Q1 2007 Review

First quarter review and an update on the carbon market

Originally published in the June 2007 issue

The first quarter started positively, with continued strength in equity markets and favourable economic news which was reflected in a slight rise in G7 interest rates. Things soured towards the end of February and during the first two weeks of March, however, as markets were hit by a steep sale of risky assets. Chinese equities fell sharply in conjunction with soft US growth data and ongoing worries about the US housing market. The resulting pain was felt across most asset classes. Emerging markets and high yielding currencies associated with the carry trade came under particular pressure.

In the last two weeks of the quarter, however, markets reversed and pushed higher as economic news, particularly from the labour market, surprised to the upside and concerns over US sub prime debt did not spread to the broad housing market. Over the quarter, the MSCI World Index gained 1.68% in LC.1

fig 1


Hedge funds performed well – except for managed futures

Hedge funds started the year well with all styles contributing positively. Only commodity managers struggled as crude oil prices declined sharply. The second half of the period proved a bit more difficult as equity hedged and managed futures had to cope with market reversals. However, by the end of March all styles except managed futures were in positive territory. Event driven was once again the best performing style as special situations and distressed managers weathered the choppy markets well. The HFRX Global Hedge Fund Index gained 1.57%.2

European managers outperformed US, Japan

Equity hedged managers benefited from rising share prices until the end of February when markets corrected. Despite the market turbulence in February and March, most managers posted gains during the period asthey quickly cut exposures. European funds generally outperformed the US and Japan. The HFRX Equity Hedge Index rose 1.66%, almost equal to the MSCI World Index (1.68% in LC).2,1

Commodity funds had a rocky start but recovered strongly

Commodity hedge funds had a tough start to 2007 as oil prices plunged, briefly falling below USD 50 per barrel. Index rebalancing, balmy temperatures and concerted investor selling were the key drivers.

Energy traders did better toward the end of the quarter as prices recovered and volatility remained high due to tensions with Iran. Metal prices also drifted lower in January on the back of rebalancing and growing inventories but recovered on expectations that the Chinese had worked off their oversupply. Copper, for example, gained over 25% during February and March.3 The soft commodity complex was initially lifted by news of low corn inventories but subsequently came under pressure on reports acreage will be expanded. About 30% of the US corn crop is expected to be used in ethanol production this year, up from 20% in 2006. Sugar dropped as abundant rain in Brazil boosted crop yields.

Most global traders expected an unwinding of the carry trade

Global traders did reasonably well considering the market conditions. Discretionary traders did better than systematic macro mangers as they were quicker to respond to the changeable markets.

Fixed income proved especially tricky as rate expectations shifted several times. In the US, yields initially rose during the quarter as the economy showed surprising strength but later came back on concerns over the housing market. In Europe, the picture was clearer as the ECB is slowly but steadily raising interest rates. Currency traders generally benefited from a strengthening of the Yen at the end of February and beginning of March. Most discretionary managers had been expecting such a move for some time as the carry trade seemed overdone. However, as seen on the chart, the move was only temporary and the Japanese currency quickly lost ground again as risk appetite came back. It is unclear to what extent the yen weakness is attributed to carry trades.

Discretionary macro traders generally have no exposure to the carry trade. On the contrary, most are currently long Yen and other low yielding currencies in anticipation of an unwinding. While there is certainly some speculative money in the trade, domestic investors in Japan are also shifting some funds abroad to higher yielding markets

Mixed performance from emerging market managers despite good conditions

fig 2


Emerging market traders had a below average quarter. Equity markets in places such as Eastern Europe, India or Taiwan all finished the period in negative territory. Performance was mixed as some funds shifted exposure quickly, and consequently weathered the correction well, while others held on to their positions and suffered as markets corrected. During March, long positions paid off again as nearly all emerging markets posted gains. In fixed income, emerging market risk spreads swung wildly but finished the quarter nearly unchanged at 166 bps over UST. EM currencies also contributed to gains in local rate fixed income as the Brazilian real and Turkish lira strengthened.

Managed futures hit badly by reversals in equities and currencies

Managed futures struggled. Performance in the latter half of the quarter was a particular setback for the style after several good months. The Credit Suisse/Tremont Investable Managed Futures Index lost 6.48%.5 Much of the pain came in February, following the acute reversals in stock indices.

