Introduction

I have many fascinations with the United Kingdom. From its controversial kings, majestic castles, the finely tuned British dialect and strong female figures from Elizabeth I to Margaret Thatcher. Indeed - my mornings glister to the drums and fifes of the "British Grenadiers" in preparation for battle against Sir Outlook and His unread emails. So when my Bank's London branch approached me to assess the market risk on a UK environmental product - I knew I wouldn't be disappointed. In fact, so interesting it was that I've dedicated an article to this! Here - I explore the UK's stellar achievement in green energy and the underlying scheme that has created the demand and supply for a tradable product.

Stellar Performance

As an introduction to the UK's performance - I observed the percentage YoY changes in CO2 emissions from 1980 across various countries. I looked at comparables such as France and Germany, but also my motherland Australia and the two global superpowers in the USA and China. The graph, highlights the UK being ahead (negative is better!), with the best 10-year average of -2.78%.

	AUS	CHN	FRN	GER	JPN	UK	USA
10-Yr Avg	0.10%	2.82%	-1.56%	-1.12%	-0.44%	-2.78%	-0.35%

Hereon, I explore a scheme, which among many, has incentivised this trend.

OFGEM and The Renewable Obligation Scheme

The Office of Gas and Electricity Markets (OFGEM) is an independent UK regulator striving towards a greener UK. It mandates the Renewables Obligation (RO) scheme that promotes large-scale renewable electricity supply. At a high level, it's simple: Every supplier producing a MWh of non-renewable energy receives an obligation. These are then recorded and totaled across a yearly horizon, also known as the compliance period. Under the RO scheme, this begins on 01/April/X, and ends on 31/May/X+1, where X is a starting year.

Renewable Obligation Certificates

Obligation requires a little more abstraction to establish a measurable construct. Thus enters Renewable Obligation Certificates (ROCs), which are pseudo-tangible, measurable objects of obligation. Here's a real example: For the period beginning in April 2021 and ending March 2022 - every MWh of non-renewable energy in Great Britain receives an obligation of 0.492 ROCs. Said differently, every 2.032 MWhs demands a single ROC, which may be viewed as a single certificate. There are two following questions: (1) how does one obtain these certificates to satisfy their obligation, and (2) what if a supplier fails to comply?

Obtaining ROCs

ROCs are obtained by generating green energy. Moving forward I will call these suppliers *generators*. Generators receive a number of ROCs depending on (i) the technology used; (ii) the time of accreditation; and (iii) the station’s installed capacity. For example in 2017 offshore wind generated 1.8 ROCs per MWh whereas onshore wind only gave 0.9.

Fulfilling the Obligation

At the end of the obligation period, every accredited supplier is required to deliver a number of ROCs to OFGEM. Alternatively, they may choose to *buy out* (BO) their mandate at a prescribed price per ROC. These are called "buy-out" prices, and are shown below starting from 2010.

Date	2010	2011	2012	2013	2014	2015	2016
Price	37.19	36.99	38.69	40.71	42.02	43.30	44.33

Date	2017	2018	2019	2020	2021	2022
Price	44.77	45.58	47.22	48.78	50.05	50.80

The following graph illustrates how suppliers in a given compliance year met their obligations by either (i) buying out; (ii) presenting ROCs.

It's clear that most obligations are met through ROC presentation. However, one may notice an increasing trend in the ROCs bought out. This may be attributed to decreasing compliance, or increases in the ROC rate per unit of non-renewable energy. Assuming stern views on a greener economy - the first case is ruled out. **Example:** Assume all ROC/MWh rates , ignoring their applicable years. > Gus Energy (GE) produces electricity by burning coal. For the compliance period starting in 2021 - GE has generated 203.2 MWh this way. As such, OFGEM has requested 100 ROCs. GE expects this and also produces 55.56 MWh using offshore wind, providing 100 ROCs. As such, GE has met its obligation. Had GE decided to entirely buy-out, they'd pay GBP 50.05 per ROC, or a total of GBP 5,005.

Life of a ROC

ROCs generated during a compliance period may be used to meet a generator's obligation for that period. However, if it has overproduced, it may sell ROCs into the free market, or *bank* the ROC for the next year. While banking is possible - the life of a ROC is 2 years. That is - a ROC could be obtained on the 01/Apr/X, not used for compliance period X/X+1, and banked for use in X+1/X+2 at the last date of 31/Mar/X+2. Thereafter, the ROC cannot be used to meet any obligations and is worthless.

The Recycle Value

Suppliers may be categorised into three groups: 1. Those who complied having at least as many ROCs as required (the generators) 2. Those who did not comply and paid a cash amount equivalent to their ROC requirement 3. Those who did not comply, did not buy-out and made a late and enforced payment Payments from (ii) and (iii) are pooled into a fund, and after administration costs are distributed to (i) on a pro-rata basis. This distribution per ROC is called the **Recycle Value**. The table below provides detail of this mechanism across the years. The first row is the ending compliance year, the second is the size of the fund, and the third with the number ROCs provided by complying suppliers and fourth - the recycle value per ROC.

