Wed 8 June 2011 – Just as not all airlines actively trade jet fuel in the spot market, so a tier of airlines will likely seek external help to manage and hedge their carbon liability under the EU’s Emissions Trading Scheme (EU ETS), although some airlines have long since staffed up, as Tim Lloyd Wright reports. There is no single airline view or approach to managing compliance and purchasing. But airlines will have only two options when they join the scheme: either buy carbon allowances and credits to cover their emissions or try to reduce their emissions. In practice, they will try both. Fuel pricing agency OPIS (Oil Price Information Service) spoke with airline fuel managers and treasury staff about how they intend to handle the practical purchasing, trading and hedging of their exposure.
Carbon allowance prices are expected to rise as the scheme gets going, they said. Principally, airlines can submit EU Allowances (EUAs) and EU Aviation Allowances (EUAAs) after each year of the scheme to comply with the ETS.
The fuel manager of a major European airline told OPIS that he is envisaging a price development in the 20 to 35 euros ($29-50) range by 2013. “After that they could go higher, the problem being that the market is very open to hedge funds and other parties, making it hard to predict,” he said.
EUA allowances are currently trading around 16 to 17 euros, and OPIS forecasts prices to rise to 40 euros by 2020.
Airlines can also submit a percentage of Certified Emissions Reduction certificates (CERs) in compliance with the ETS, but this will be cut sharply after 2012.
“The proportion of CERs you can surrender will be cut from 15% in 2012 to 1.5% in the next phase of the scheme,” said the fuel purchasing manager. CERs certify that another actor in the scheme has reduced its emissions, although airlines will be specifically excluded from a type of industrial CERs, a category somewhat discredited by market distortions created when high-greenhouse-potential hydrofluorocarbons are taken into account.
For one interviewee, the hedging concepts involved in the EU ETS were not particularly exotic in themselves, though they are novel.
“It’s very seldom that you start using a new instrument,” he said. “And this is a bigger situation, because you can’t make a choice not to do it. You have to take some sort of action.
“But I don’t see anything particularly unusual – it’s very similar to buying fuel or using interest rate markets.”
His company had created a fuel hedging committee out of the fuel and treasury departments and he thought this would be a good forum for also managing the company’s carbon requirements.
He was comfortable using the futures market, though there is one considerable difference in the case of EUAs.
Participation in oil futures can typically be exited by settling monetarily with the exchange. In the case of carbon allowance futures, at expiry the certificates are simply credited to the holders account, known as physical delivery.
“It’s quite complex, because you get the certificates towards the end of December,” said the fuel manager. “Unlike jet fuel, where you simply have your fuel purchasing on one side and your hedging on the other, here there are spot markets, auctions, over the counter, forwards and via the exchange, and they’re all physically delivered.”
Generally, there is interest among airlines in paying for and receiving their emissions allowances as near to the date they are required to be surrendered as possible. In theory, that suggests the use of the March contract of 2013 for emissions generated during 2012. The allowances for the first year must be submitted in April 2013.
Although fuel managers say they are watching for opportunities to use the March contract, the liquidity (buying and selling volume) of contracts is concentrated in the December, and to a lesser extent, in the June contracts. Effectively, this means that the truest market value of the allowances is best reflected in those months. Hence, while there are cash management benefits in buying the March contract, there may be other risks.
Auctions, OTC and futures
Airlines will receive for free a proportion of the carbon allowances they will ultimately surrender back to the authorities. In practice, this proportion will range from some 60% to 80% of their requirements.
Apart from these free emissions allowances, the largest source of allowances will be auctions held intermittently in each member state.
The methodology of the auction means that airlines will bid for quantity and price together. Once sorted in price order, the associated quantities will be added together until the total amount of allowances being auctioned is reached. These bidders will have succeeded in buying allowances. Bidders who bid at lower prices will have been unsuccessful. The price bid by lowest of the successful bidders is assessed as the price for all the buyers in that auction.