As a consequence, managers were forced to cut positions and were then lightly positioned on the rebound in the second half of March. Fixed income and currencies also contributed to losses as long established trends reversed. Short fixed income holdings suffered due to a rally in bonds and long Euro positions got smacked as well. Long-term trend followers also lost in commodities. Luckily short-term traders faired better as mean reversion strategies worked relatively well. However, these gains were insufficient to make up for losses by the systematic trend followers.

Relative value strategies performed consistently well

The HFRX Relative Value Arbitrage Index gained 2.40%.2 Returns came from all buckets. Convertible bond arbitrageurs, equity market neutral and multistrategy managers performed above average while fixed income traders and managers focusing on credit underperformed. Managers were aided by healthy buying and good prices as demand for structured convertibles came from a variety of groups, including long only investors. Furthermore, there were ample opportunities in single names on the credit and equity side as well as a healthy degree of new issuances.

Long volatility positions benefited

The return of realised volatility in February and March benefited long volatility mangers. Quite a few funds have built up volatility exposure in the last few months and were rewarded. In particular, managers benefited from long gamma positions and a general demand for products with longer dated options, such as convertible bonds. Fixed income arbitrage remained challenging as there were few movements for arbitrageurs to participate in. Equity market neutral had a great quarter on the back of 'normalisation' of market conditions, mainly benefiting the fundamental players.

Event driven continues to fire on all cylinders

Event driven strategies extended the winning streak that began in June 2006. The HFRX Event Driven Index gained 4.00%.2 Special situations and distressed performed equally well. Special situations mangers were bolstered by strong equity markets and exposure to sectors and themes such as exchanges, mining, energy or utilities. LBO activity remained strong. The period saw the announcement of the largest LBO deal in history with a USD 45 billion bid for TXU, a Texas utility, by KKR. Credit and distressed did well as credit spreads tightened slightly over the quarter to 316 bps over UST 6 and no disadvantageous events affected managers. The US sub prime housing market offers dedicated funds some desperately needed new distressed paper.


This report is intended to help investors understand the international carbon market.7 We focus on new developments in the carbon and power markets as well as longer term opportunities and scenarios to combat climate change. We also explain how hedge funds operate in the carbon space.

Kyoto aims to place a cost on carbon emissions and a value on reductions

The carbon market was born out of the Kyoto Protocol which aims to place a cost on carbon emissions, a value on emissions reductions and to enable trade of the resulting allowances or credits. In response to Kyoto, the European Union (EU) committed to reduce greenhouse gas (GHG) emissions to 8% below 1990 levels by 2012. The primary GHG is carbon dioxide or CO2. To meet this target at the lowest economic cost, the EU developed an Emission Trading Scheme (EU ETS).

The EU ETS is a cap-and-trade scheme that currently covers about 12,000 industrial plants across all 27 member states. Each country is given a fixed number of allowances for free. One allowance (EUA) represents the right to emit the equivalent of one tonne of CO2. Each country then distributes its allowances to the installations covered by the scheme. Currently, the EU ETS covers CO2 emissions from large, stationary installations in the following sectors: fossil-fuel power generation, ferrous metal producers, mineral processors, pulp and paper, and refineries. It is likely that other sectors, such as transportation, will be included in the future.

The EU ETS is being implemented in two phases. Phase I (2005-2007) is something of a test model to establish the system. Phase II runs from 2008-2012, with total emissions caps tightening every year to achieve the Kyoto target. The greatest emphasis has been placed on thermal power generation, which currently accounts for almost 23 of all allowances in the system and more than 80% of total transactions. For the purpose of this review, we will focus on this sector.

Carbon projects generate credits that can be monetised

In addition to domestic GHG abatements, there are also 'flexibility mechanisms' that allow the import of carbon credits into the EU ETS. In theory, these mechanisms should allow the abatement of emissions in developing countries at minimal cost.

