Short-Term Forward, Long-Term Forward (cont.)
This premium reflects how the market prices future deliveries and payments,
which usually incorporates the seller's cost of carry interest rate plus a premium assessed
by the market to create a calculation known as the
allowance loan rate. The market assumes prices will escalate between 6% to 8% every year, going out seven years. The rate
is compounded yearly. In the above example, the rate used was 7%, but in reality this
rate will reflect whatever the market will
bear2. Therefore the difference in terms of cost to
the seller of holding on to the vintage 2001 allowances for delivery in July 2001, rather
than selling them immediately, is around $22.50 for each allowance. As the contract
term extends past the year 2004, this cost decreases due to regulatory uncertainty.
Swaps
For settlement transactions (both immediate and forward) allowances are usually
being exchanged for cash. This is the simplest form of allowance transfer and the most common
in emissions trading markets. However,
swaps have also become another popular type
of transaction. At its most basic, swaps allow one party to exchange
allowances of one vintage year for allowances of another vintage year from a second party.
Viewed in the context of compliance for the U.S. Acid Rain Program, swaps have the ability to use the market to efficiently distribute allowances. Take for example, utility A, which has plenty of SO2 allowances for the year 2000, but is short 10,000 vintage 2002 allowances. On the other hand, utility B is short on vintage 2000 allowances yet is long by at least 10,000 allowances for the year 2002. Through a swap transaction, utility A could exchange its surplus vintage 2000 allowances for utility B's surplus 2002 allowances.
Immediate Vintage Year Swap
In the above example, we can assume the two utilities will transact this swap concurrently. Still, the swap generally would not be made on a one-for-one basis. If the transaction were done on a cash basis, the value of the vintage 2000 allowances would be higher than those vintages further out, reflecting the price differences in the market between earlier and later vintages. A ratio is used to calculate this difference, and it is usually given in terms of the earlier vintage and how it relates to the inherent value of the later vintage.Vintage Year Swap Formula
{[ratio between vintage years x (later vintage year - earlier vintage year)] x amount of earlier vintage year allowances} + amount of earlier vintage year allowances = vintage year swap amount
For example, again, using the above illustration, utility A would give utility B 10,000 vintage 2000 allowances in return for 10,700 vintage 2002 allowances.
i.e. {[3.5% x (2002 _ 2000)] x 10,000} + 10,000 = 10,700
The premium paid by utility B reflects a ratio of 3.5% per year between vintage years, which is calculated based on the cash differential between vintages and quoted in the marketplace.