(C.) Hybrid Structures
At the core of the advanced structures discussed above is a focus on managing price risk. Price risk can vary depending on one's perspective and therefore, requires varying management strategies. The numerous tools available in emissions trading markets can be used in varying combinations and at different times in order to execute a comprehensive market strategy to protect both upside and downside risk. There is no limit on the combinations of these risk management tools, and with the increasing volume and sophistication of emissions markets, new combinations and variations emerge frequently.
The creative use of calls and puts is one example. The basic option tools of calls and puts are being combined and utilized in creative ways to manage risk in increasingly sophisticated ways. Calls and puts on their own allow the buyer to hedge price risk in one direction, either the upside risk for buying allowances or the downside risk for selling allowances. However, hybrid structures can mitigate price risk in both directions at the same time.
Below are a few basic hybrid structures that are currently being employed by market participants. These combinations should present an idea of the potential for customizing the use of these tools.
Collars
Active participants in emissions markets are constantly keeping an eye on their buy
and sell positions, finding their upside and downside risk often intertwined. One way to
hedge against prices moving in either direction is to simultaneously buy a call option and sell
a put option. This allows the market participant to set a price ceiling for
purchasing allowances but, at the same time, establish a price floor for selling allowances.
Here is an example. To hedge against the risk of market prices going above $200 an allowance, a utility buys a call option with this strike price for a premium of $10. At the same time, a utility may be willing to sell allowances for not less than $150. In this case, the utility sells a put option with a strike price of $150 for a premium of $10. If price goes above $200, the utility exercises the put, buys at $200, and saves money. Or, if price drops below $150 the utility sells at $150 and makes a profit. With these transactions the utility "collared" its price risk, and the options have cancelled each other out. This equates to a "zero-cost" collar.