In North America, and indeed worldwide, all levels of government are enacting measures to reduce greenhouse gases. To respond, companies should adopt a new line of dynamic risk management practices that link the production process to the financial decisions related to emissions, requiring energy companies to take account of these market developments within their risk software solutions. This article provides mathematical computations for considering these effects.

North American governments becoming more aggressive

To name but two recent developments, on March 10 the government of Canada provided details of its greenhouse gas emissions regulations under the Turning the Corner plan, one of the toughest regulatory regimes in the world, to reduce greenhouse gases by an absolute 20% by 2020. On April 18, US President George W. Bush announced a national goal to stop the growth of US greenhouse gas emissions by 2025 through regulations, government incentives, and new funding for technology research.

Oil and gas producers and electricity generators across North America will be affected by the Turning the Corner plan and more strident US initiatives. Companies should take appropriate actions to deal with their effects.

Northern exposure to Turning the Corner

Under the Canadian plan, the province of Alberta will be required to reduce emissions by 50% relative to business-as-usual by 2050 or 14% relative to 2005.

According to the plan, there is a cap of 100 kilotonnes of green house gases (GHG) per year, and companies are required to reduce their emissions intensity to reach that target. Companies can meet their target through in-house reductions, by contributing to the Alberta-based technology fund at a rate of $15/tonne, for every tonne above the 12% target, or by investing in Alberta based in-province offset projects.

New markets for carbon create new needs

Establishing a market price for carbon and setting up a carbon emissions trading market are two pivotal market-based elements of the Canadian greenhouse gas emission reduction plan.

Emission trading is a market-based mechanism to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. It is also called cap and trade. Currently more than 65% of electricity generated in Alberta is based on coal, and, due to emissions trading, coal would become less competitive as a fuel compared to other alternatives such as natural gas and even nuclear plants.

In this market-based trading system companies are issued emission permits and are required to hold an equivalent number of allowances that represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap of 100 kilotonnes of GHG per year.

Of course companies can decide to emit more than their specified cap if they buy emission credits from those who pollute less.

Assigning financial values to emissions

From an economic perspective, the buyer company is paying for over-cap pollution, while the counterparty is getting paid for under-cap pollution. This market mechanism provides enough incentives to those who can reduce their emissions most cheaply and punishes companies that are producing more than their cap.

It is notable that the cap and permit trading system is a quantity-based instrument, in a sense that it fixes the cap and allows the price to vary. So there is an uncertainty of the cost of compliance as the price of a permit is not known in advance and will vary over time according to market conditions.

The new risk equations

Under this scheme, energy companies will face a new risk management challenge. On the one hand, a new contract type will show up in the daily transactions with a new risk factor called “Permit Price” that may be very unstable and therefore unpredictable. The contract could be applied on both future and spot permit prices.

On the other hand, unlike other financial and physical contracts for which mark-to-market (MtM) is based on a variety of market rates and prices, and there is a one-directional relationship from market risk factors to mark-to-market process, the new emission trading contracts will be affected by both market rates and production levels, with a two-directional relationship between value of contracts, level of production and risk factors.

To put it in perspective, a typical financial or physical contract such as buying or selling a specified amount of natural gas is only a direct function of natural gas prices and other related risk factors. In fact, the only risk factors affecting the value of the contract, MtM, would be natural gas prices and the corresponding FX rate if underlying currency is different than the local one. In particular,

MtM of a Natural Gas Contract = f(Natural Gas Prices, Fx (1)
Rates|Currencyˆ=Local)

In this case, the level of the production of natural gas does not show up in the MtM function and it logically has no immediate impact on the left-hand-side of the equation, which represents the market value of the contract.

A different situation for emissions

In contrast, that is not the case for emission contracts. The relationship between the value of the contract, level of production and emission prices are two directional:

MtM of an Emission Contract = f(Emission Prices, Emission (2)
Cap-Total Emission, Fx Rates| Currencyˆ=Local )

Total Emission = f(Total Production) (3)

Production Level = f(Emission level, Other factors of (4)
production, Fx Rates| Currencyˆ=Local)

To put Equations 2 through 4 in perspective, consider a typical oil sands producer that is granted an emissions cap of 365000x units per year (on average, 1000x units per day), and is producing 200,000 barrels of oil per day. Equation (2) shows that the MtM value of a contract is a function of emission prices, emission cap, and total emissions granted to the producer.

Equation (3) highlights the positive affect of production level on the level of emissions. The last equation considers the effect of emission levels on production of oil sand. For example, if the emissions level for any level of production goes to infinity the production of oil sands should go to zero because of skyrocketing cost of buying emissions contracts.

Let Pemission be the market price of a unit of emission at any time, and Poil be the price of oil. Assuming all other factors are equal, suppose that P*emission solves the following equation, for a given level of oil production, and its market price:

Marginal Revenue(Poil , Pemission | Emission Cap-Total Emission>0) = Marginal Cost(Production Factor Cost, P*emission)

The left-hand side of the equation is the marginal revenue of the oil producer, which represents extra revenue that an additional unit of oil production will bring to the oil sands producer. The right-hand side, similarly, measures an extra cost of an additional unit of oil production. P*emission is the desired emissions price for which the equality above holds. Of course, there is a set of values associated with P*emission represented as (Poil, Pemission, Total Emission, P*emission).

The oil producer does not have any control of the emission prices, and any changes in the relative value of Poil and P*emission , could result in different set of values for (Poil, Pemission, Total Emission, P*emission).

For instance, a relative increase in Poil compared to Pemission, could make it profitable for the producer to pass its emissions cap and therefore to take some long positions in the emissions market by producing at the maximum level of production capacity. Or if Pemission soars enough it could be potentially possible for the producer to produce under full capacity and go short in the emissions market.

As it is clear, there is a two-directional relationship between level of production and the type of position (short or long) in the emissions market, depending on the relative value of Poil and Pemission, to the values corresponding to P*emission.

For this reason, unlike other conventional financial and physical contracts for which taking a long or short position more or less depends on price and rate risk factors, decision making process for the emission contracts will be driven by not only those risk factors but also producer’s level of production. In fact, relative value of Poil and Pemission , would even force producers to avoid producing at full-capacity.

In this regard, there will be a signal sent from the level of Poil and Pemission, to the producers to change their positions in the emission contracts, which will be also a function of the level of production.

In short, there should be a new line of dynamic risk management practices, which should link the production process to the financial decisions related to emissions. This would normally require energy companies to take account of these developments in the market within their risk software solutions.

About the author

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Akbar Shahmoradi is a senior quantitative risk specialist for RiskAdvisory, the Calgary-based energy trading and risk management software firm. He can be reached at ashahmoradi@riskadvisory.com.

Greenhouse gas regulations impacting risk management decisions by energy companies

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