Energy Derivatives Market Dynamics
The EU Emissions Trading Scheme options and futures markets dynamics during the period 2005– 2011. Observations on returns, volatilities and volumes on derivative instruments are studied. In addition, spot/ future correlations, term structures and option implied volatility smiles and surfaces are examined.
The European Union Emissions Trading Scheme (ETS) The European Union Emissions Trading Scheme (ETS) was established in 2005 as the cornerstone of the EU effort to comply with the demands of the Kyoto protocol. The protocol, adopted in 1997, aims to reduce the world’s CO2 emissions to pre- 1990 levels by the year 2020. The idea behind the scheme is to incentivize reduced carbon emissions by creating a Europe-wide market in CO2 emissions where allowances can be
ETS Our discussion seeks to analyze the rapidly growing CO2 derivatives markets that have developed as a result of the creation of the ETS. This study is the first to comprehensively examine the dynamics of the ETS derivatives markets for both Phases 1 and 2.
ETS The primary aim is to investigate whether the market has changed since the end of Phase 1 and whether there is any evidence of the emergence of maturing market dynamics. Apart from investigating evidence of a maturing market, another question addressed is whether the EU emissions market can be seen to exhibit commodity like behavior.
Oil derivatives The study adopts oil derivatives, specifically West Texas Intermediate (WTI) crude oil futures and options , as benchmarks to analyze the development of the ETS derivatives markets. ETS derivatives, and futures in particular, have overtaken the spot market in terms of trading volume, and so an analysis of derivative behaviors will be more informative.
Important findings The research finds that volatility declined dramatically in Phase 2 while the stabilized at a high level. It also finds the term correlation between spot and futures contracts structure of futures prices to indicate contango, contradicting previous findings for typical commodity markets which find evidence of backwardation (see Pindyck 2001; Considine and Larson 2001a, b; Milonas and Henker 2001).
Important findings In contrast, the current analysis of the term structure of futures prices for the WTI crude oil data indicates periods of contango and periods of backwardation. This echoes the findings of Escobar et al. (2003) who also find very little evidence of consistency in term structures of oil futures over time. Consistent with Samuelson (1965) there is evidence to indicate a declining term structure of both EUA and oil volatility.
Important findings In the options market a clear development in the volatility smiles and surfaces in Phase 2 relative to Phase 1 is observed. The Phase 2 analysis indicates consistent volatility smiles and a persistent forward skew , with the number of contracts traded approaching levels observed in the WTI crude oil options market. Overall the results are clearly indicative of an increased maturity and stability in the EU ETS derivatives markets.
The EU Emissions Trading Scheme The EU ETS was created in 2005 as the cornerstone of the EU effort to comply with the demands of the Kyoto protocol. The scheme seeks to allow low emitters to profit by selling on their excess emission allowances while high emitters are punished by having to pay for more allowances. Mills (2008) highlighted how market based systems such as this can help counter the effects of climate change in two ways. First by improving the efficiency of schemes aimed at
The EU Emissions Trading Scheme The EU ETS covers approximately two billion tons of CO2 emissions per annum and is applied to over 11,000 industrial installations in the 27 EU countries along with Norway, Iceland and Liechtenstein. In terms of the structure of the marketplace, the trading of spot EU allowances (EUAs) takes place mainly through Bluenext in Paris and Nordpool, the Nordic power market, these two representing 70 % and 20 % respectively of transactions in 2006 (Daskalakis et al.
The EU Emissions Trading Scheme EUA futures are traded primarily on ICE Futures Europe in London (previously known as the European Climate Exchange), Nordpool, and also on the European Energy Exchange in Leipzig. The underlying asset of the futures contract in all these exchanges is 100 spot EUA’s with December contracts being by far the most liquid (Bloch 2010). Options are also actively traded on EUA futures having been first introduced by
ETS Phase 1 Analysis Although the ETS remains an emerging market, its high profile and political, economic and environmental significance has resulted in a large volume of research. This research is largely focused on assessing market development in Phase 1 of the scheme. The first phase of the scheme was quite problematic with allowances being over allocated culminating in the price of emissions allowances collapsing to below 10 cents
Fig. 1 Spot prices for EU allowances
ETS Price Determinants Another strand of the literature in the area has focused on investigating the primary drivers of CO2 prices. While some of the work supports the argument that the EUA prices are driven by market fundamentals which affect the production of CO2 (Bunn and Fezzi 2007; Mansanet-Bataller et al. 2007), other work argues in favor of a time-series approach (Benz and Truck 2008; Seifert et al. 2008; Paolella and Taschini 2008).
ETS Price Determinants Concentrating on the first approach, Christiansen et al. (2005) identify the primary drivers in the market as economic growth, energy prices, and weather conditions. Additional work by Kara et al. (2008) finds that the relationship between these drivers and the price of CO2 emissions reflects evidence of reverse causality with CO2 exerting a significant influence on the prices of power, gas and several other emission related commodities and
ETS Derivatives and Market Dynamics In this study daily ECX futures and options data is used as opposed to looking at spot data. This is motivated by the higher volume of futures transactions and also the fact, as highlighted by Alberola et al. (2009), that the spot price has so far proved less robust than futures in terms of signaling. A number of studies have assessed the impact of derivatives on the underlying EUA market and on environmental policy. Chevallier et al. (Chevallier et al.
ETS Derivatives and Market Dynamics Bohringer et al. (2008) go so far as to argue that overlapping regulatory instruments should be avoided in order to achieve efficiency in global environmental policy. These authors argue that the main risk for industrials operating in the ETS is CO2 price changes and this also serves as the primary incentive for reducing emissions. If these risks can be hedged easily with derivatives, Bohringer et al. (2008) argue that derivatives may soften
ETS Derivatives and Market Dynamics In terms of market dynamics, much of the work has again focused on Phase 1 of the ETS. Investigating the term structure of ECX spot and futures prices between 2005 and 2006 Borak et al. (2006) find a dynamic term structure over time but conclude that since March 2006 ECX futures prices are in contango. This contradicts the findings from other commodity markets which find evidence of backwardation (Pindyck 2001; Milonas and Henker 2001).
ETS Derivatives and Market Dynamics Borak et al. (2006) also examine the correlation between spot and futures prices and find a very strong correlation between spot and Phase 1 futures prices, with reduced correlations for Phase 2 futures. The correlations also decline as there is a movement out of the maturity spectrum, indicating that investors’ opinions about distant time periods are less affected by short-term spot movements.
Options Analysis This section analyses the development of the EUA options market using WTI Crude options as a benchmark for comparison. The analysis on options involves examining the implied volatility smiles and surfaces in the EUA options market as an indication of market development since 2006. The option price data adopted is the exchange traded ECX options traded on ICE Futures Europe in London.
Volatility Smiles Volatility smiles involve graphing the implied volatility of options with the same underlying asset and maturity against their strike prices . Volatility smiles are adopted to identify how the market prices options with different strikes and hence the different levels of moneyness in existence in the EUA market.
Fig.2 Implied volatility smile for WTI options in October 2007
Fig. 3 Implied volatility smiles for ECX options in October 2007
ECX Volatility Smiles-Phase 1 Figure 3 displays the average implied volatility smiles for ECX options with maturities in December 2007, 2008, 2009 and 2010 based on data from October 2007. Examining the December 2007 contract, it can be seen that the implied volatility is static and extremely low across all strikes.
Fig.4 Implied volatility smiles for ECX options in October 2010
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