If two million allowances are auctioned and one airline bids 15 euros for 1 million tonnes, another bids 14 euros for 500,000 and a third bids 13 euros for 500,000, then a subsequent lower bid will be disregarded because all the available emissions are accounted for. All the buyers will pay 13 euros.
Aside from auctions, airlines, hedge funds, banks and the like can buy allowances in spot markets such as BlueNext. On the Intercontinental Exchange, EUAs are traded as daily futures contracts where delivery is made almost immediately.
Alternatively, the key instrument tends to be the December futures contract of the current year. Liquidity tends to be much greater in that contract than in the daily future.
Airlines can also trade over-the-counter (OTC) for their allowances from banks such as Citibank, Barclays Capital and Deutsche Bank. These actors charge a fee, but simplify procurement and can mitigate credit risk for purchasers.
Some of those airlines OPIS spoke to indicated they would most likely seek their marginal requirements through the OTC market, while others felt most comfortable buying futures.
“The jet fuels market is not particularly used to the futures market. It is in the habit of using OTC solutions,” said the treasury officer of one. “But if you are familiar with futures you realise it’s a cheap way to deal with your requirements. With OTC you can’t see the spread you are paying, because you have nothing to compare with.”
With the free allocation of EUAAs taking place in February of 2012, a hot topic is how best to use the capital the allowances represent.
“We’re looking at ways to use them as collateral for borrowing, and there are a lot of ideas around about this,” said the treasury manager.
Suitable strategies for smaller airlines
Here again, there is not one single approach and it has to be said, there is quite a lot of uncertainty among CFOs and fuel managers at smaller airlines about how best to meet EU ETS requirements.
OPIS asked the fuel and risk managers of organisations who readily admit to devoting huge resources to their own compliance, as well as an ETS consultant, how they might meet the challenge were they transported suddenly to a role at one of the smallest participants in the scheme.
“I think if I were a small airline my strategy would be not to manage this at all,” said the Northern European major airline treasury manager. “I’d try to buy a clean product if I could – one with the carbon included. This combined product is perfect for the small player.”
He said smaller airlines should start by calculating the amount of allowances they will actually need, explaining: “They’ll find it’s extremely small, but the costs in terms of treasury and fuel department people in developing an ETS strategy are very high.
“In our case, we are too big, we’ve already committed the resources, but in the case of a small player, let the fuel include the cost of the emissions rights.”
According to a major airline fuel manager, the advice was to look first to the auction system.
“I would just buy in the auctions,” he said. “Buy all the certificates you need there. It’s a transparent process. You can show your management you’ve bought them against an auction price which is the official inlet of the ETS, so you cannot be wrong.”
Helge Hafstad, Environment and CSR Manager at SAS, said that it was not easy to give advice without being in a particular company’s shoes, “but it would probably ease the administrative burden for small players if they bought on a ‘clean basis’.”
He added: “They still need to surrender the certificates at the end, but it would mean they wouldn’t need to trade or source them. Each company in the scheme, including suppliers, have an ETS account, so they can just credit your account when you buy the fuel,” he said.
Peter Hind, who has advised airlines on EU ETS compliance in his role as Managing Director of RDC Aviation, believes that for most small airlines the ETS represents a compliance burden rather than a financial one.
“Bear in mind that there are getting on for 5,000 participants in the aviation scheme, but 40 airlines account for 60% of emissions,” he said. “So there are an awful lot of carriers out there who need to get access to the market for relatively modest amounts of carbon, and buying it bundled in with fuel may be a very good way to achieve that.”
Tim Lloyd Wright is Business Development Director for OPIS Europe, which publishes the Jet Fuel and Gasoil Report. OPIS has recently launched OPIS Clean Jet, a benchmarking service for airlines who want to manage their fuel and carbon together. The full version of this article can be found in an OPIS Primer
The term clean, when applied to pricing, came from the electricity market after the ETS started in 2005, and means energy with carbon compliance costs figured in. Here, OPIS’s assessments of futures and swaps markets for jet fuel cargo prices are added to the most traded carbon futures contracts to obtain a picture of ETS compliant fuel costs towards and in 2012 ($1141.32/mt):
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