The NOx market’s wild ride: Are you ready to hop on board?

By Peter Zaborowsky, Evolution Markets LLC

Jan. 9, 2004 — This summer was the first of an expanding regional program aimed at reducing the NOx emissions from electric generating and large industrial facilities, which contribute to the transport of smog in the Eastern U.S.

It was a wild ride, but analysis of trading patterns indicate prices are settling in for next year. Here’s a look at what happened and what to expect.

Staged implementation

On May 1, 2003, compliance under the expanded NOx SIP Call market program began. In this first year of the program, facilities in eight states regulated under the previous regulatory regime, known as the Ozone Transport Commission, were required to make a 35-40 percent reduction from last year’s levels as the emissions standard was ratcheted down to approximately 0.15 lbs NOx/MMBTU from an average 0.23 lbs NOx/MMBTU.

The program controls NOx emissions from May through September (referred to as “the ozone season”) by allocating a finite number of allowances (the right to emit one ton of NOx in a specific or future year) to a defined population of sources.

On May 31, 2004, sources in an additional 11 states will be required to control NOx to the same levels as sources in the affected eight state region this year. The number of sources will increase from 300 under the previous regime to 1,500 under the new program. In addition, the number of allowances allocated expands from 135,000 to approximately 500,000 per year.

Roller coaster ozone season

The quirks of the two-phase program — combined with volatile fuel markets and unseasonable weather — have made for interesting market dynamics. While this seaon’s compliance region included mostly experienced NOx market participants operating under a tighter cap, next season is an entirely different matter.

New states and new sources enter the program. Some states have additional early reduction credits under compliance supplement pools, rewarding sources that generated voluntary reductions in the past two years and easing their native industries into the NOx program.

More importantly, legal action by several of the newly regulated states, led to a one-month delay in the start of next year’s ozone season for these sources. This ruling, in most cases, did not change the number of allowances allocated, however, meaning there will be five months of NOx allowances for use by sources with only four months of compliance obligations.

Not surprisingly, this has directly impacted price, and led to a wild NOx market this past summer. Vintage 2003 and 2004 allowances were in a relatively tight price range at the beginning of the year, but the spread soon blew out as 2003 vintage prices skyrocketed from less than $5,000 to $8,000 at the beginning of the ozone season. The vintage 2003 over 2004 premium exceeded $3,000 at one point.

The reasons point back to the staggered implementation of the program. An extra year before the implementation of tougher caps afforded many new sources time to install emissions control technology. Excess allowances for 2004 were anticipated as large compliance supplement pools and the shortened compliance period next year inflated the supply side of the 2004 market. Lastly, natural gas prices spiked at the beginning of 2003, which the market speculated would lead to higher demand for 2003 allowances as Northeastern utilities switched fuel sources from natural gas to oil.

Just as quickly as the price for 2003 allowances doubled going into this summer’s ozone season, the bottom fell out of the market. By the end of the compliance period this September, the price for 2003 vintage NOx allowances had dipped below $2,000.

What was the cause? In a word: weather. The Northeast experienced the coolest May since 1967, and the heat never really kicked in — even through the first couple of weeks in June. Without customers turning on their air conditioners, utilities in the Northeast had little use for their peaking units, which tend to quickly consume allowances. Natural gas prices also dropped nearly 20 percent in June on weakened demand and news of elevated storage levels.

The dramatic drop in 2003 vintage allowance prices brought down the 2004 vintage, as well. In July alone the price dipped to $2,600 from $4,025. Companies were unloading credits they did not need because of a projected overhang of 2003 vintage allowances into the 2004 ozone season.

Furthermore, many of the new sources affected in 2004 received their allocations this year, leading to a surge of supply in the market. (States have placed their allowances into the EPA tracking accounts at different times over the past year.) This supply came mostly from distressed companies that were liquidating allowances to raise cash and sources that were looking to help finance the control equipment they had just installed.

What to expect in 2004

Prices for 2004 allowances have stablized since August, but what does all this mean for companies looking toward compliance in 2004 and 2005? The market provides signals, which can help in planning for next year. Vintage 2003 and 2004 prices are now at parity as many market participants believe it is unlikely there will be discounts on the use of 2003 vintage allowances in 2004.

