How to navigate carbon prices in energy portfolios

Various carbon markets can be entered depending on a business’s operations and needs. Two key carbon markets when managing energy portfolios are compliance and voluntary markets. Compliance carbon markets are mandatory for certain businesses to participate in, enabling them to achieve carbon emission reduction goals, and are typically mandated by government or regulatory bodies. For voluntary markets: the clue is in the name. Voluntary market participation is not mandatory, and companies choose to enter into voluntary markets on their own merit to achieve internal environmental, social and governance (ESG) goals. 

Companies can approach carbon pricing from several angles, employing practical tactics such as hedging, Power Purchase Agreements (PPAs) to fix energy pricing, and operational levers to stabilise margins. Another tactic is to keep abreast of regulatory and policy changes while maintaining the agility of your business that allows you to act accordingly to these changes, with some strategic forward planning. Whatever your approach, this article will take a look at some of the key ways your business might choose to navigate carbon prices in energy portfolios. 

Understanding carbon pricing mechanisms

Carbon pricing mechanisms can be separated into two main categories: firstly, cap-and-trade schemes, in which carbon emissions are reduced by allowing companies to trade emission allowances on the carbon market, creating emissions trading systems. Allowances are eventually reduced, with the hope that companies will reduce their dependence on them in time. The second is carbon taxes, which operate on a fee-based system which taxes emissions produced instead. It includes allowances in the sense that tax credits can be exchanged for reduced greenhouse gases. Auctions in which participants can bid for these credits exist in both models, which creates an entire secondary market for carbon trading. 

There are several factors driving price formation, including unpredictable factors such as weather, fuel switching, and macroeconomic demand, as well as more long-term strategic considerations like policy tightening, allowance supply, and industrial output.

Depending on the region in which your business operates, regional nuances may apply to and affect the portfolios that you operate across borders. Different countries may offer differing benchmarks, linkage prospects, and varying local policies, which may mean different reporting rules than your operating country. 

Increased carbon costs can also cause merit orders to rise, meaning that power producers may be less likely to dispatch plants or may increase the bid prices of their energy on the market. The profitability of power plants, for example, gas, can be worked out by balancing the cost of the combustion required to produce the energy with the value of the energy generated. Clean spark spread includes the effect that carbon emissions trading systems might have, for example, a 10% rise in allowance prices might affect clean spark spreads, as well as affecting Power Purchase Agreements (PPAs) indexed to market benchmarks.

Measuring exposure in energy portfolios

When considering exposure risks in your energy portfolio, it can be useful to think in terms of direct vs. indirect exposure. Direct exposure applies directly to your own companies’ Scope 1 and 2 carbon emissions, such as onsite combustion, and applies carbon tax and trading schemes directly to this output. Scope 3 emissions are related more to indirect exposure risks, such as purchased electricity and embedded emissions in purchased fuels and certificates.   

It can be useful to quantify business sensitivity using position data, which can help you analyse the risk your business might be subject to. The types of position data you might examine could include how the wider global value chain might impact your investment decisions.

Carbon intensity metrics relevant to assets and contracts should also be considered. Weighted average portfolio intensity can change in line with market values rising or falling, and these changes can cause a knock-on effect on your portfolio, for example, if newly acquired assets are different in carbon intensity from the remainder of your portfolio.

Some businesses choose to build a carbon price sensitivity ladder to translate price moves into EBITDA and cash-flow impacts. For example, one calculation could apply ±€10/tonne steps for visibility. 

Accounting and reporting should be considered for accurate energy portfolio management, with considerations including procurement disclosures and assurance. It’s also crucial to consider audit trails for allowances and credits for easy and accurate reporting. It can be helpful to develop your own quick checklist for pre-reporting, covering data source points such as emissions factors, contract terms, settlement calendars, or loss factors for transparency. 

Hedging and procurement strategies

Compliance instruments, such as spots or forwards, can be a valuable tool for making informed decisions or reporting on your carbon energy portfolios, as well as for making financial moves, such as determining when to buy allowances. Some businesses take part in hedging to stabilise energy pricing, aligning hedges with forecasted emissions. Businesses can take one step further by cross-hedging: assessing different energy sources, such as coal and gas, and cross-hedging correlated commodities (e.g., gas coal/power). 

Contractual levers, including carbon pass-through clauses in PPAs and supply contracts, can ensure that the financial impact of market movements is shouldered by either the buyer or the seller of energy, depending on who is most impacted by the market shifts. Indexation choices, such as fixed, floating, or collar, can help market participants manage volatility and resulting price fluctuations. 

Then there are green procurement routes, which can help to prove that a portfolio is investing in sustainability through verified certification. Guarantees of Origin verify the source of a unit of power right down to the power plant that generated it. Still, it is worth weighing up cost vs. credibility, as many Guarantees of Origin are not internationally recognised.

Scenario planning and policy watch

Scenario planning can help your business become more resilient in the face of changing carbon pricing. Consider both macro-to-micro scenarios, with macro factors such as major recessions, extreme weather, or fuel disruptions balanced against more micro influences, including policy tightening or temporary fuel disruptions, and translate these effects into carbon price ranges. 

Businesses should stay informed about regulatory developments to ensure they are prepared for any market changes by tracking regulatory pipelines. Changes to look out for might include allowance supply changes or, from a more global perspective, border adjustment mechanisms. For example, a general geographic spread and diverging regional policies can create basis risk, which is why multi-market portfolios need localised hedges.

Your decisions may be influenced by factors such as policy changes, so it’s essential to review portfolio decisions regularly, perhaps with an annual strategic review of risk in relation to the business. Trigger points should be continuously assessed, with pre-agreed actions decided when thresholds are breached.

Integrating carbon strategy with decarbonisation

When considering carbon pricing as part of a larger decarbonisation strategy, it’s worth prioritising measures with dual benefits. Lower carbon intensity can reduce exposure to volatile allowance prices over time, which is a more stable long-term decision. Preparation, such as fixing energy, is also sensible: PPAs and behind-the-meter projects can provide visibility into consumer energy usage, stabilising both energy and carbon cost components. 

Spreading risk by balancing your portfolio across a range of asset mixes, as well as contract type mixes and geographic mixes, can also stabilise the volatility that your portfolio might experience. Above all, transparency is key, so it's essential to align reporting with recognised standards and avoid participating in nefarious greenwashing activities, such as double-counting.