Look Both Ways: Counterparty Risk Assessment in the EU ETS Markets

The inclusion of international shipping within the European Union Emissions Trading System (EU ETS) from 1 January 2024 brings new opportunities, but also new risks.

 

From its launch in 2005, the EU ETS has covered EU-domiciled companies’ “onshore” emissions within the power, energy-intensive industrial, and aviation sectors, with maritime emissions included from 1 January 2024. Today, in the secondary market, circa 70% of all EUAs are traded on exchanges which tend to pose higher transaction and administrative costs, including minimum capital requirements, maintaining margin requirements and dealing with standard contract sizes. The remaining balance is traded Over-The-Counter (OTC) outside of regulated exchanges via privately negotiated bilateral contracts. Our research suggests that the increased flexibility offered by OTC trading is likely to see it ascend to being the preferred option for the typically small to medium-sized shipping companies that are likely to require relatively smaller EUA volumes to meet compliance obligations. However, like all OTC trading, both parties to a trade assume mutual counterparty risk.

 

On one side of the EUA OTC trade is the EUA Trader, and on the other side, the ‘shipping company’ (most likely to be the ship owner or, if agreed via a separate contractual agreement, another entity such as a technical manager or charterer). As part of the latter’s established onboarding and Know-Your-Counterparty (KYC) processes, Infospectrum has been conducting comprehensive counterparty risk assessments on EUA Traders under its “VERify” offering. The EUA Traders assessed cover a range of companies from independent groups focused on decarbonisation-related commodities (compliance credits, voluntary offsets and other energy attribute certifications) to diversified commodity traders and fuel (including bunker) suppliers that seek to leverage their trading experience and, in some cases, to supplement and/or complement their core trade to service existing client demand. Other than trading EUAs, some of these Traders are also offering "EUA warehousing” services to shipping companies.

 

Beyond Trading - "Warehousing" EUAs

 

Under the EU ETS registry, Operator Holding accounts (one of the three main account types under the centralised electronic Union Registry database of the EU ETS) are used by compliance entities to record EUA ownership and track submissions made to meet compliance obligations. Market sources have indicated that, given the significant bureaucratic backlog for new account registrations, non-EU shipping companies’ registry accounts may only be operational by mid-2024. Certain EUA Traders are offering an interim service to these shipping companies to purchase and “warehouse” EUAs until the latter’s account has been opened. This approach increases a shipping company’s exposure to the EUA Trader by presenting added risks of deferred EUA deliveries. We have found there to be a great deal of variability in the risk profiles of EUA Traders we have assessed, in terms of factors such as transparency, ownership and control structures, track record, operational scale, commercial strengths and weaknesses, access to liquidity and financial position. Moreover, similar to the dynamics of the bunker industry, the ability and willingness of an EUA Trader to offer credit terms to their shipping counterparties has emerged as one of the key differentiators in this fast-evolving and highly competitive, commoditised compliance market.

 

New Entrants, New Risks

 

While the inclusion of maritime emissions within the EU ETS provides new avenues of growth, EUA Traders may find that, the particular (often obscured) operational and structural profiles of some of the “offshore” shipping entities they trade with on an OTC basis, adds a new layer of complexity to counterparty risk management, likely contrasting with existing experience with EU ETS-“onshore” entities. The low-disclosure offshore domiciles used by a number of shipping companies, obscure ultimate beneficial ownership, despite the growing importance of sanctions checks and reputational risks. Additionally, combined with potentially limited financial visibility, the difficulties of conducting due diligence and understanding default/credit risk are compounded.  Furthermore, the unique difficulties posed by the typical owner-operator model require an assessment across the counterparty chartering chain to align regulations, enforcement, accountability and recourse.

 

Clarity from Complexity

 

Given the aforementioned unique characteristics of shipping companies, Infospectrum’s 25-year track record in delivery of precision counterparty risk assessment services leverages a proprietary Multiple Factor Verification (MFV) framework that contextualises rigorous data analytics with human intelligence. Our 50+ geographically diverse Analyst team specialises in navigating the specific complexities of the maritime, commodity and energy sectors; we combine global/industry knowledge with local access, to authenticate, validate, analyse and interpret quantitative and qualitative information and provide real-time actionable insights based on a comprehensive approach to transactional counterparty due diligence.  Our Institutional expertise is reflected in a proprietary databank of 32,000+ company risk assessment reports of which 400 - 500 entities are assessed each month. The MFV process has been expanded most recently to include an ESG-specific solution, the ESG Assessment Report (ESG-A), designed to provide clarity regarding an entity’s ESG strategy, accountability, performance, and transparency within a consistent framework.

 

Without adding material burden to transaction costs, Infospectrum’s Analysts can provide EUA Traders, EU ETS service providers and shipping companies with the necessary clarity to inform their internal due diligence processes, enabling them to capture viable opportunities and mitigate risks in this new and ever more challenging compliance market.

 

Related: PRESS RELEASE: Infospectrum's ESG Assessment Report