However, the 2004/2005 vintage spread is significant. In fact, 2005 vintage allowances are trading at a $1,150 premium over vintage 2004. This can be attributed to a general market understanding that there will be a significant surplus of allowances in 2004, which will force regulators to institute constraints, known as progressive flow control, on the use of 2004 vintage allowances in 2005. This mechanism triggers the discounting of banked allowances if too many accumulate.

And beyond (text added from the print article)

A review of the forward curve provides insight into perceptions regarding the future of the market. The forward curve illustrates 2003 vintage through 2007 vintage values in both real (constant 2003 dollars) and nominal terms.

The 2005 premium is apparent, as is the sharp drop-off in 2006 and 2007 vintage values. The fact that there are few well positioned companies in the current economy willing to spend money today for compliance three to four years out is certainly a factor.

It remains to be seen whether these out-year vintages have become a relative bargain as price for 2007 vintage (around $1,500 in real dollars) is well below the initial EPA estimates of $2,000 to $2500 per ton for average incremental control costs for the region. EPA did its modeling taking into account each unit regulated under the program and primarily, the costs to retrofit SCR units or other control equipment on the best configured plants in the region.

The EPA assumed the most cost effective control technology would be installed in all cases. Therefore, the 2007 forward price reflects the market’s view that all announced control equipment installations will be up and running by that time and allowance prices will begin to drift down towards the marginal cost of control (in the case of SCR, the cost of catalyst bed replacement and amonia use).

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The NOx market’s wild ride: Are you ready to hop on board?

Peter Zaborowsky, Evolution Markets LLC

This summer was the first of an expanding regional program aimed at reducing the NOx emissions from electric generating and large industrial facilities, which contribute to the transport of smog in the Eastern United States. It was a wild ride, but analysis of trading patterns indicate prices are settling in for next year. Here’s a look at what happened and what to expect.

Staged implementation

On May 1, 2003, compliance under the expanded NOx SIP Call market program began. In this first year of the program, facilities in eight states regulated under the previous regulatory regime, known as the Ozone Transport Commission, were required to make a 35-40 percent reduction from last year’s levels as the emissions standard was ratcheted down to approximately 0.15 lbs NOx/MMBTU from an average 0.23 lbs NOx/MMBTU. The program controls NOx emissions from May through September (referred to as “the ozone season”) by allocating a finite number of allowances (the right to emit one ton of NOx in a specific or future year) to a defined population of sources.

On May 31, 2004, sources in an additional 11 states will be required to control NOx to the same levels as sources in the affected eight state region this year. The number of sources will increase from 300 under the previous regime to 1,500 under the new program. In addition, the number of allowances allocated expands from 135,000 to approximately 500,000 per year.

Roller coaster ozone season

The quirks of the two-phase program—combined with volatile fuel markets and unseasonable weather—have made for interesting market dynamics. While this seaon’s compliance region included mostly experienced NOx market participants operating under a tighter cap, next season is an entirely different matter.

New states and new sources enter the program. Some states have additional early reduction credits under compliance supplement pools, rewarding sources that generated voluntary reductions in the past two years and easing their native industries into the NOx program. More importantly, legal action by several of the newly regulated states, led to a one-month delay in the start of next year’s ozone season for these sources. This ruling, in most cases, did not change the number of allowances allocated, however, meaning there will be five months of NOx allowances for use by sources with only four months of compliance obligations.

Not surprisingly, this has directly impacted price, and led to a wild NOx market this past summer. Vintage 2003 and 2004 allowances were in a relatively tight price range at the beginning of the year, but the spread soon blew out as 2003 vintage prices skyrocketed from less than $5,000 to $8,000 at the beginning of the ozone season. The vintage 2003 over 2004 premium exceeded $3,000 at one point.

The reasons point back to the staggered implementation of the program. An extra year before the implementation of tougher caps afforded many new sources time to install emissions control technology. Excess allowances for 2004 were anticipated as large compliance supplement pools and the shortened compliance period next year inflated the supply side of the 2004 market. Lastly, natural gas prices spiked at the beginning of 2003, which the market speculated would lead to higher demand for 2003 allowances as Northeastern utilities switched fuel sources from natural gas to oil.

Just as quickly as the price for 2003 allowances doubled going into this summer’s ozone season, the bottom fell out of the market. By the end of the compliance period this September, the price for 2003 vintage NOx allowances had dipped below $2,000.

