Chapter IV. Portfolio Management

(A.) Why Advanced Structures?

Until now we have primarily discussed one type of emissions trading transaction structure, the immediate settlement. As you might expect, this is just the beginning. Financial markets have been dealing in the trade of commodities for more than a century, and over that time increasingly complex vehicles have been developed. As structures gain market acceptance, they are often modified to create new ones, ever innovating to satisfy the demands of increasingly sophisticated market participants. The motivating factor behind the genesis of advanced structures in commodity markets is always to create new and better ways to manage risk.

Risk Management
Risk can come in many forms, but it almost always boils down to one issue: price. It is impossible to always accurately predict what the price of a commodity will be in the future, whether it is years or even months ahead. Therefore, financial markets have designed tools to enable market participants to lessen or hedge their risk that the price of a certain commodity will rise or fall. This also applies in managing and minimizing long-term compliance costs.

To take an example from emissions trading, consider a utility that projects it will be short on allowances in the year 2002. The company is determined to make up their shortfall in the trading market and sees that the going rate for 2002 allowances is $150. This utility has the risk that the price of 2002 allowances, which is holding at $150 today, may rise significantly in the future. This would increase the cost it must pay to purchase its allowances if it buys allowances in the future.

On the other hand, a utility holding an excess of allowances in 2002 confronts a risk directly opposing that of the previous example. If the utility is long on 2002 allowances, it certainly would not mind the price going up from $150. But, the utility is also hoping that the price will not fall and reduce the value of its allowance holdings. Although through the first half of 1999 SO₂ trading market has been relatively stable, it has demonstrated considerable volatility since its inception, making price risk very real.

Dollar Cost Averaging
All emissions market participants would have to agree that, although everyone has their own view of the direction of allowance prices, no one really knows for sure. In a sense, this puts even the most seasoned emissions marketing participant on an equal footing with the greenest emissions trader. What really sets the two apart is how they use the tools available in the marketplace to offset what they cannot accurately predict in price.

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