• Alessandro Vitelli

A maturing market, but less of it?

In principle, carbon emissions markets are self-destructive. Once the cap on emissions has been lowered to zero, or as near to zero as it can be, then the market has served its purpose and can be dismantled.

Obviously this doesn’t happen overnight and Europe's ETS is still a long way from that goal, but there should be some evidence over time that the market is making clear progress towards this goal.

Sunday's Financial Times contains an interesting article detailing the entry into the market of big-name investment funds, who are not necessarily interested in the short-term gyrations in the price of EUAs but rather the "opportunity to cash in on a market whose direction will ultimately be dictated by politics and support for a “green recovery” after the pandemic."

This suggests that the EU ETS is approaching maturity as a financial market, and that investors are willing to treat carbon in the same way they do financial derivatives, currencies or commodities like gold. The volume of trade in the carbon futures market is at a record high, which seems to reflect the increased speculative and investment activity as detailed in the FT.

The chart below compares the aggregate volume of trade in the rolling front-December contract on ICE Futures each year since 2010. In 2020 we should see the market trade more than 4.5 billion front-Dec EUAs. Compare that to 2010 when the market barely topped 2 billion EUAs.

But pretty much everywhere else I look, the data points to a market that is shrinking, in line with the basic premise of cap-and-trade markets outlined above.

Take the most obvious statistic: the declining cap on emissions, as expressed through the total supply of EU allowances. Naturally, this is steadily falling.

As a corollary of the shrinking physical supply, the open interest in each front-December contract during the year of its expiry has tended to be lower in recent years.

Why has open interest been declining?

One possibility is that as the cost of carbon started to impact utility margins for coal-fired power, coal plants were increasingly sidelined, resulting in lower hedging demand and therefore lower open interest. We know that fuel switching was particularly heavy in 2019, and it's significant that OI in 2019 dropped significantly starting in the summer. It's probably no coincidence that power emissions fell by approximately 100m tonnes last year.

It could also reflect the transfer of futures positions into physical holdings of EUAs over time.

Elsewhere, in the auction data there are also signs that this particular corner of the market is becoming the province of smaller players. The typical volume of EUAs being offered at auction is shrinking, but the number of individual bidding entities is rising. (I stress "typical" because 2019 and 2020 have been affected by the UK's suspension and reinstatement).

In the chart above the respective trends are illustrated by the yellow line (auction volume) and black line (number of bidders).

At the same time the total number of bids placed at each auction is declining, and so (rather faster) is the size of those bids. So we could suggest that there is a trend towards more (see above) but smaller companies entering the auction, seeking to cover their own requirements at a pre-set price, rather than large speculative or intermediary participants that are ready to increase their bids to secure volume.

One important statistic to add to the above is that on average around 70-75% of all bidding entities are successful in each auction. So more participants, smaller bids and still the same success rate.

(It's also worth remembering that if or when the EU imposes border carbon adjustments on imports, free allocations will probably decline, driving more compliance entities into the auction market.)

What does this signify? One theory is that non-compliance participants are becoming less interested in holding physical EUAs, but instead prefer to focus on futures and options. Once upon a time, banks were significant intermediaries in the market, taking large physical positions through the auctions on behalf of their clients. But since many banks have quit the EU ETS over the last decade, the job of intermediating has fallen away, or been taken over by smaller aggregators.

This increase in participation is a notable deviation from the standard definition of a mature market: typically as a market ages, the number of participants shrinks until there are just a handful of dominant players. Take grains, for example, where just four companies – Archer Daniels Midland, Bunge, Cargill and Louis Dreyfus – account for three-quarters of the grain moved on world markets.

The EU ETS' deviation from this definition of a mature market is probably due to the fact that the it has in-built protection against barriers to entry for new players: anyone can bid in the auctions as long as they meet the qualifications, and more than 11,000 separate buyers must by law participate in the market to some extent.

All of this is to suggest that the headline data on price, volume and volatility in the secondary (futures) market all point towards a busy market with plenty of speculative as well as investment activity.

We're not in the same league as crude oil just yet – US production of crude is currently around 10.7 million barrels a day, according to the EIA, yet WTI futures on CME traded more than 650 million barrels on August 21.

Beneath the increasingly hectic carbon futures market, the physical underlying primary asset is becoming more scarce, and smaller compliance buyers are having to actively manage their own positions where beforehand they may have relied on banks.

Meanwhile, futures have become sufficiently liquid and mature to support the same sort of investors that other mature markets such as crude oil are able to support. Sunday's FT article seems to confirm that development.