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Carbon: the ‘one-way’ bet for hedge funds


The EU decided long ago that if it wanted to reduce pollution effectively, it had to put a price on carbon, and over time that price had to increase. Some of the world’s largest oil traders and hedge funds managers now seem to believe it.

Over the past four months, the price of European carbon allowances – marketable securities that dictate how much it costs power plants and industry in Europe to emit a tonne of carbon dioxide – has climbed to a record high above 30 €. In turn, they have increased the cost of pollution for businesses such as electric utilities and will soon do so for manufacturers of products like cement and steel.

For veterans of the niche carbon market industry, created 15 years ago, the price hike didn’t make sense. Coronavirus lockdowns and the resulting deep global recession reduce emissions in Europe because factories have slowed down and demand for electricity has plummeted. Prices should, according to them, go down and not go up.

But the market is changing, attracting a new breed of traders who care less about short-term factors such as the oversupply of the market this year. Instead, they see an opportunity to cash in on a market whose direction will ultimately be dictated by policy and support for a “green recovery” from the pandemic.

“By 2022, the price of carbon in the EU could easily reach 40 €,” says Florian Rothenberg of consultancy firm ICIS. “But if financial investors and speculators believe it, the price could easily reach much higher.”

A renewed interest in the European carbon market could have ramifications for European industry. At around € 25 a tonne, the price of carbon is already high enough to have started pushing coal out of the electricity grid, with utilities switching to cleaner natural gas or carbon-free renewables.

The next step, traders suspect, is for the price of carbon to rise enough – between € 40 and € 50 per tonne – to start forcing other sectors to invest in cleaner technologies and fuels – good for the environment, but a seismic change for the industry whose impact is not yet fully understood.

Hedge fund manager Pierre Andurand is regarded in the industry as one of the most successful oil traders of his generation. Having returned investors over 150% profit in the first five months of the year by successfully betting against the price of oil, he is now diverting a small portion of his $ 600 million fund to carbon.

“We are convinced over a five-year horizon that the price must go up – that’s pretty much a guarantee,” says Andurand. “As long as the EU maintains its commitment to tackle climate change and use the carbon market, we are convinced that prices will rise.”

Investors flock

He is not alone. Vitol, the world’s largest independent energy trader, is expanding its carbon team of five. And to show how important he thinks the market will become, he has appointed the former director of European gas – one of his main distributors of money outside of his core oil operations – to lead the company.

The Amsterdam Stock Exchange. Traders believe the price of carbon may need to double to around € 50 per tonne in the coming years to have the full impact the EU intends

The Amsterdam Stock Exchange. Traders believe the price of carbon may need to double to around € 50 a tonne in the coming years to have the full impact the EU expects © Yuriko Nakao / Bloomberg

Some of the world’s largest hedge funds, such as Brevan Howard and Citadel, would also be seen by rival traders as playing a larger role, while banks such as Morgan Stanley, Macquarie and Citi have regularly built their teams, seeking to benefit from an increased customer base. internal activity and trade.

Insurers and pension funds would also be more interested in potential hedging against the climate-related parts of their portfolios.

For Erik Petersson, managing director of the Macquarie Group’s commodities and global markets team in London, the renewed interest in carbon from investors is a natural reaction to signals from politicians.

Faced with a deep recession, the EU has not hesitated in its commitment to tackle climate change despite the associated costs, at least redoubling its efforts to reduce emissions on the continent. Its revised objective is to reduce greenhouse gas emissions by 50 to 55% by 2030 compared to 1990 levels, compared to the current target of 40%.

“The market has attracted new attention over the past 12-24 months due to political announcements for 2030-2050 where the EU sets carbon targets,” said Petersson. “They are a long way off, but they paint a picture of a higher carbon price, which is essentially necessary to achieve these goals.”

Expectations as to where the price may eventually settle vary widely. But in more than a dozen interviews with hedge funds, banks and investors active in the industry, none have said they believe prices will drop significantly. The only differences were in the extent to which they might increase, the duration and extent of political risk if the mood in Brussels were to change.

