Carbon hedging strategies for power traders

How the carbon market works

A market for EUAs to be traded has been created for traders by the EU Emissions Trading System (EU ETS). The environment can help ease the cost burden on traders by enabling them to forward-sell energy far in advance.

Overview of the EU ETS

Cap-and-trade models are a key element of the EU ETS, which allows regulatory changes to force an annually shrinking cap on emissions. EUA allowances allow the striking off of one tonne of carbon per EUA, which can be sold or bought by over- or under-emitting companies.

Allowance supply and demand dynamics

Since 2023, this capping mechanism aims to reduce emissions by 62% by 2030 and an annual reduction factor of 4.3%. Carbon prices and in turn, wholesale energy prices, then move up or down depending on scarcity, driving demand for allowances. As marine and aviation free allowances decrease, their expected demand will increase.

How carbon costs affect the generation stack

The emissions of coal are considerably higher than those of gas: almost double. This means that when the cost of carbon allowances rises, coal becomes much more expensive, making it a much less profitable commodity to trade. Traders will be wise to use active portfolio management using swaps to time the buying of allowances rather than in bulk all at once. The difference in emission intensity can also be beneficial to traders, as they can use spreads such as clean spark spreads and clean dark spreads to exploit gas and coal margins, respectively.

Carbon-adjusted marginal cost

Traders must integrate the costs associated with carbon-adjusted margins and treat them as a bundled cost, like fuel itself. So that traders can hedge against carbon-adjusted marginal cost, they must calculate the following: emission intensity, carbon cost and marginal cost.  

Transmission into wholesale electricity prices

Carbon pricing has the most effect on fossil fuels because gas and coal are the largest emitters of carbon emissions in the energy industry. Because of this, they are usually one of the most expensive forms of energy, so they are usually the marginal plant. The marginal plant sets the market-clearing price for other energy sources.

Marginal plant price setting

Marginal plant price setting allows power traders the ability to transmission carbon pricing into wholesale electrical pricing. The marginal plant is the last plant required to meet energy demand, as it is determined by merit order. The merit order lists power plants by short-run marginal costs.  

Carbon pass-through mechanisms

Carbon pass-through rates allow energy producers the opportunity to pass carbon pricing into the wholesale market through pass-through rates. Pass-through rates help traders to measure the difference in electricity rates with carbon costs included.

Regional differences across Europe

EUAs can be used by traders to hedge risks associated with carbon pricing by matching forward power sales, securing pricing for years to come. Different regions have different effect on how traders can hedge, depending on the mix of energy generation they produce.

Generation mix differences

In Germany, the region experiences high liquidity. This makes it a good candidate for proxy hedging: good energy traders aim to reduce market price volatility as much as possible. Traders in Spain and Italy will often proxy hedge against Germany due to these regions having much smaller liquid markets. Most market participants have moved back towards systematic hedging since the widespread energy volatility of 2022.

Fuel dependency variations

Heading strategies are disrupted by regional fuel dependencies, with both high carbon prices and fuel-switching volatility driven by sensitivity to the mix of energy generation options. Europe is particularly sensitive to this because of the sheer mix of generation in so many different regions. In Asia, however, carbon prices closely track coal prices and traders closely monitor coal volatility. The USA has higher renewable penetration, which means the industry in some areas is moving away from carbon hedging focused on fossil fuels. This region also employs short-term or spot-focused trading rather than long-term hedging approaches that we might see more commonly in Europe.

Trading and risk implications

One method to manage the risk of emission pricing is to exploit its volatility. This can be done via forwards, which is when traders purchase EAUs over the same 1-3 years in which they sell power forward, thereby avoiding the higher risk of carbon exposure by hedging on margin. Futures and options can also reduce risk by locking in future carbon costs. Strategic trading will also look at potential future price rises linked to stranded fossil fuel assets as legislation favours renewables.

Traders can also utilise spot transactions, which can expose them to greater market volatility because of purchases so close to compliance deadlines, but for more modest portfolios, it can be successful.

Finally, fuel switching between gas and coal can help avoid the higher carbon prices associated with coal. Because carbon is a higher emitter of carbon emissions, when carbon pricing increases, coal becomes the least competitive of all of the fuel sources, so if switching to gas can avoid these price spikes, it’s preferable.