect to be long for the foreseeable future that, before the Coronavirus hit, were already taking advantage of comparatively high EUA prices to boost earnings and/or hedge the carbon component of electricity purchases. To be confident to take this approach, these companies needed to have a good understanding of their current and future carbon exposure.
Deciding what to do
EUAs are a company asset to be optimised like any other. The key to their optimisation is for a company to understand their expected requirements, how the rule changes coming in 2021 will affect those requirements and what the future holds for EUA prices.
The ultimate decision on whether to try to use EUA inventory to raise cash and what path to take will depend on a large number of factors, such as: overall EUA position, urgency of cash requirement, EUA price, the size of the reduction in production, creditworthiness of the company and other factors. The starting point is to get on top of what your company’s carbon exposure is expected to be both now and in the future. Redshaw Advisors specialise in helping companies to understand their carbon financial risk. Our Carbon Support Programme presents carbon risk in an easy to understand format and is supplemented by a technical helpline and a procurement service. You can read more about it here.
You are welcome to speak to the Redshaw Advisors team to discuss your options. We can be contacted on +44 203 637 1055.