Bridging the gap?
About a month ago I wrote about how carbon is embroiled in a “Fundamentals vs Technicals Deathmatch”, and from the vantage point of the five weeks that have elapsed since then, it looks like the technicals won. EUAs climbed to a 14-year high of €30.80, before immediately nosediving as the market suffered altitude sickness.
Now we find ourselves back in the €25-26s, roughly where we were before the Great Covid Sell-Off episode, and it feels like prices aren’t sure where to go next. Summer holiday season has begun, and while we’re not likely to be sunning ourselves on Mediterranean beaches this year, there is still a relative calm over the market. August is coming, with its traditional halving of supply, and there’s a sense of anticipation beginning to build.
There’s been a lot of speculation over market behaviour over the last month; principally, why prices have held up so strongly despite plenty of suggestions that they were heading even lower.
Some attribute the consolidation to one or more large players exerting a strong influence over trading; they’ve pointed to sharp rallies during periods of low liquidity – typically the last one or two hours of the session – when a determined buyer can sweep up small-volume offers and in so doing, move the market significantly.
Others have added that this sort of activity can spook traders that have put on short positions: the rally forces shorts to cover and this magnifies the price increase.
A few observers and traders point to compliance buying whenever the price dips. For the most part, they say, industrials have been absent from the market since prices started rising in May, but pressure of time – there’ll be no borrowing from 2021 allocations to meet 2020 compliance next spring – and a growing sense that the market is not going to revisit below €20 any time soon mean they need to start accumulating now.
And yet another set of participants highlight the bullish longer-term outlook, pointing to the review of the EU ETS and MSR that are due to start next year, as well as the negotiations over the Green Deal that would commit the EU to achieving net zero emissions by 2050. All of these policy proposals would likely mean a tightening of the EU ETS cap, a drop in EUA supply and higher prices.
There’s a great article in the Wall Street Journal that lines up all the reasons why carbon has gone up so much this year.
What I find interesting about these sudden spikes or drops is that there is never a follow-through. Prices shift – bang – and then they resume moving sideways at the new level. Normally, you’d expect a sudden move in prices to reflect some new information that gradually filters through the market and sustains the change in direction for a little while (days, even).
There may be a second “push” – as on July 23, for example – but the point is that it’s just that, not a change in the market balance or some news on supply or demand.
Then of course there are the afternoon shenanigans. At some point later in the day, when things are quiet, someone decides to sweep up the (relatively few) offers and drive prices higher on very little volume. Usually, this holds through to the close. The most obvious examples were on July 10, 14, 17, 21, 23, 28, etc etc… And there have been a few examples where the price has dropped like a stone into the close as well.
Stepping back to the wider picture, it’s interesting that very few have attributed the fall back from €30.80 to the current market fundamentals. It’s generally accepted that 2020 will be a dog’s dinner of a year in terms of market balance, that the verified emissions will be at least 200 million tonnes lower due to the virus and lockdowns, but this doesn’t appear to have been a factor in the market moves since we bottomed out at €14.34 in March.
So as we look ahead to August, the market is considering how to react to the 50% cut in auction supply. Bear in mind that in every August since 2008 – except in 2019 – prices rose over the course of the month. That’s despite participants being well aware of the auction reduction months in advance and despite frequent price rises during the second half of July.
If long-term optimism over the EU ETS is still the major driver, then prices should continue to consolidate or even rise next month, as long as those investors are still in acquisition mode.
But last year’s August decline is still something to think about. 2019 wasn’t a bearish year, even if prices ended up more or less unchanged over the whole twelve months. The fuel switch from coal to gas offset any longer-term bullishness for investors.
And since there is more or less general agreement that last year’s August fall was the product of the continuing shift from coal to gas, it'll be no surprise that it could still be a factor this year as well. German grid data shows that coal generation in January-July 2019 fell 21% from 2018, but it has fallen 35% from last year in 2020.
Conversely, gas generation gas grew 15% in January-July 2020 from the same period a year ago, and it had already risen 18% year-on-year in Jan-Jul 2019. In short, the fuel switch is still a factor this year, and this could be a bearish influence in August, particularly if there is no heatwave.
So the fuel switch is still relevant and still has a role to play; just not a very positive one.
August pricing may also be affected by the fact that the resumption of full auction volumes in September is in fact going to mean an increase in supply.
September is when the MSR shifts from the 2018 TNAC to the 2019 TNAC. As we know the TNAC for 2019 was 1.385 billion tonnes compared with 1.654 billion a year earlier. This means that the MSR takes out fewer EUAs (332 million in 2020-21 compared with 397 million in 2019-2020).
As a result, the typical EU auction will sell 3.6 million EUAs, including the recently introduced Innovation Fund volumes, compared to 2.7 million in the first half of the year. 419 million EUAs from August 1 through the end of the year, compared to 300 million for the same period in 2019.
And as we move into autumn there is also the possibility of a second wave of lockdowns. Already we are seeing signs of an uptick in infection rates in Europe and some piecemeal response measures from governments who are more frightened of an economic meltdown, but if the virus gets a serious grip we could go back to the scenario in March, which won’t be good news for anyone.
August looks like being pretty finely balanced in terms of price outlook: the cut in supply may mitigate some potential weakness, but there are darker clouds on the horizon.