As governments ramp up pressure to reduce greenhouse gas emissions, carbon pricing is a growing worry for many industrial companies. Some have found help in a surprising place. In a succession of private deals, an asset manager in London has been securitizing carbon permits. Jon Hay discovers how asset finance can be used to manage this unpredictable risk.
Securitization has been used in a remarkable variety of situations and industries, but almost always to finance an asset that generates income, with varying degrees of predictability. Some 50 years after the market began, it is intriguing to find securitization being used in a new way — to hedge a cost.
That is what a specialist investment firm in London, Tramontana Asset Management, is doing for large companies by securitizing carbon permits in privately placed deals.
It has been exploring this field for nearly three years, having been asked to help provide a solution by clients. The firm is finding plenty of demand for the product from issuers and from investors, who like the fact that it is aligned with environmental, social and governance issues.
Tramontana has done over $5bn of these deals so far, and the amount is growing every year.
Carbon permits are a way for governments to incentivise companies to reduce their greenhouse gas emissions. Under the European Union’s Emissions Trading Scheme — the most developed such system in the world — companies in the power, oil refining, metals, cement, glass, paper, chemicals and aviation industries have to surrender permits each year to cover all the carbon dioxide, nitrous oxide and perfluorocarbons they emit.
Sometimes they are allocated permits for free; in other cases they have to buy them. But the permits, known as EU Emissions Allowances, are tradable through the ETS. One EUA gives the right to emit gases equivalent to one tonne of CO2.
Each year the quantity of permits available falls, forcing the industries collectively to cut emissions. The trading enables those which manage to reduce emissions more easily to sell permits to those which find it more difficult. The market can thus allocate the cost of carbon reduction to where it can most efficiently be borne.
Any permits unused in a year do not expire — they can be kept for use in future.
Companies can also generate carbon credits by engaging in projects that are deemed to reduce emissions or extract CO2 from the atmosphere, such as renewable energy or afforestation. These credits can be sold to other organisations wanting to offset some of their own emissions, either to comply with legally enforced schemes or on a voluntary basis. From this year, however, the EU ETS no longer accepts credits from overseas carbon reductions.
Getting serious
For a long time, the ETS was ineffective because governments had been too generous in allocating permits. They were so plentiful that they were very cheap, sometimes just €5 a tonne, too low to incentivise reducing emissions.
As an illustration, someone who flies four times from London to Rome and back is estimated to cause about one tonne of CO2 emissions. Adding €5 to the combined cost of those flights is unlikely to deter many people from making the trips.
But through a series of reforms, the EU has tightened up the ETS, creating a Market Stability Reserve to sequester permits from the market, to reduce the supply and drive up the price.
It has begun to work. The EUA price touched €30 in 2019, the first time for a decade. In March 2020, it began a new climb, from about €17. It broke up through €40 in February 2021, €50 in July and €60 in September.
At that level, the cost would still not put someone off flying to Rome. But it does begin to make a material difference to more keenly priced markets, such as electricity or petrol.
For companies that have to participate in the ETS, buying EUAs is an absolute necessity, but the likely cost is very hard to predict. Unlike natural commodities, where supply can expand to meet demand, carbon permits are rationed by design.
Market prices for commodities do not move in a linear fashion at the best of times. In the 2008 financial crash, annual oil consumption contracted only 2%, but oil fell from $140 a barrel to $42 in six months.
EUA prices could just as easily overshoot if the market senses scarcity — arguably what has happened in 2021. If costs became unbearably high, the authorities would step in to moderate them. Nevertheless, for the treasury teams at industrial companies, EUA price risk is becoming a headache.
It is especially awkward for companies such as power generators, which often sell electricity forward at fixed prices. If the EUA price jumps, they could be seriously out of pocket.
Futures imperfect
The normal answer to anxiety about the price of a needed commodity is a futures market. EUA futures are traded at the Intercontinental Exchange and the European Energy Exchange. These are very liquid in the short end, but the liquidity only goes out to 18 months, so they are of limited use for longer term hedging.
Moreover, futures exchanges take an extremely conservative approach to the credit risk of those trading on it.
Anyone engaging in a contract must post a deposit, known as initial margin. Then the contract is marked to market daily. If the contract would be more expensive for one party to replicate today, its counterparty must cover the difference by posting a further deposit, variation margin, to the exchange, to ensure that, if necessary, it could be replaced as counterparty.
For example, if a company has bought EUAs for delivery in 2022 at €60 and the future falls to €40, it would have to post €20 a tonne at the exchange.
Banks find this easy, because they have ready access to liquidity, but for companies it is more difficult.
Even if the contract is in the money, margining can be a nuisance, because the exchange will hand the company cash — perhaps tens of millions. It cannot do anything useful with this money, because it might have to give it back to the exchange if the price changed again. So with deposit rates negative, it just creates a cost of carry.
The exchange margining system is blind to the credit quality of the participant — Warren Buffett would pay as much as an Iowa farmer.
To get round these strictures, there are over-the-counter derivatives markets, run by investment banks away from exchanges and without margin requirements. But the OTC market in EUA hedges has dried up.
Under Basel III, that kind of instrument is very capital-intensive for banks, so over the past four or five years they have put up the pricing on them so much that demand has been stifled.
ABS unlocks hedging
Three years ago, Tramontana spotted an opportunity here. Using securitization in such a context seems left field. But once the idea is explained, it makes sense — indeed, it is surprisingly simple.
The asset manager finds a company worrying about how much it is going to have to pay for EUAs in the coming years. It creates a special purpose vehicle, which goes out and buys a quantity of EUAs — as much as the company wants to hedge. The average deal size is about €200m.
