• Alessandro Vitelli

Autumn stock-take

It's officially autumn; compliance buyers are weighing up the choice between doing their 2020 buying now or waiting till the spring, fuel prices are on the rise as temperatures fall, and analysts have updated their price predictions for the rest of the year. Time for a stock-take.


There's a real smorgasbord of factors to look at this year, and I've deliberately left out key elements like the weather (which I'm even less qualified to predict than the BBC), and economic indicators, (which frankly don't make any sense unless you're one of those lucky ones being spoon-fed by the Fed – maybe that should be spoon-Fed).


But even without those big-ticket players, there is an all-star lineup of influences that have been and will continue to toy with carbon prices.

1. Covid-19. Infections are on the rise pretty much everywhere in Europe, and the alarming rate of the increase in some countries has people worried about a return to the lockdowns of March and April. It’s pretty clear that such a move would be a last-ditch option for governments that are struggling to contain the economic and social cost of this pandemic, but it’s definitely an option.


If it were to happen, we’d see power demand drop massively, as they did in the period from March to May – just look at what happened in Germany. And as power demand drops, so does demand for carbon.


I'm assuming that governments are going to avoid national lockdowns, and try more targeted local measures. That's still going to hit productivity and business-industrial demand for power. Yes, there will be some compensation from residential working-from-home demand, but not nearly enough.


The Wartsila Energy Transition Lab shows that total power generation in the EU is down almost 6% so far this year, but within that figure, gas powergen is off by 8.5% and coal is down by a massive 22.3%. Nuclear is down 13.6%, while renewables are up 10%. When the time comes to add up 2020 verified emissions, we may well see power sector emissions down by something in excess of 200 million tonnes.

2. Brexit. Although Brexit never really went away, it was certainly bumped off the front pages for a while. Now it’s back, and just as risky as ever. The EU doesn’t want to sign a trade deal without knowing what the UK will do about state aid, but the UK doesn’t want to legislate a plan for state aid until a deal is signed. Of course, negotiation is often like this and there’s often an eleventh-hour compromise, but does anyone *really* know what’s going to happen this time?


And on top of the Brexit brinkmanship is the issue of what the UK does to replace the EU ETS in 2021. For a while last year a lot of people were pretty confident the UK would set up its own emissions trading system, but as the deadline approaches (and the government’s borrowing to offset the impact of Covid-19 steadily increases), the UK Treasury is seen to be leaning towards a carbon tax.


I think by now everyone in the market has given up on the idea of the UK remaining a participant in the EU ETS, and the possibility of a sudden flow of excess UK-issued EUAs into the market has been de-risked. This is primarily because UK-based traders will have shifted their registry operations onto the continent, while larger industrials will have trimmed their portfolio to match their actual emissions, or shifted them to European subsidiaries. There may well be some selling on the news that there will be no deal between the EU and UK, but any UK surplus sales will probably be swallowed up in the wider sell-off.

3. The US presidential election. Of course, markets are on high alert any time there’s a major election, but I think most will agree that this one is even more important to the climate sector. On one side we have business-as-usual, also known as no interest at all in climate, while on the other you have a pro-Paris, pro-energy transition platform.


The timing of this election is especially important: China recently announced its own carbon-neutral target, and EU leaders will probably have agreed a 2050 net zero goal by the time the election takes place. Remember also that the US formally exits the Paris Agreement on November 4, the day after the vote.


A win for the Democrats and a re-commitment to Paris certainly boosts sentiment and reverses, at least symbolically, the direction the US has been taking for the last four years. Practical climate legislation, however, will depend on the outcome of the Congressional elections.


4. European climate ambition. The market had a little bit of fun with itself when the Parliament unexpectedly (at least to me) voted for a 60% reduction target for 2030. Prices shot up to nearly €28 in the moments after the result was announced, but within two or three days they were testing short-term lows. I like to think traders thought more deeply about the result of the vote and the likelihood of 60% surviving the negotiations among member states.


The upcoming process is going to be quite a show: there are a variety of 2030 targets being promoted: Denmark’s 70%, Finland’s 60% and Germany’s 55% for example. Eastern member states are being a little more coy, and it’s hard to see them wanting to push much harder than the lowest common denominator. But the talks will be long, detailed and who knows? they could take more than a couple of months to sort out.


It's more likely that we’ll see member states come to agreement on their 2050 net-zero commitment this autumn. While this has less immediate relevance to the market, it does underpin a long-term pathway that strategic investors will hope to follow.