A whole industry based around carbon projects has emerged as it is cheaper and quicker to pick the 'low hanging fruit' before making expensive investments in new technology. Such projects include methane capturing or HFC23 reduction. Both are very potent greenhouse gases. While compliance buyers (large emitters) make up a significant portion of the trading volume in the carbon market, financial players are becoming increasingly active. This includes commodity trading groups in investment banks, hedge funds, private equity firms and venture capitalists.

Too many allowances were handed out in phase I, which led to a price collapse

The European carbon market was heavily criticised when prices collapsed in April/May 2006 after it became clear that far too many allowances had been handed out in phase I (2005-2007). Despite this failure, the market has moved on and traders have begun to focus on the next phase (2008-2012). Fig.3 shows the prices of EU allowances for phase I and II.

Fig 3


The scarcity of permits determines the price in the longer term

The EUA price is, as in any market, set by supply and demand. Supply is determined by allocated allowances, some reserves for new entrants and issued carbon credits. Demand drivers include the ETS participant's actual emissions through the year, which in the short-term is driven by the weather and fuel prices.

For example, many European power producers can utilise coal or gas, so when the price of coal falls relative to cleaner gas GHG emissions will rise. In the longer term, political factors and the scarcity of permits will determine the price. Lobbying from the utility sector, for example, led to an over-generous allocation for phase I and the lack of scarcity led to the price crash. Most experts expect a much tighter regime starting next year during phase II.

In financial terms, the EU ETS volumes on exchanges and through brokers totalled EUR 14.6 billion last year. This is about three times more than the exchanged and brokered value from the previous year. Fig.4 shows the volumes and financial values of CO2.

European power producers gradually priced in the full cost of carbon

Fig 4


What is the impact of carbon prices on power markets? It is evident that European power producers gradually began to price in the full cost of carbon over the course of 2005. Going forward, CO2 prices are expected to be fully priced in.

To generators, CO2 represents an opportunity cost, as they can 'burn' or sell their allocations. Theoretically, generators will only produce electricity if the revenue from selling electricity exceeds the revenue that they could earn from selling their fuel and EUAs. Hence, it makes economic sense to fully incorporate the new 'cost'. However, the cost in phase I did not involve any cash outlay since the allowances were given out for free. This has created a debate about windfall profits as generators benefited from the carbon pass through with little to no abatement efforts. Since most utilities operate vertically integrated in an oligopolistic market environment, they face little margin pressure. This has caused much controversy, particularly in Germany, where around 70% of installed thermal capacity is coal-fired, and a number of new plants are guaranteed free certificates for many years due to successful lobbying.

Auctioning of permits will remain modest

The solution to this lies in the auctioning of permits, which is designated in phase II, but only up to 10% of the total. While some countries are set to auction a proportion of their allowances, the overall level of auctioning will remain modest. The problem with auctioning is that other energy-intensive industries, such as steel makers, may not find it so easy to pass through their higher costs as they compete with other companies that are not part of a carbon constrained world.

Putting a value on emissions has now become mainstream thinking

Despite its weaknesses, there has also been some evidence that the EU ETS is starting to work as it should, by initiating internal abatement and bringing companies to market that benefit from these abatement. Putting a value on greenhouse gas emissions has now become mainstream thinking. Knowing that we will have a carbon-restricted world in the future, large emitters are considering investing in more expensive technology that will improve energy efficiency. Coal- and gas-fired plants can be newly built or retrofitted with state of the art equipment that makes them vastly more efficient.

What does carbon trading mean for utilities?

  • Higher costs: thermal power stations (coal, gas, oil) may have to buy extra permits
  • Higher revenues (permit price is factored into each MWh)
  • Changes in load factors (some generators may switch between lignite, coal and gas: see chart on next page)
  • Change in investment policy: efficiency improvements, upgrades, clean coal, alternative energy etc. (also on the next page)

Clean generators will have an increasing edge over 'dirty' producers

The EU's increasingly strict attitude towards phase II (and inevitably post 2012) means that profitability and valuations for 'dirty' producers are under threat. It is expected that utilities will be given no more than 25-40% of historical emissions, or perhaps none at all, after 2012. By contrast, the 'clean' generators (nuclear, hydro, renewables) should be immune to further cap tightening and benefit from higher electricity prices. Fig.5 shows the EU electricity mix. About half is considered clean (1-3).

