The EUA market may have settled into a 20-22 €/t range over the last few weeks, but there has been a notable widening of the contango across the curve. The implied cost of carry for the Dec-18–Dec-20 spread has gone from 1.8% per annum (p.a.) at the start of September to 3.5% p.a. at Friday’s close (5 October). The contango was even wider on the Dec-18–Dec-21 spread, at an implied 4.1% p.a. at Friday close. The widening of the contango suggests that the so-called ‘repo’, an arbitrage trade on the cost of carry, should be at levels tempting financials and funds into this low-risk trade. With a repo, a market participant buys the front end (Dec-18) and sells a further-dated contract (Dec-20, for example), locking in an implied rate of interest. So long as the participant’s cost of funding is lower than the cost of carry on the curve, it is a profitable trade. While this looks like a no-risk trade, there are some tail risks that market participants will consider. The main one we tend to hear is a concern over what happens if the EU ETS was to be wound up before the expiry of the further-dated leg of the trade. While that event would obviously render the trade worthless, the risk is a tail probability event which we currently assess as having less than a 1% chance of happening. There is extremely little political will among the European Commission or European Parliament to end the EU ETS. Even if that were to occur, such a big change to EU policy would take around two years to get through the EU legislative processes. And even if that process started now, it would be unlikely to be agreed and implemented before the expiry of the Dec-20 contract. Given such a low risk, we expect to see more capital coming into the repo trade, which should narrow the contango in the timespreads.
|Fig 1: EUA cost of carry, €/t||Fig 2: EUA rates of funding, % per annum|
|Source: Reuters, Energy Aspects||Source: Reuters, Energy Aspects|