Environmental futures versus carbon cash products Combined physical

Environmental futures versus carbon cash products Combined physical and financial carbon hedging London, November 23, 2004 Seb Walhain

Presentation outline The carbon asset-liability ratio curve under the EU ETS The marginal abatement cost curve Choosing make-or-buy based on the cash products market Environmental futures as alternative to spot and forwards Developing the right trading and/or compliance strategy Conclusions, merits of trading versus cost of compliance 2

EU Emission Trading Scheme New assets, new liabilities, new values Two main ways to reduce emissions under the EU ETS - Allowance trading sets a cap on emissions and companies can either buy or sell allowances depending on their emissions and the cost of abatement. - Credit origination involves generating credits by investing in individual projects in developing countries that reduce emissions The EU ETS covers ± 46% of EU CO 2 emissions Penalty of € 40 per t. CO 2 e (2005 -2008) and € 100 (2008 to 2012) Forward market semi-established into 2008, increasing liquidity and participation, decreasing volatility and contractual diversity 3

Value of allowances Expected value of total allocation expected ~ 14+ Billion Euro Value of traded market ~ 2 Billion Euros per year (at 5 Euro per tonne and 10% of allocated allowances traded) Allocated value to 15 major companies ~ 2750 M Euro 4

Ref. Point Carbon 5

Accounting example of Asset to Liability 2005 Estimate CO 2 asset (IAS 38 Intangible Asset measured at fair value with all changes recognised in profit and loss. RECOMMENDED by IFRIC) Monitor CO 2 liability (IAS 20) Emissions per year = 1 Mt. CO 2 Total allocation per year = 0. 9 Mt. CO 2 Value asset on allocation ~ Euro 7 million Value final short position ~ Euro -3 Million 6

Reducing CO 2 in Poland - up to 4 times more effective Influencing factors for carbon abatement costs: - Efficiency of power plants; - Age of power plants; - Type of fuel. Costs to reduce CO 2: - NL: ± € 20 per tonne; - Poland: ± € 5 -7 per tonne: 1) - Old (25 years and older) and inefficient (± 27%) power plants; 2) - Main types of fuel are lignite and hard coal. ÞHigh emissions per MWh: large reduction potential. 1) Source: Coal Convenant, August 2000 2) Costs to reduce 1 tonne of CO 2 depends on type of technology. 7

The Marginal Abatement Cost Curve Company with 5 m tons CO 2 emissions 40 EUR/t 30 Cost of Reduction Measures (M 1 -3) Marginal Abatement Costs 20 M 3 M 2 10 M 1 0 0, 5 1 1, 5 2 2, 5 Million tons CO 2 8 Ref. : Evolution Markets 3 3, 5 4 4, 5 5

Make-or-buy versus the cash products market Costs lower than market price: Invest and sell! Worst Case Allocation EUR/t 40 30 Marginal Abatement Costs 20 Market Price 10 0 0, 5 1 1, 5 2 2, 5 3 Million tons CO 2 9 Ref. : Evolution Markets 3, 5 4 4, 5 5

Hedging The use of market instruments (call and put options in this case) can narrow the price exposure and allow for better forward planning 40 30 EUR/t 20 10 200 4 10 2005 Ref: Evolution Markets 20 06 2007 2 0 0 8 200 9 2 0 1 0 2 0 1 1 20 12 20 13

The trouble with trading. . 11 Open H/C/T accounts New IT and tracking IT and systems 8 Brokerage agreements Verify actual emissions, registries Unclear fiscal treatment, VAT 3 Exchange agreements Optimise costs of trading (“bro”) and transfers (tax) Unclear accounting procedures 3 (ISDA, EFET, IETA) Standard contracts Intra / inter company position netting Credit approval new counterparties TRADE

Environmental Futures markets have two central roles: risk transfer and price discovery. The fundamental difference between futures and forwards is the fact that futures are traded on exchanges and are standardised. Forwards trade over the counter and can be for any conceivalbe underlier and for any settlement date. Forwards are entirely flexible. Parties to the contract decide on the notional amount and whether physical or cash settlement will be used. If the underlier is for a “physically” settled product like Allowances, parties agree on issues such as delivery point. Forwards entail both market risk and credit risk. A counterparty may fail to perform on a forward. With futures, there is only market risk. This is because exchanges employ a system of daily margining that all but eliminates credit risk. Q 3 ‘ 05 Futures Contract Party A 12 Q 3 ‘ 05 Futures Contract Clearing House Party B

Carbon Banking at Fortis CUSTOMER Project financing CUSTOMER Carbon for fund carbon origination CUSTOMER Position management and Trading services Investment in funds Carbon price info. Position management Registry management fees 13 Fortis fund for emission reductions CUSTOMER Due diligence of financing mandates CUSTOMER

Carbon Banking at Fortis A core environmental products team horizontally integrated across organisational boundaries and professional disciplines Mees. Pierson Inter. Trust Providing EUA and CDM registry and custodian services Later using superior administration and interfacing for a user friendly interaction with registries Global Markets Environmental Products Trading Desk with CER and EUA lines and knock on impact advice to other desks, particularly energy desks. Corporate & Investment Banking Financial services including carbon value CIB Project Finance Incorporating carbon price in due diligence and Discounted Cash Flow Models Equity investment Investing in clean energy funds for the generation of emission reductions 14

Conclusions The corporate efforts required to manage the financial consequences and administration for compliance under the EU ETS are considerable, and to actively trade the market an effort must be made that is potentially very disproportionate to any returns to be had. The market is shifting from driven by policy signals to driven by fundamentals (300% price difference!), and fluctuations in weather (climate!), energy prices and economic developments have great volatility inducing potential creating a large yet high risk market. Portfolio pooling and compliance management outsourcing are alternatives well worth considering to developing own trading capabilities for over 90% of potential market participants. 15

Contacts Seb Walhain Seb. Walhain@nl. fortisbank. com +31 20 535 7295 Claire Byers Claire. Byers@nl. fortisbank. com +31 20 535 7020 16