For much of European industry, which has spent decades worrying price of oil and other fuels as one of their main production costs, it requires a radical change of mindset. While oil prices appear likely to remain relatively manageable for the next several years, with plentiful supply available below $ 60 a barrel, the price of carbon could end up having a much larger impact on their fortunes, especially if the EU is reducing the number of credits. or “free” European emission allowances (EUA) made available to industry.

Hedge fund manager Pierre Andurand:

Hedge fund manager Pierre Andurand: “As long as the EU maintains this commitment to tackle climate change and use the carbon market, we are convinced that prices will rise” © Bloomberg

“The carbon mechanism is already pushing back thermal production and the next carbon reduction is likely to come from the industrial sector,” says Petersson. “For them to reduce their carbon emissions and encourage investment, you have to see a much higher price for carbon.”

EU leverage

Traders believe the price may need to double to around € 50 per tonne in the coming years to have the full impact the EU intends. They compare the situation of the EU Emissions Trading System, or ETS, to the oil market at the turn of this century, when a handful of investors noticed that a decade of underinvestment in China’s new production and rapid rise meant prices were going to have to go up.

Despite a few volatile swings along the way, these deals ultimately made their fortune, with crude prices rising from $ 30 per barrel in 2003 to $ 147 on the eve of the financial crisis.

But the comparison is not exact. The difference in the carbon market is that the EU essentially holds all the levers of supply, writes the rules and decides how many EU allowances or carbon credits to release – or absorb – to influence the market. price over time. It has been compared to a supercharged Opec, where rather than controlling around a third of the supply, as the cartel does in the global oil market, the EU ultimately controls everything.

That’s not to say it’s not a real deal. In the short term, buyers and sellers often respond to the usual supply and demand signals. If the economy slows and emissions fall, more participants are likely to sell, as seen this spring when the coronavirus dampened demand and prices have fallen by almost 40% from € 26 to € 16 per tonne.

If the price drops too much – or potentially rises too high – the EU has the ability to tighten or loosen supplies through the ‘Market Stability Reserve’, or MSR, which was launched in 2019 to effectively reset the market. market after the weight of excess supply accumulated during the financial crisis.

The Grosskrotzenburg coal-fired power station in Germany. At around € 25 a tonne, the price of carbon is already high enough to have started pushing coal out of the power grid

The Grosskrotzenburg coal-fired power station in Germany. At around € 25 a tonne, the price of carbon is already high enough to have started pushing coal out of the electricity grid © Alex Kraus / Bloomberg

Nima Neelakandan, head of environmental trade at Morgan Stanley in London, says what is happening with prices is a market attempt to “strike a new balance” driven by a fundamental shift in expectations about the climate ambitions of the EU. These ambitions are today very often echoed by companies, from Big Oil to Big Tech, which are trying to respond to calls from investors to do more on climate change.

“How many emissions do we want to reduce by 2030 and then 2050 has become the debate and these are very long term goals, so the market is trying to rebalance itself,” Neelakandan said. “The political orientation and ambition have become much clearer. And that’s not just the ambition of the EU, but businesses around the world. “

The critical moment is expected next year. The ETS covers around 45 percent of the block’s emissions, mostly from utilities and large industrial companies. But it is likely to add more sectors such as maritime transport under its jurisdiction while reducing the distribution of free credits, increasing the demand for allowances and in theory increasing prices.

“The EU wants to include more sectors and would not do so if it did not believe that the EU ETS had been a success so far,” said Neelakandan. “This is all playing into the recent price action.”

An employee recovers diesel at the Duna oil refinery in Hungary. Some energy traders are now diverting resources from their oil offices to carbon credits

An employee recovers diesel at the Duna oil refinery in Hungary. Some energy traders are now diverting resources from their oil offices to carbon credits © Akos Stiller / Bloomberg

However, parts of the EU fear that carbon will become a one-sided gamble for speculators. And that the real impacts of a price that increases too quickly could range from closure of coal-fired power stations in Poland to impose additional levies on European industry at a time when the economies affected by the pandemic are already weak.

