Ask Alpha, April 2015: Expanded CP2 market may affect supply-demand balance for carry trade services

April 5, 2015 by Rahul Rana

Alpha 2Alpha Inception is an energy consulting and advisory firm based in Houston, and is also the founding organisation behind the Carbon Markets Compliance Association (CMCA). Each month, representatives share their expertise on various carbon market topics. To ask a question, please email it to contact@californiacarbon.info. Readers should also take note of the disclaimer provided at the end of this feature.

Q. With the expanded program and the slight reduction in holding limits in proportionate terms, is it harder for compliance entities to find ‘carry-trading’ counterparties?

A: A carry trade occurs when one party (carry-provider) purchases a near-dated delivery of allowances and simultaneously sells a later-dated delivery in similar volumes.  This allows the other party (carry-subscriber) to retain cash on their balance sheet, while still hedging compliance obligations, typically at a “carry-rate” that is less than their own internal cost of capital.

With respect to the Holding Limits for allowances, on the one hand, there is a finite cap in terms of how much volume the carry-providers can purchase against their longer-dated sales in the market.  Additionally, with an expanded program including more entities it is possible there could be more demand from carry-subscribers.  One might reasonably expect that, as a result, the “carry-rate” would increase over time.

One the other hand, as the expanded program has increased the number of compliance entities, the continued progression of the program has also attracted additional non-compliance entities and increased the program confidence of entities who are already participating.  Some of these compliance and non-compliance entities have very low internal cost of carry. This could lead to more market carry-providers, or at the very least provide more demand for the near-term deliveries from those who do not incur great costs in holding allowances on their balance sheets.

Q. In an issue of Ask Alpha last year, you referred to the lack of a V17 ICE contract as a reason why the May 2014 advance auction did not clear. Yet the V18 ICE contract has only registered 250,000 in traded volume so far [at the time of asking]. What secondary market activity can be expected on the V18 in the next few months?

A: The next few months of secondary market activity could be interesting, particularly as relates to the forward vintages.  Over the past 6 months we have seen increased interest in the V17 ICE-Futures contract with delivery out through December 2017.  These make sense particularly if a compliance entity with obligations in 2017 and a higher-than-market internal cost of carry can lock in these forward hedges.

One of the key differences with the V18-Futures contract is the applicable compliance period.  2017 is the final year of the second compliance period (CP2) and 2018 is the first year of the third period (CP3).  Compliance entities have already begun to incur obligations in CP2 whereas there is still much uncertainty with respect to what those obligations may be in CP3.  This could result in continued demand for the V17 forward vintage, and lower interest in the V18.

Disclaimer: This communication is published solely for informational purposes and should not be construed as advice. Unless expressly stated herein, this communication is not to be construed as an offer to buy or sell, or a solicitation of an offer to buy or sell any financial instrument or to enter into any transaction. Alpha Inception acts as a consultant for clients and does not have the authority to transact on behalf of or bind any clients and is not an agent for any clients, unless specifically stated by the client and Alpha Inception, LLC. Past results are not necessarily indicative of future results. Futures, options and derivatives products are not suitable for all investors and trading in these instruments involves substantial risk of loss. Opinions, historical price(s) or value(s) are as of the date and, if applicable, time indicated. Alpha Inception and any of its employees, officers, directors, affiliates, clients and agents may have interests in securities, futures, derivatives or options referred to in this communication, including directorships or performance of investment services. In addition, they may buy or sell those financial products as principal or agent and as such may effect transactions which are not consistent with any recommendations in this communication.

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