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Risk-adjusted Carbon Intensity

Price risk is incorporated into derivative instruments designed to hedge against unfavourable changes in commodity pricing. Many larger companies use commodity futures to lock in the option of paying a specific value for a commodity, often using a marginal amount of the contract’s purchase value with collateral tendered as insurance against the risk of default.

However, just because volatility is actively traded, this does not mean the risk-to-reward ratio represents a good return on investment. Risk is priced into financial instruments, with companies which have a lower credit rating having to pay more in yield on debt instruments because there is a higher danger of default or delinquency on the account. High-yield bonds have a lower secondary market value because purchase price is inversely related to yield.

For producers which rely on specific materials, ensuring the resilience of their supply-chain is another way to hedge against global market shocks, and this is especially true in the current geopolitical arena….

 Energy companies have to price in the cost of uncertainty over the price of materials and infrastructure used to generate electricity for the grid. The covariance between volatility in natural gas prices and in electricity prices demonstrates the uncertainty in the sector’s profit model. What then is the cost of this uncertainty?

The VIX index, which tracks the performance of securities listed on the Chicago Board of Options Exchange (CBOE), was up 6.83% at close of trade 04.04.26. It closed for the day at 17, “its lowest closing level since February, shortly before the U.S. and Israel began their bombardment of Iran.” according to Marketwatch 

The put-call ratio for the Cboe Volatility Index (VIX was +6.77%),  fell as low as 0.2 this week, the lowest in a year. “That is a sign that investors have been favoring VIX calls, which would likely pay off in the event of a sudden selloff, over VIX puts, which represent a bet on a calmer market.”

Volatile prices make it more difficult to accurately forecast economic performance and price increases can be passed on to the consumers, causing inflationary pressures i.e. in the Headline CPI. For this reason, food and energy prices are excluded from the Core CPI due to their high volatility which can have a distorting effect. Core CPI is a more effective indicator of long-term structural trends.

The Department for Energy Security and Net Zero (DESNZ) and the International Panel on Climate Change (IPCC) have issued a number of reports enable industry benchmarking for comparison between energy providers, from which proxies can be derived representing the risk-adjusted carbon intensity of energy production.

Researchers at nocarbon.ai found that UK electricity prices demonstrate a volatility coefficient of 0.53, natural gas of 0.45. Renewables have a volatility coefficient of close to zero because after the upfront installation cost, there are no materials overheads and basic maintenance costs are not significant. They are thus buffered from the supply-side pricing shocks that oil and gas producers experience.

The risk-adjusted CO2 factor is derived from the base intensity used as a multiplier for one added to the price covariance. The base intensity input uses IPCC lifecycle data. The second input variable uses the DESNZ 20-year price history.

This metric penalizes carbon intensity based on financial volatility. It accounts for the ‘cost’ of uncertainty in the energy supply chain.