What was the cause? In a word: weather. The Northeast experienced the coolest May since 1967, and the heat never really kicked in—even through the first couple of weeks in June. Without customers turning on their air conditioners, utilities in the Northeast had little use for their peaking units, which tend to quickly consume allowances. Natural gas prices also dropped nearly 20 percent in June on weakened demand and news of elevated storage levels.

The dramatic drop in 2003 vintage allowance prices brought down the 2004 vintage, as well. In July alone the price dipped to $2,600 from $4,025. Companies were unloading credits they did not need because of a projected overhang of 2003 vintage allowances into the 2004 ozone season.

Furthermore, many of the new sources affected in 2004 received their allocations this year, leading to a surge of supply in the market. (States have placed their allowances into the EPA tracking accounts at different times over the past year.) This supply came mostly from distressed companies that were liquidating allowances to raise cash and sources that were looking to help finance the control equipment they had just installed.

What to expect in 2004

Prices for 2004 allowances have stablized since August, but what does all this mean for companies looking toward compliance in 2004 and 2005? The market provides signals, which can help in planning for next year. Vintage 2003 and 2004 prices are now at parity as many market participants believe it is unlikely there will be discounts on the use of 2003 vintage allowances in 2004. However, the 2004/2005 vintage spread is significant. In fact, 2005 vintage allowances are trading at a $1,150 premium over vintage 2004. This can be attributed to a general market understanding that there will be a significant surplus of allowances in 2004, which will force regulators to institute constraints, known as progressive flow control, on the use of 2004 vintage allowances in 2005. This mechanism triggers the discounting of banked allowances if too many accumulate.

Zaborowsky is managing director of Evolution Markets LLC.

Additional information about the future of allowances and accompanying graphs for this article can be found on our Web site.


Checklist for climate change

“Corporate Governance and Climate Change: Making the Connection”—which was commissioned by CERES, a coalition of investor, environmental and public interest groups, and written by the Investor Responsibility Research Center (IRRC), an independent firm that advises institutional investors managing more than $5 trillion in assets—gives a 14-point “climate change governance checklist” to help evaluate companies’ responses to global warming. Is that company you’re examining doing the following?

“- At board level: 1. Assigning a committee of directors with direct oversight responsibility for environmental affairs. 2. Conducting a formal board-level review of climate change and monitoring company response strategies.

“- At management level: 3. Placing the chief environmental officer in a position to report directly to the chief executive officer or the CEO’s executive committee. 4. Making attainment of greenhouse gas targets an explicit factor in employee compensation. 5. Having the CEO issue a clear and proactive statement about the company’s climate change response and greenhouse gas control strategy.

“- With reporting: 6. Including a statement on material risks and opportunities posed by climate change in the company’s securities filings. 7. Issuing a sustainability report based on the Global Reporting Initiative or comparable “triple bottom line” format, which includes a discussion of climate change and a listing of the company’s greenhouse gas emissions and trends.

“- With emissions data: 8. Calculating and registering greenhouse gas emissions savings or offsets from company projects. 9. Conducting a system-wide inventory of the company’s emissions and reporting the results directly to shareholders. 10. Establishing an emissions baseline (dating back at least 10 years) by which to gauge the company’s emissions trends. 11. Making projections of future emissions and set firm, company-wide targets to manage and control them. 12. Hiring a third party auditor to certify there are no material misstatements of the company’s emissions data.

“- With other actions: 13. Participating in an external voluntary greenhouse gas emissions trading program. 14. Purchasing and/or developing renewable energy sources.

The study finds that despite the (studied) companies’ governance actions on climate change, U.S. companies, in particular, are still pursuing business strategies that discount the global warming threat. By contrast, non-U.S. companies are more likely to report on the financial risks and undertake climate change mitigation strategies. In fact, the electric power industry as a whole scored lowest on the checklist, despite being the largest source of U.S. emissions and vulnerable to changing clean air regulations.

“Recent corporate scandals point to the high price paid by everyone—investors, employees, and pension beneficiaries—for inadequate corporate governance practices,” said Mindy S. Lubber, executive director of CERES. “This report uncovers that climate change is a new ‘off-balance sheet’ risk that could affect shareholder value. We need leaders in the private and public sectors to support climate change policy solutions that achieve real emissions reductions. As responsible stewards, we can and must rise to this governance challenge.”

More information about the report can be found online at www.ceres.org.