EUAs are a natural hedge against equities

The particular situation that the European carbon market is in makes EUAs a natural hedge against equities.

While credit restrictions could reduce consumption and therefore emissions, a greater factor in EUA demand is the reduced availability of finance for emission reduction projects, both within and outside of Europe.

Most analysts seem to be saying that the CDM pipeline is facing restrictions as projects find it difficult to find funding – and even that Phase 2 compliance buyers will not be able to fill their quota of CERs (collectively, EU ETS participants can use UN-regulated offsets, called CERs, to cover up to 13.4% of their emissions). This will make higher internal reductions necessary, exerting upward pressure on EUAs.

Within Europe, a higher cost of capital makes clean technology more expensive, so a higher carbon price will be necessary to make the business case for the same capital investment.

While tighter credit tends to send stock downwards, it will tend to send EUAs up.

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2 Responses to “EUAs are a natural hedge against equities”

  1. howardchong Says:

    I’m not convinced that consumption is not as large a driver of EUA demand as tight credit.

    For example, a shock of a 2% global slowdown equally shared across all countries is about a 2% drop in the amount of EUA permits needed after everyone has planned their production. Who will buy this 2%? In other words, who is the marginal buyer. Seem like in Phase I year 2006 that the marginal buyer was Coal power, but in year 2007, when prices were 0, there was no marginal buyer, there was just an excess of credits.

    I don’t disagree that tight credit markets are a factor that increases EUA prices via the pathway of less funding to CDM projects. But the other (fiust order) aspect affecting CDM investment is a review of CDM project criteria (stricter tests for additionality, for example). This would predict companies whose revenues are based on future project approval having stock prices go down while those with existing projects have their prices go up.

    The CDM’s biggest challenge is the oversight. Third party reviewers get paid fees that are linked to approving projects. Maybe not directly, but there is a reputation effect. If you got to pick a building inspector, would you pick the one with a high track record of approving projects or a low record? This is exactly the same problem as building appraisers and mortgage reviewers in the subprime crisis. However, in that case, the person holding the bag were the collateralized mortgage debt holders. In this case, Mother Earth will be the one holding the bag in terms of promised reductions that never happen, and that is something that is hard to detect.

    You write “While credit restrictions could reduce consumption and therefore emissions, a greater factor in EUA demand is the reduced availability of finance for emission reduction projects, both within and outside of Europe.”

  2. Thanks – I definitely agree with you about the limitations of the CER verification process!

    EUAs crashed this morning so perhaps my analysis is just wrong…

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