All of this will be more or less supportive in the longer term for EUA prices. Now that the market knows the 2030 fight is more or less a straight shoot-out between 55% and 60% traders can price in whichever outcome they consider more likely. It’s worth remembering the price action from the morning of October 7 though, when the Parliament vote was announced. It still feels to me as if the baseline scenario is 55%.


5. Market fundamentals. As I have written before, the EU ETS is straddling a pretty bearish set of short-term fundamentals and a rather more upbeat long-term view. EUAs are well within the fuel-switching price band, and as long as nothing much changes in the power complex, there doesn’t seem to be much need for them to go higher right now.


Auction volumes are much higher in the second half of 2020 than they were in 2019, and for many traders this is a fairy constant bearish pressure on the market. During September the cover ratio was never higher than 1.95, while the discount to prevailing spot prices has widened to €0.05 since the end of August, compared to a year-to-date average of €0.04.


The data is beginning to describe a system where buyers know just where to pitch their bids to ensure the volume is delivered, but at the lowest possible price. And of course, the active Trade at Auction market means that there is a ready supply of non-participants ready to take on that length. But for how long?


Demand from compliance buyers is one thing that may put a floor under prices. Industrials are normally willing to buy at a price that’s usually around €1-2 below where the market is at any given time, but lately that discount has begun to narrow. This could be due to the “no borrowing” rule that is in place for 2020 compliance, which has been widely advertised to buyers but which may still catch some companies out. Any company that's been running a deficit by borrowing each year's allocation to pay off the previous year's compliance has a steep reckoning coming.


And once we get 2020 compliance out of the way there will be a process of discovery for industrials, many of whom will find out they are to be given far fewer EUAs for free in Phase 4. With cashflow under pressure due to Covid, we will probably see a return to borrowing for at least the first three or four years until the outlook is clearer. But with free allocations falling behind verified emissions for many more installations, that’s only a short-term solution.


And what of the speculative traders? We have seen a lot more within-day volatility, suggesting that the short-term speculators are still happy to ride the waves. Intraday price moves were considerable in June-July and again in September, and this encourages a more short-term strategy, particularly when the medium-term picture becomes unclear at the same time. That volatility is shrinking a little as we move into October.


The analyst forecasts suggest that there is not much upside to prices over the remainder of this year. The consensus Q4 forecast falls between €27 and €28, not too far from where we have been over the last three weeks. The general view is as expressed above, citing Covid, Brexit and the EU’s climate legislation as the main players. If there is not much short or even medium term upside, then perhaps this explains the sideways channel that we’ve seen since early September.


Of course, once we get to 2021 things may look brighter. Tighter allocations, a steeper LRF and the loss of the UK’s net long position in the market are a good start.


Look even further ahead and you are staring at the European Commission’s “to-do” list, which includes the MSR review, a possible Border Carbon Adjustment Mechanism, and a re-basing of the EU ETS cap in line with the new 2030 target.


6. Coal plant EUAs. I’m not going to let this go without thumping my particular drum – the looming impact of coal plant phase-out policies. Not many people seem to be paying attention to this issue, but it’s going to be influential.


To date, we have commitments from at least 13 countries to quit burning coal for power by 2030. Add to that Germany (2038 deadline) and Poland (2049), and the 7 EU member states that are already coal-free, and you have 22 out of 28 member states.


Of all these, just one – Germany – has made any comment on what it will do with the EUAs that those coal plants will no longer need.


Remember, EUA cancellations are a member state decision. The EU ETS cap has already been decided, and the allocations (including auctions for the power sector) will be made every year. So we have to know what those countries will do about unneeded EUAs.


Here’s an example. Back in 2013, total UK emissions from gas and power were 142 million tonnes. The country auctioned 107 million EUAs – a sizeable shortfall.


However, by the time we got to 2018, Britain sold around 100 million EUAs while the emissions from its coal and gas-fired power plants had fallen to almost a third of that number. There had been no adjustment to the auction volumes at all – in fact auctions were higher in 2017 and 2018 than they had been in the three preceding years.


No matter what anyone in Brussels says about steeper 2030 targets, and a rebasing of the cap – probably in 2026 – once coal plants start closing in larger numbers, auctions are going to be flooded with EUAs that nobody needs. I’ve estimated elsewhere that the market could take in as many as 2.5 billion EUAs (gross) between 2021 and 2030 that are simply not needed.


Of course you can understand governments’ unwillingness to cancel such a large number of EUAs and the revenue they represent, particularly in view of the debt they’re running up battling Covid-19. But the fact remains that unless these EUAs are taken off the market, and permanently, they will keep a pretty heavy lid on prices.