	10	11	12	13	14
Buy Out and Late (MM)	324.00	358.00	123.00	164.00	42.00
Num ROCs (MM)	21.30	25.00	34.40	44.80	60.80
Rec. Value	15.17	14.35	3.58	3.67	0.7

	15	16	17	18	19
Buy Out and Late (MM)	25.00	0.00	460.00	604.00	842.00
Num ROCs (MM)	71.30	84.40	90.20	103.20	107.60
Rec. Value	0.35	0	5.1	5.85	7.82

The Importance of the Buy-Out Price

Assume there is no demand for excess ROCs. Then generators are left with a worthless certificate. Furthermore, assume there is demand but the market is oversupplied. Then there are more certificates in the market than required for the population of suppliers to meet their obligation. As such, unpurchased ROCs not only have a value of zero, but all ROCs generated will receive no recycle value. All these points will discourage suppliers from investing in green energy. As such, the buy-out price plays an important role of setting the market; it is the canvas that will be painted on, and must be appropriate for the painter. The buy-out price was originally set at GBP 30.00, and designed to ensure excess demand of 10% (10% of suppliers will purchase ROCs from the free market). Thereon, the price grows at the Retail Price Index. The main assumption in understanding the ROC's value is that there is excess supply, and demand. However, we will also consider a small deviation from equilibrium.

Demand and Supply

I've used GeoGebra to create the demand and supply application below. The price slider reflects the equilibrium, which is anchored by the buy-out price. Though more on this later. The graph reflects ROCs sold on the free market. This is supplied in excess of those held by generators, which I've notated by $Q_{H}$. This value is negative as it's removed *from* the free market. $Q_{B}$ represents the ROCs supplied at the buy-out price, and $Q_{D}$ reflects the total number of ROCs demanded. Starting at a buy-out price of 2 GBP, clearly $Q_{B} < Q_{D}$ per our assumption that there is excess demand. Hence $Q_{D}-Q_{B}$ ROCs are purchased at the buy-out price. Click `Display Total Buy Out` to view this total amount. Ignoring operational costs, this amount is then transferred to ROC holders, which may be viewed by clicking `Display Buyout Transfer`. That is, those holders of $|Q_{H}|+Q_{B}$ ROCs receive the Total Buy Out on a pro-rata basis. Therefore a ROC is worth more than the buy-out price since a holder not only complies, but receives the Recycle Value. As such, the true equilibrium price is not 2 GBP, but 2 + $\mathbb{E}(R)$, where the latter term is the expected Recycle Value $R$. Move the slider to 2.3. This may be a more realistic example of the ROC value, which means more supply and green energy!

ROC Price Analysis

We've discussed what ROCs represents, and how its value is determined through demand and supply. We now observe real price data. Recall that certificates are generated in a compliance period, and have a maturity of 2-years under banking. Therefore, when understanding the value of a ROC, it is sensible to distinguish them by year of production or the commonly used term *vintage*. Those ROCs expiring the soonest may be more prone to exogenous shocks and increased volatility. ROCs are either sold bilaterally, or on a public electronic auction (eAuction). I have eAuction data as it's the only source of publicly available information. The average price quoted at the end of an eAuction, is the arithmetic mean of all ROCs cleared in that auction. As such, the price of a ROC with a single vintage cannot be extracted. Therefore while can use this data to estimate the volatility of a vintage, it have downward bias for ROCs expiring soonest, and upward bias otherwise. Auction data from Feb-2011 is shown below. Every auction is around a month apart, and the annual volatility of percentage changes is 6%. Under this, a one factor volatility model with no drift (Black-76) is used to forecast a 95% confidence interval for the next auction, as shown by the envelopes below.

The price series moves with changing buy-out prices, expectations of recycle values and idiosyncratic exogenous shocks on supply.

Floor on the Price

Performing future forecasts relies on scaling the volatility of the normal probability distribtuion of log returns on ROC prices. However, if a purchaser will only pay at most the buy-out price plus an expectation of recycle value - is there a fundamental floor on forecasted ROC prices? Furthermore, would scaling the probability distribution lead to unrealistic outcomes on values below the buy-out price? The answer to this is yes. After consulting with external brokers - ROCs have never sold less than 2.50 GBP on the buy-out value for a compliance period. This is something we kept in mind when generating price stresses on our short-swaps. If buyers will only pay at most buy-out plus recycle value, the observed discounts must come from suppliers. This raises an interesting question: what incentivises suppliers to discount their ROCs?

Idiosyncratic Exogenous Supply Shocks

If there's lacking demand for ROCs, and a vintage is expiring, then generators may sell at lower than buy-out to incentivse demand. Furthermore, internal pressures in risk, or large capital charges may force holders to discharge their ROCs to the market immediately. These are two main drivers for suppliers discounting their ROCs.

Conclusion

The United Kingdom has historically been a leader in many of its endeavours. While superpowers have exchanged hands, the UK brings itself back to the frontfront in tackling climate change. Its renewable energy programs have created demand and supply for a product that can be profitable for efficient generators. Though more importantly - it has decreased CO2 emissions in the UK. A win-win.