The major investment banks remain heavily engaged in the energy markets, hedging fuel prices and even producing energy for their own or their clients’ benefit. But Brad Hintz, a Sanford C. Bernstein & Co. research analyst who tracks the investment banking and securities industries, told Breaking Energy that the big banks are also positioning themselves for potential regulatory changes which will force the launch of a national carbon-trading market.

“Goldman Sachs, JP Morgan, Morgan Stanley, and Barclays are all major energy traders,” Hintz observed. “They are the banking giants in that space, and they – along with the commodities exchanges – provide the risk management services needed to balance demand and supply in the global energy markets.”

Meanwhile, said Hintz, while “it may appear that agreements like the Kyoto Protocol are falling by the wayside, the banks are well aware that there could eventually be a [U.S.] consensus that climate change is real and carbon reductions are truly necessary. If that happens, Wall Street will profit from the development of a new market.”

The new market will spur the big banks to offer – and trade – a range of products enabling the regulated community to meet the new rules. So, it’s no surprise that the major players are all jockeying for position.

“The ICE,” Hintz observed, referring to the Intercontinental Exchange in Atlanta, “owns the European Climate Exchange, which trades carbon offsets in the EU. While this is still a small business for ICE, by owning carbon-trading technology, they are well-positioned if, and when, carbon emission rules tighten around the world.

For the big banks, “There’s no way to make money trading carbon right now in the US,” Hintz pointed out, acknowledging that “there are voluntary carbon emissions regimes that have been established. California, for example, has its own little carbon trading network. But these state and regional markets are of little significance to the market.”

So, for now, “Wall Street is looking ahead to the day when carbon emissions are limited or taxed. These banks want to provide services to help their clients meet the rules as cost effectively as possible. They want to be able to buy forest land and get a carbon credit. They want to participate in carbon sequestration projects. And they want to be able to profitably trade carbon offsets that bring together companies that want to release carbon with companies that are able to reduce their carbon usage.”

Traditional Energy Trading Wins the Day, for Now

In the meantime, Hintz added, the major banks are still trading traditional energy as a way to profit from “spark spreads” – the difference between the cost to run a turbine and the revenue from electricity sales – and “crack spreads,” which represent the difference between the price of crude and its refined products.

For example, said Hintz, Goldman Sachs until recently owned in New Jersey a gas-fired power plant which “sold electricity into the New York market during the summer, when prices were very high, and reduced electricity production when gas was in demand and electricity was plentiful.”

In a statement to Breaking Energy, Goldman spokesman Michael DuVally said the plant was operated by Cogentrix [Energy], which owned interests in a number of power plants across the country. “Cogentrix,” DuVally said, “gradually sold down those interests in recent years and transformed itself into an energy project development company. In September, the private equity firm, Carlyle, announced it is buying Cogentrix from us.”

Hintz said that tougher banking regulations which limit risk taking are pressuring the banks to divest themselves of their power-producing plants, but “that just means the plants will be owned by a fund sponsored by the banks. The Street’s commodities businesses will evolve from balance-sheet business owned and run by the banks into operations in which the banks use their expertise to invest other people’s money in commodities projects.”

Oil companies won’t manage the energy risks for others. But the investment banks will.” – Hintz

One of the big banks, Morgan Stanley, has long been a major energy player: importing, storing, and producing energy. Although its prominence in those spaces has reportedly waned, all the big banks enable energy users and producers to hedge their prices.

Hintz observed that such exchanges as the Chicago Mercantile Exchange don’t offer options for poor-quality crude, “so you go to Morgan Stanley, Goldman or JP Morgan, which because of their size are able to manage hundreds of different oil sources and transportation risks and provide a form of price insurance that is not available elsewhere. Oil companies won’t manage the energy risks for others. But the investment banks will.”

A West Coast investment banker familiar with the carbon markets and new-energy financing agrees that the major investment banks have long kept their eye on carbon trading. The banker, who declined to be identified for this story, said, “Back when there was a reasonably active discussion on a national carbon-trading program, the big banks were all at the table. They knew that a mandate for carbon reductions would impose obligations on the companies releasing carbon, and they knew that the obligations would facilitate the creation of commodities [meaning carbon-offset instruments]. The banks would be happy to see liquid and diverse products arising from the quote-unquote carbon commodity.”

This is the second article in a two-part Breaking Energy series on investment banking and energy trading, read the first here.