Carbon projects aim to reduce emissions in developing countries at low costs. Kyoto's flexible mechanism allows rich counties to help poorer countries to reduce emissions there, and then 'import' carbon credits. Since GHG emissions are a global problem, it does not really matter where the reductions take place and scientists and policy makers agree that it is more efficient to clean up the worst emitters first. This concept is also referred to as picking the 'low hanging fruit'. Most carbon projects are in BRIC countries (Brazil, Russia, India and China). Examples include capturing coal mine methane, landfill gas flaring or HFC23 (trifluoromethane) abatements. Both HFC23 and methane are very potent GHG (much stronger than CO2) and therefore their reduction is lucrative, if enough credits are generated. The largest buyers of carbon projects are carbon funds and the public sector.

Fig 5


Carbon funds often use the EU ETS as a hedging tool for their project pipeline

Emissions trading: Most hedge funds trade emissions (EUA) as a hedge to their carbon projects portfolio. Since the process of 'importing' carbon credits is lengthy, complex and risky, the projects have to be heavily discounted in early stages. There are several hurdles for project and each time a hurdle is passed, the project increases in value. Only at the end of this process can the value be monetised. Since most Kyoto credits will be delivered from 2008 onward, carbon funds hedge the risk-adjusted amount directly in the EU ETS. They essentially forward sell EUAs in expectation that credits will be delivered. This hedging mechanism works in similar fashion to delta-hedging a long option position. As the present value of the carbon projects increases, the manager sells more EUA and vice versa. This eliminates some of the price risk and has proved valuable when the price for phase I EUAs collapsed.

Power trading: Power refers to the electricity market. Electricity is an immature market which allows dedicated managers to extract alpha. The schematic illustration below shows this:

Power is not storable and is thus volatile and mean-reverting: exactly what hedge funds like

Managers invest in this market through futures and options strategies. Factors such as weather and water levels in reservoirs can affect electricity prices. Power is traded primarily in Europe and North America. European power traders mostly focus on the Scandinavian market, with some traders active in Germany or the UK. There are also a large number of non-financial buyers, such as generators or large consumers, which contributes to an inefficient market. Despite the liberalisation and integration of European power markets, there are still large arbitrage opportunities between countries, especially for short-term transactions. As we described earlier, emission prices are now factored into power prices in Europe, which means that power traders have to follow the carbon dynamics closely. Since power is not storable and its transferability is limited, it is very volatile but mean-reverting: exactly what hedge funds like.

Fig 6


As we explained earlier, carbon prices are determined by supply and demand, which again are influenced by coal and gas prices as well as weather conditions and power demand. CO2 prices are positively correlated with gas prices and negatively correlated with coal prices. This is because gas is less carbon intensive than coal. These relationships can be used by dedicated traders to extract alpha.

Clean generators will benefit if carbon prices are high enough

Listed equity: In a tighter carbon regime and/or more auctioning of permits, large emitters such as Drax in the UK or RWE in Germany may face smaller profit margins and hence may find it difficult to defend their valuations. Conversely, relatively clean generators such as utilities that derive a large part of their revenues from nuclear, hydro or renewables will benefit. Hedge funds can therefore look for short opportunities in 'dirty' producers and longs in 'clean' ones. Renewable energy has also attracted the interest of investors and most companies are growing rapidly and their shares have performed well. Even though some valuations seem stretched currently, managers that specialise in this segment should be able to separate the wheat from the chaff.

Private equity offers leveraged exposure to the carbon market

Private equity: Private equity investments represent a long-term opportunity for asset mangers to gain leveraged exposure to the carbon market. It usually involves buying a stake in a company that is pursuing emissions reductions in developing countries such as China or India. The company aims to generate revenues by selling these carbon credits to governments or private sector firms that need to comply with their Kyoto targets. In addition to GHG reductions some projects may also deliver additional revenues, for example electricity generation from using methane as fuel.