The money to buy the permits is raised by the SPV issuing securitization notes to an investor. So far, all the deals have been done privately, with a single investor each, such as an insurance company or pension fund.
The company then has a private stash of EUAs, which it can take from the SPV when it needs them. It is contracted to pay the SPV, and hence, the investor, for the EUAs, in most cases through a single payment at maturity, that includes the interest on the financing. It has achieved the benefit of locking in a future year’s supply of EUAs at today’s price, without having to pay for them now.
Tramontana acts as arranger and collateral manager for the deals.
So far, all the deals have been simple, single year structures — for example, the SPV buys EUAs now, which the company will receive and pay for in 2025. Maturities are typically three to five years, sometimes longer or shorter.
If a company wants to hedge another year’s requirement, Tramontana will structure a separate deal. As long as the investor is willing, deals can be adjusted after closing if the company wants to enlarge the volume hedged.
What investors get
The investors’ exposure is to the credit risk of the company, but backed up by collateral — the EUAs themselves, which can be sold if the company defaults. The deals are not tranched into senior and subordinated layers, because they represent a single pair of risks: the company’s credit and the EUA price.
There are some variations on the structure. Some investors, depending on the company’s credit quality, want it to post margin, against the risk that it defaults and the EUA price also falls. Tramontana and its investors can be more flexible in how they structure margin requirements than futures exchanges — they can be satisfied with further EUAs or letters of credit, whereas exchanges only take cash.
Other investors don’t want margin, but are paid through the credit spread. Working with one investor at a time makes it easier to meet requests to customise documents.
Abstruse, intellectually demanding asset classes like this are often lucrative for investors. Not so this one. The returns are small, because of the low risk involved. But they are still attractive to some, compared with other low risk alternatives.
The securitizations enable non-specialist investors which do not have their own carbon trading desks, as some investment banks have, to gain access to a specialist asset class.
Sparse field
So far, Tramontana appears to be pretty much the only player in this space. Not every client is convinced of the merits of the idea, but those which are usually go ahead and do a deal with the firm.
The pitch to companies is that they are exposed to EUA price risk, which they typically hedge somehow. A securitization can offer a much cheaper hedge. It involves complexity, but companies willing to invest the time have found it makes sense for them.
It might be objected that the company could just borrow the money in the ordinary way and buy the credits in the spot market to keep them on its own balance sheet. But this does not appear to be common.
Sometimes securitization can be a cheaper way for the company to borrow. The investor is getting the benefit of collateral. This security argues for a credit spread lower than what the company pays for unsecured borrowing.
In practice, that is not always the case because the securitization being a bespoke, illiquid financing commands a premium compared with public debt.
Whether securitization works for a specific company will depend partly on how it organises its treasury management and capital allocation — companies vary a lot in this respect.
Tramontana is not marketing the product ferociously. The deals take a long time to bring to market, so it is concentrating on going deep with the clients it has rather than trying to find many new ones. On balance, Tramontana is more in need of more companies than more investors, but there is plenty to keep it busy.
More to do
The evolution of policy around the world is likely to favour further growth in carbon markets.
The EU’s new objective of a 55% reduction in emissions from 1990 levels by 2030 is another supportive policy measure, and climate change is now central to the agendas of many governments, including the US and China.
Carbon taxes are attracting a lot of attention as a tool to steer the economy to cut emissions. But they have drawbacks. Tobacco has been punitively taxed for decades, but people still smoke. In the same way, companies could just accept to pay carbon taxes and carry on emitting.
Cap and trade schemes can have a more direct and reliable effect on emissions, provided they are calibrated strictly enough and cover a large enough segment of the economy. So far, the ETS covers about 40% of EU emissions, and this portion shrank by 35% between the scheme’s launch in 2005 and 2019.
Shipping is likely to have to join the ETS from 2023, and from this year, the annual rate of reduction of new EUAs created has risen from 1.74% to 2.2%.
Having left the EU, the UK has created its own similar ETS, which opened in January 2021. Tramontana has not yet done any deals using UK credits, and the UK market tends to be in surplus, but this is possible.
The US has for many years had regional carbon markets covering certain states. California’s market, opened in 2013 and linked with Quebec’s, is the second largest in the world. Some hope the US will introduce a nationwide, mandatory cap and trade system.
China opened its national scheme for the power industry in February, although for the time being the conditions are not particularly onerous.
Meanwhile, the Taskforce on Scaling Voluntary Carbon Markets, backed by Mark Carney, ex-governor of the Bank of England, and led by Annette Nazareth, a former commissioner at the US Securities and Exchange Commission, is seeking to build a global market for firms to trade carbon offsets on a voluntary basis.
New assets
The opportunities for securitization in the energy transition will not be limited to carbon permits. Tramontana is considering deals involving energy storage — a part of the power landscape that is so far very little developed, but that is likely to become very important as solar and wind power take over, to deal with the intermittency of their supply.
An SPV financed by investors could buy an industrial size battery and engage in a contract with a company, which would buy power from the battery and sell power into it under a usage agreement.
Unlike in the EUA deals, these structures would conceptually need a third party, besides the investor and the energy hedger. A big power trading firm which knows how to model power prices and profit from using the battery would operate it. But this power firm and the hedger could be one and the same. The investor would earn a simple asset return.
As the economy goes through what green supporters hope will be a new industrial revolution of clean technology in the coming years, a great many more niche financing needs will emerge. They will provide chances for able practitioners to find new and creative ways to use securitization.