The idea that hedge funds or banks are getting carbon-rich as other industries struggle is uncomfortable with some politicians, even if they support the longer-term goal of the cost of pollution more expensive.

“Some people are betting on increased climate ambition in the EU, but you want the price of the EUA to reflect the decisions of the market rather than those of speculators,” Bas Eickhout, MEP for the Dutch Greens, said in July at Carbon Pulse, an industry publication.

Agile traders

When Peter Krembel joined RWE – one of the largest public services and polluters in Europe – in 1999, its business arm was taken over after the fact by a company that was making a comfortable income fleet of coal-fired power plants and gas and nuclear power plants.

“I was placed in this third level operation,” says Mr. Krembel, now commercial director of RWE’s supply and trading division. “Stuck in the basement of the headquarters, we were an annex at best.”

RWE's Peter Krembel argues restrictions on carbon trading would distort the 'price signals' companies need to make the right investment decisions

Peter Krembel of RWE argues that restrictions on carbon trading would distort the “price signals” that companies need to make the right investment decisions © Frank Peterschroeder / RWE

Two decades on his unit employs 1,600 people and feeds into all facets of the company’s strategy, essentially serving as an alchemist for the larger group. She turned an unprofitable coal company into the basis of a carbon trading machine that can help smooth out RWE transition to a cleaner business.

RWE recently purchased enough carbon credits to fully cover its carbon pricing exposure for the next three years. It’s an example of how carbon has forced companies to become more nimble, requiring fleet-based trading to source cleaner supplies for customers, while also increasing profits with additional speculative positions. The business arm, which also covers electricity, gas and other fuels, made a third of the company’s 2.1 billion euros in current profit in 2019.

Krembel argues that restrictions on carbon trading would distort the “price signals” that companies need to make the right investment decisions.

Greenpeace activists project images at the headquarters of the European Commission in Brussels. Insurers and pension funds are increasingly interested in carbon as a potential hedge against the effects of climate change

Greenpeace activists project images at the headquarters of the European Commission in Brussels. Insurers and pension funds are more interested in carbon as a potential hedge against the effects of climate change © Stephanie Lecocq / EPA-EFE

“These markets need to be well organized and well regulated, but the makeup of market players is not our concern,” he adds. “We need the depth and liquidity that other participants in these markets bring. A market doesn’t have to be a bunch of utilities – it’s poison for the whole industry. “

Others argue that the claim that dozens of funds drive up the price is overstated. Energy Aspects, a consultancy firm, said in July that the limited data available on positions suggested that most of the purchases seen in recent months have come from utilities and other industrial end users, rather than funds.

“If the price of carbon is to have a significant impact on emissions, you need a high price – probably € 50 a tonne and more,” says a hedge fund manager active in carbon markets. “Right now it’s mostly driven by compliance buyers whose point of view has become,” Well if you could easily see $ 50 worth of carbon, we better buy it now because it won’t be much cheaper “.”

Others question the role of the EU and the need to withdraw from the market to allow trade to fully mature. “The supply side is completely settled by the EU – whatever they decide to change happens,” says Tom Lord, a trader at Redshaw Advisors. “When it’s so political, it’s not necessarily a good thing for the market.”

Market growth

While some funds may take a long-term view of price, other energy traders go further. Michael Curran, head of emissions trading at Vitol, says the goal is to grow in a market they see developing in the same spirit as the physical oil market, with trades in arbitration, storage and logistics.

Although they, too, expect the price of carbon in the EU to rise, they believe that non-traded products such as carbon offsets – like planting forests – could be the biggest area for growth. .

“The opportunity for European carbon credits could be a price increase of three or five times over the next few years,” says Curran. “But if [the price of] EUAs increase, this will lead to other carbon products like offsets, and the opportunity to see prices increase 10 to 20 times over the same period. “

Mr Rothenberg at ICIS says traders are realizing the implications of the EU’s long-term goals. “It sounds like a good investment,” he says, “especially if you have the support of the EU.”



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