There will be a successor to Kyoto after 2012 which will include the US and China

While investment horizons for major emitters span several decades, the Kyoto Protocol only extends until 2012. There is thus a major disjuncture between the existing framework and the long-term certainty needed for investment in low-carbon capital stock. Most business executives are hesitant to invest billions in research and new technologies without knowing future regulations. However, considering today's almost unilateral recognition that climate change is real and we need to act, it is almost certain that there will be a 'daughter' of Kyoto. Most market observers expect a post 2012 scheme which will involve the US, China, and other developing countries. Obviously, the level of the caps and baselines are going to be negotiated in a long process and domestic concerns have to be overcome. The entry of the US would certainly give the market a huge boost. Most observers think that the 'tipping point' is near and there will be some form of federal GHG legislation by 2009 under the new administration. Consequently, the carbon markets will become more global and much larger in the years to come.

Despite the push for clean energy, it has to be kept in mind that global energy use is still rising and even if the EU's emissions and renewable energy targets are achieved, the worldwide absolute use of fossil fuels will still rise considerably (see next chart). As a result, thermal power production will remain dominant for decades to come. Since natural gas (the cleanest of the dirty fuels) will grow more and more expensive in tandem with oil and the security of supply will become more of an issue, the potential for innovative clean coal technologies is immense.

Carbon capture and storage is a potentially revolutionary technology

Modern coal-fired power stations are already much more efficient than a decade or two ago, but much work needs to be done. One solution might be the emission-free coal plant using so-called carbon capture and storage (CCS). CCS involves 'capturing' CO2 produced in coal- or gas-fired power generation before it escapes into the atmosphere. The CO2 can then be sequestered, or stored, in such a way that it causes no environmental harm.

Many experts believe that CCS will play a major role in reversing global warming because globally, coal-burning power plants are by far the largest source of GHG emissions.

Many industrial corporations are now making investments with the aim of becoming major player in the emerging CCS industry. General Electric, for example, sees CCS potentially bringing it USD 75 billion of revenues from 2010-2020.8

Several demo plants are being considered to test the feasibility of large scale CCS

In the near term, CCS investments are almost entirely exploratory. Several demonstration plants are being considered to test the concept. CCS is not entirely new. In the US CCS has been in use for decades, for reasons unrelated to climate change.

In these projects, the CO2 is captured from natural sources and then injected into aging oil fields. This process, know as enhanced oil recovery, can increase the amount of oil recovered from an average field by as much as 50%. However, all existing CCS projects are small in scale. One major challenge is to find suitable storage locations. While some of the CO2 could be used in oil recovery, there will be a need for a very large number of new injection locations. Currently, geological investigations are being conducted to find suitable underground storage space in abandoned coal mines, depleted natural gas fields, and very deep saline formations.

Scientists believe that CO2 also could be sequestered in ocean depths below 3,000 meters. However, environmentalists are probably not going to like that idea. The following picture illustrates the approach to low CO2 emission power plants.

The economic merit of CCS will depend on the price attached to GHG emissions and, possibly, government handouts. Using current technology at current costs, installing and operating CCS systems will raise the cost of generation from a conventional coal plant by in the order of 50%.9 If retrofitting of older plants is required, estimated costs are considerably higher. Hence, the economic viability of CCS depends largely on emissions costs.


  • The carbon market aims to place a cost on carbon emissions and a value on its reductions
  • Carbon projects reduce emissions elsewhere and generate credits that can be monetised
  • The price of credits and allowances is set by various factors such as weather and fuel prices.In the longer term, the scarcity of permits determines the price
  • Traded volumes and financial values of CO2 have risen strongly
  • The cost of carbon has affected European power prices as generators began to factor in CO2
  • Putting a value on emissions has now become mainstream thinking
  • Hedge funds operate in the carbon market by: financing carbon projects, trading emissions, trading power, cross-commodity trading, long/short listed equity, private equity
  • Despite the push for 'clean' energy, the absolute use of fossil fuel will still rise over the next few decades
  • Hence, emission-free thermal power plants are a potentially revolutionary technology


  1. MSCI Equity Indices
  2. Hedge Fund Research, Inc.
  3. Bloomberg
  4. JP Morgan EMBI+
  5. Credit Suisse/Tremont Investable Managed Futures Index
  6. Credit Suisse High Yield Index, STW
  7. Point Carbon, unless otherwise indicated
  8. JPM Global Corporate Research
  9. Intergovernmental Panel on Climate Change, IPCC