Utility hedging strategy may undermine future carbon demand - analysts

02 December 2013 17:50 Source:ICIS
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Analysts expect European utilities to keep their hedging rates constant in 2014 after increasing them this year and last. This could impact carbon demand, because utilities have stepped up their hedging strategies to reach further forward this year than previously, buying both for the year ahead and also further out. However, next year, most of these forward emissions are already hedged, so analysts expect demand to slow, because buying would return to a more constant rate.

Utilities lock in profit margins by selling electricity production under forward contracts, and similarly fixing the fuel necessary to generate it and the amount of EUAs needed to cover emissions from the combustion process.

In 2013, the main European utilities have increased the percentage of electricity sold in advance, their third-quarter financial results show (see table). Slight declines in front-year hedging have generally been compensated by a higher hedging ratio farther out.

“We saw a shift from a two/three-year hedging at the start of phase II [of the EU Emissions Trading System (ETS)] to a one-year hedging in 2010-2012, to then come back to a two-year hedging in 2012,” said Matteo Mazzoni, carbon and power analyst at Italian energy consultancy Nomisma.

Swedish utility Vattenfall hedged 85% of its power production for delivery in 2015 in continental Europe at 30 September 2013. This is 22 percentage points more than the percentage of 2014 electricity hedged at 30 September 2013. German energy giant E.ON, Czech power incumbent CEZ and German energy company ENBW also hedged a higher percentage.

Reasons

Analysts said every case is linked to the generation fleet, domestic market conditions and changing views on future power markets by individual companies.

But generally, “there are two main causes – first, covering themselves against a possible decline of power prices, and second, against a possible increase of carbon prices,” said Mazzoni.

Save for some exceptions in Central and Eastern Europe, utilities are no longer allocated any free EUAs since the start of phase III of the EU ETS, making them are more vulnerable to price spikes. If the European Commission’s back-loading plan – a measure to support prices by delaying some of the scheduled supply in the short-term – will be finally approved, analysts expect carbon prices to rise.

The main reason for utilities’ higher hedging ratios is to stabilise their credit ratings in an environment where the outlook was generally negative, according to ICIS carbon analytics firm Tschach Solutions. Usually utilities profit from a so-called ‘predictability premium’ in credit ratings calculation, which increases if future income becomes more predictable as a result of higher hedging quotas, said Philipp Ruf, senior analyst for the EU carbon market at Tschach Solutions.

“Hedging could improve earnings visibility and hence support credit profiles,” said Josef Pospisil, senior director for utilities and transport at rating agency Fitch Ratings, although he said the level of change observed in hedging strategies did not result credit revisions.

Looking ahead

Analysts agreed that utilities are likely to stick to this hedging profile in 2014.

“It’s logical to expect that in the short term this trend continues. Back-loading would lead to an increase in EUA prices. And considering that power prices’ forecasts are very conservative, selling power at current prices, given the current coal and carbon prices, makes perfect sense,” said Nomisma’s Mazzoni.

EUAs demand in 2014 will remain in line with levels observed this year, he said. “Next year, utilities will have to cover only a marginal share of 2014 sales, while they’ll cover 2015 sales and a part of 2016 sales. A strong back-loading will increase demand in the first months,” he added.

Tschach Solutions’ Ruf agreed that the hedging rates will stay high and utilities will not change their strategy again. “We don’t see the need for the high predictability of incomes to disappear,” he said, adding that the effect of hedging continuing at the same pace is that demand would come back to the levels recorded before the change of strategy.

“If their hedging becomes even more aggressive, demand will increase further until the new strategy is reached and then stabilise. Should they go back to less aggressive hedging, we expect a ‘gap’ in which carbon demand from the respective utilities would be much lower,” Ruf added.

A changing hedging appetite would also impact carbon demand from banks and investment firms in the auctions, as they usually sell the same amount of spot EUAs to utilities under forward contracts that they buy on auctions in the so-called carry trade ( see EDCM 22 November 2013 ). Silvia Molteni

By Silvia Molteni