Can Brussels chase the speculators out of the EU ETS?
Party coordinators in European Parliament’s environment committee want to clamp down on speculative traders participating in the EU ETS. There’s been a steady drumbeat of complaints over the past few months from MEPs and some member states, claiming that unnamed speculators have driven the price of EUAs too high, and that it’s costing industry too much money.
Leaving aside the issue of the five-fold increase in natural gas prices and a trebling in power prices over the past 12 months, carbon is seen by some elements in Brussels as the scapegoat, a key cause of the problem, and Something Must Be Done.
Let’s just focus on the numbers for a moment. A megawatt of electricity in Germany (which sets you back nearly €200 right now in the wholesale month-ahead market), represents about half a tonne of CO2 emissions (€44) if you’re using gas to generate, or let’s say one tonne (€88) if you’re using hard coal.
A year ago, that megawatt of power would have cost you around €65, and the carbon component would have cost €27 for gas or €55 for coal.
Just compare carbon’s share of that power price. A year ago the cost of carbon represented 42% of the wholesale power price (85% for coal). Today carbon’s share is 22% (gas) or 44% (coal).
And the Brussels contingent thinks carbon is the problem?
Yes, we should acknowledge that politicians are doing what they can to mitigate the impact of high energy prices on consumers, mostly by setting maximum tariffs on domestic prices and absorbing the difference from the wholesale price.
That comes at a significant cost to national treasuries, but happily the strong price of EU Allowances is pouring approximately €200 million a day at current EUA prices into the coffers of EU member states.
So high carbon prices are not only helping to prevent catastrophic climate change, but they are also helping governments offset the impact of high energy costs. Win-win, yes?
Going back to the high price of EUAs, exactly what price of carbon would be low enough to satisfy politicians and populists? €20? €60? Or should the carbon price be analysed against the costs of those commodities that it impacts?
We’re back in this tug-of-war in which overall climate ambition comes up against sectoral interests, and it makes you wonder whether MEPs actually talk to each other.
Despite all the above, the Brussels contingent has decided that the one way to combat the impact of ever-rising carbon prices on the cost of energy is to limit access to the market for what it calls “speculators”.
None of us are naive enough to believe there aren’t any speculators in the market; there’s enough evidence to show otherwise. The immense price increases in 2018 and 2021 were said by some to be the product of speculation, but in both cases – coincidentally – the EU brought forward major legislation designed to tighten the EU ETS.
So how much of those price jumps was driven purely by speculative buyers, instead of by compliance buyers who read the same analyst reports and decided to buy carbon while it was still relatively cheap. Is that speculation too?
The challenge arises when you try to gauge specs' influence on prices and when you try to understand what the market would look like without them.
Data is a little imprecise. For a start, the Commitment of Traders reports detail positions held by what regulators call “investment funds", which I suppose is a pretty good proxy. However, ESMA’s recent report suggested that there is some mis-categorisation of some participants, so we can’t really be 100% certain.
And other categories, like “other financials” or “commercial undertakings”, are a little vague. Some clear definitions would be useful, for a start.
In any case, CoT data shows that investment funds’ holdings of long EUA positions fell from 54 million EUAs at the start of February to just 27 million a month later. Since then, they’ve grown again and were at 37 million last week.
Compare this to “investment firms and credit institutions” (i.e. banks), who held a combined short position of 692 million EUAs last Friday.
That’s because banks tend to buy and hold spot EUAs on behalf of compliance entities. They hedge this physical position by selling EUA futures, hence the short futures position.
So banks have bought nearly 700 million physical EUAs on behalf of clients, and investment funds have bought about 5% of that total in futures.
But this is almost beside the point. The politicians are worried about the price rising, so maybe we should look at price action instead of the slice-of-time data.
At the root of this market we have one seller – the EU – and several thousand buyers. The EU sells once a day, in the auction where there is an average of 22 buyers, according to EEX data.
So where do all the other thousands of buyers go? Well, many of them buy bilaterally from service providers like aggregators, banks, or trading houses (the sort of companies that would be categorised as “commercial undertakings" or "investment firms and credit institutions" in the CoT report).
Some of them – relatively few – are large enough to be members of the futures exchanges, with the financial resources to sustain positions on ICE or EEX. But as exchange margins rise even further, active participant numbers are declining.
So the CoT data suggests there are fewer investment funds active in the market compared to last year. As far as traders are concerned that means there are comparatively more compliance buyers, and perhaps more intra-day traders.
Algorithmic trading is also becoming more influential, traders say. The exchange “order book”, which shows the live bids and offers, shows many more bids and offers for 1 lot (1,000 EUAs), often appearing and disappearing within seconds and reappearing at a different price as the market moves.
I've lost count of the times that traders have mentioned "algos" and their increasing influence on the market as orthodox participation has declined in recent months.
