Hedge Funds Seeking 15% Returns May Try CO2 Market, DIW Says

March 22 (Bloomberg) -- Hedge funds seeking annual returns on investments of 15 percent may enter the European Union carbon market after prices plunged 59 percent in the past year, according to DIW Berlin.

The plunging price may be enough to attract some new investors to the market, even as supply threatens to overwhelm demand over the next few years, said Karsten Neuhoff, an energy and climate policy specialist at the provider of economic research in the German capital. “It could be an attractive market for hedge funds,” he said yesterday by phone.

Carbon permits for December fell 3.4 percent to 7.18 euros ($9.46) a metric ton on the ICE Futures Europe exchange in London at 12:55 p.m. local time. They fell to a record 6.38 euros a ton on Jan. 4.

The market may be oversupplied by 2.7 billion tons by 2014, DIW estimated in a report dated March 8. Prices fell because they needed to find a level attractive to speculative buyers such as hedge funds, Neuhoff said.

Those investors target returns of 10 percent to 15 percent a year, more than that needed by power utilities to cover their cost of capital, DIW said.

“Our results differ from previous analysis of emission trading schemes, which typically assumed that banking between years is pursued at a 3 percent to 5 percent discount rate,” the researcher said in the report.

Poland Blocked

The drop in the price shows the market is not meeting the European Union’s expectations, and intervention by lawmakers and regulators is justified, DIW said. A temporary set-aside of allowances of at least 1.4 billion tons is needed to recalibrate the market and keep supply at a level where buying by utilities will have an impact on prices, given the supply of allowances in planned auctions, selling of spare allowances by factories and flow of imported offset credits, Neuhoff said.

Poland on March 9 blocked a move by other nations to detail the region’s climate-protection plans after 2020. The EU parliament voted for a set-aside of an unspecified volume of EU carbon allowances, which may temporarily support prices by eroding the oversupply.

Trading in carbon contracts jumped 56 percent in February on ICE, the biggest exchange for carbon trading, compared with February 2011, according to data from the bourse. Aggregate open interest, a measure of trading positions that have not been closed, was yesterday at 671 million tons, 51 percent more than the same day last year.

The uncertainty about future regulation might make the market less attractive for hedge funds and too risky for many pension funds, Neuhoff said. “We are in a situation where people are anticipating policy changes.”

‘Potential Lenders’

New lenders may already be entering the market, including banks and pension funds, because of the returns available, Barclays Plc said March 12. Those investors may narrow the premium of 2013 futures compared with those for 2012, Trevor Sikorski, an analyst in London for Barclays Capital, said at the time. Carbon permit spreads widened to 6 to 7 percent above the Euribor rate, he said.

“As more new potential lenders enter the market, we expect some of the super contango that is now present along the curve to begin to be unwound,” Sikorski said.

The premium narrowed 3 cents today to 54 cents a ton. It has shrunk 18 percent since March 9, the session before Sikorski’s comments.

The spread widened to 83 cents on Feb. 27, the highest level since Oct. 14. Factories, especially those in countries with high levels of sovereign debt, have sold near-dated carbon allowances and bought longer term because that may be a cheaper way to raise finance than lending from banks, Sikorski said.

Some banks are scaling back their carbon businesses as prices slump, including JPMorgan Chase & Co. and UBS AG.

To contact the reporter on this story: Mathew Carr in London at m.carr@bloomberg.net

To contact the editor responsible for this story: Lars Paulsson at lpaulsson@bloomberg.net