Anecdotally, “human” participation in the market is falling. There appear to be fewer traders placing bids and offers, and the spread between those can be as wide as 30 or even 50 cents at some points during the day. That’s a far cry from the historical norm, where spreads were more like 2-3 cents.
Less participation also means less volume on the screen, and when someone does decide to buy or sell, they need to chase the market farther to fill their order. This means steeper price moves which under more normal conditions may not have been merited.
So when a politician makes a market-moving comment, as Peter Liese - the senior MEP on the EU ETS reform file did on Wednesday, the market reaction will be even more violent.
The result is worsening price discovery and greater difficulty in trading. Even if you’re a small industrial looking to buy just 1,000 EUAs, you’ll be dealing with a seller who has to lay off that risk in the futures market. And if they can’t do that easily because the algo offer keeps disappearing, then their prices won’t be as sharp and the execution may not be as swift.
Speculative traders have a sizeable function in this and any market. They add liquidity, they add price transparency and they make it easier to trade at any given price. Yes, they’re trading for their own book, but they are also making it easier for others to trade.
If politicians want to scare away these specs, then they can look at the current market and get a pretty good preview of what the result would be.
Daily volume in the benchmark December 2022 futures contract this month is averaging 23 million EUAs. In April, it was just under 19 million EUAs in April. Last year, the market traded closer to 27 million EUAs a day.
To repeat: traders complain about the lack of participation, the lack of volume in the market, and are worried that Brussels’ words and actions are deterring the participation of the kind of entity that makes it easier to trade carbon.
So what is Brussels planning to do?
So far, there’s not a lot of meat on the bones of any legislative proposal. As far as we know, the proposal that goes before the Parliament's environment committee next week intends to prevent financial speculators from opening EU ETS registry accounts.
Which is… pointless?
How many speculators actually hold, or want to hold, physical EUAs? The point of speculation is to get in and get out of the market in a hurry.
By stopping specs from opening a registry account, the EU would prevent them laboriously buying spot EUAs, waiting two days to take delivery, making sure that two people were on hand to clear the transfer, and then repeating the same process whenever they wanted to sell.
That’s before you consider the relative illiquidity of the spot market, which trades an average of just 3 million EUAs a day on screen.
Just for giggles, someone should take a look through the various national registries, and count just how many investment funds or ETFs actually have registry accounts. I haven’t done it, but I’d be willing to bet that hardly any of them do.
The easiest way to get exposure to the price of carbon is to access the futures market. It's quick, you can leverage a position and you have a liquid pool of counterparties to trade with.
To be clear, there is no indication in any legislative proposal of whether the EU intends to restrict access to the futures market. The proposal only talks about registry accounts.
And how much impact would this proposal have? Probably none.
Furthermore, we don’t yet know exactly how the Parliament intends to classify “speculators” or which exemptions there should be.
And that’s a fun part: exemptions. The Parliament wants to allow some non-compliance participation. It recognises that the market needs, even requires, some intermediaries. Anyone who is carrying out business on behalf of a compliance company, for example, should be allowed to play.
But again, how exactly does Brussels plan to identify these companies that provide services to compliance entities? I mean, you have large utilities who manage compliance for smaller utilities.
You have aggregators who buy EUAs for smaller industrials.
You have retail banks who buy EUAs and hold them for larger industrials.
Would any of these companies engage in speculation? Possibly.
When a utility trading desk unwinds a hedged power position to put on a more profitable one, couldn’t that be seen as speculative trading?
If an aggregator builds a large position ahead of expected compliance demand, is that speculation?
And banks were known for running large proprietary books a few years back. There’s nothing to stop them from doing the same today, alongside their sizeable client business.
And what could the EU do about speculation, anyway? Would someone from each of these companies have to go before a judge and swear that they will only buy or sell EUAs on behalf of an industrial client?
Would there be someone from ESMA peering over the trader’s shoulder watching which account EUAs are sent to?
On a purely practical level, it’s hard to work out how exactly the EU would prevent non-compliance companies from participating in the market. While all the talk is about preventing speculators from opening registry accounts, this is widely derided as a pointless measure, as I’ve discussed above.
The obvious answer would be to prevent speculators from accessing the futures market. But how exactly? There are so many routes to the market that it’s really difficult to see how it could happen, unless exchanges were ordered to submit membership applications to the EU.
The EU would have to find a way to block, or rather filter, access to the futures exchanges. And companies would have to prove (see above) that they are carrying out client business.
But again, there are intermediaries that offer exchange access as well, so they would have to be controlled. What about retail outlets like IG Index and SparkChange?
It’s also tempting to point out that there is just as much speculation in gas, power and coal markets, and that the EU doesn’t seem to be interested in those.
Saying that you’re going to chase the speculators out of town probably goes down well in a Eurosceptic-leaning member state, or with a popular audience that’s grappling with the effects of high energy prices.
But the EU ETS isn’t the source of the problem, it’s just a symptom.