Updated: Apr 4
It’s been a somewhat wild start to 2022. As the energy index below shows, we had a relatively calm start to the year before Russia invaded Ukraine and the fertiliser hit the fan.
Europe's carbon market saw extreme volatility as speculative investors stampeded to the exit, there were reports of margin calls in natural gas that forced some traders to liquidate EUA positions, and even some juicy theories about Russian investors clearing out their holdings from funds that were active in carbon as well.
Now we’re seeing a market that is a pale shadow of its former self. Average daily trading volume in the front-December futures contract on ICE is down by around a third since the invasion, bid-offer spreads are widening, and volatility is up, up, up.
And there has been one really interesting development that I wanted to focus on here, which is the development of an inverse correlation between carbon and natural gas.
Under “normal” conditions, that is to say, when the carbon price is actively discouraging the combustion of coal to generate power, the prices of carbon and natural gas should move in tandem.
That’s because if gas becomes relatively more expensive to coal (which means that coal becomes relatively more attractive for power generation) then the price of carbon needs to rise to continue to “punish” coal.
So, back in the heady days of 2018-2021, we see a pretty consistent positive correlation between gas and carbon, as shown in these two charts:
Since the second half of 2021, though, gas prices have risen far, far beyond a level where the cost of carbon can compensate to keep discouraging coal use. Basically, Coal is King again.
We’ve seen this in the generating data, we’ve seen it in government plans to extend coal plants’ operating life, and even in plans to bring some coal units out of strategic reserve. Just yesterday, RWE said it would close a unit at its Neurath lignite station, but it would keep it in reserve in case the current crisis requires.
Natural gas is also a very important part of some industrial processes, such as metals, cement, chemicals like ammonia, and fertiliser too. And those same high prices forced a lot of industrial installations to close down, or at the very least to reduce operations, late last year.
So there’s a “new” relationship in town that's driving the price of carbon: a rising gas price means reduced industrial production, which in turn means reduced demand for EU Allowances.
So instead of EUAs rising with gas, they’re moving in opposite directions. And recent data shows the emergence of this inverse correlation.
And the correlation is very clear in the day-to-day trading in the energy markets. Take March 31, for example, when Russia’s president Putin confirmed new rules requiring western buyers to pay for their natural gas in rubles or face a cut-off in supply.
As gas traders panicked and started buying in response to the flash headline, carbon sank like a stone. Compare this to the gradual and tandem rise in both markets during the first half of 2021, when demand for gas was just getting started.
So the received wisdom, that carbon and gas prices move together, is – temporarily? – deceived wisdom.
A quick observation about the decline in liquidity and the increase in volatility in the EU ETS this year.
As market makers and spec traders have withdrawn from the market over the past month, it’s meant that buyers have less choice when it comes to live offers. Any determined buyer who needs, say, 50,000 EUAs can try to buy on ICE, but prices will travel higher pretty quickly, as we have seen on numerous occasions.
Data from the daily auctions shows a marked increase in the total number of bids since the start of March.
Sure, this might reflect greater compliance demand ahead of the annual deadline, but it could equally suggest that more traders are prepared to compete in the daily auction rather than risk driving volatility in the secondary market.
Some EU governments have blamed speculative traders for high and volatile EUA prices, saying that investment funds should be banned from the market.
But these are the traders that provide liquidity and make price discovery easier, and their positions have been cut drastically in the last two months.
Can it be a coincidence that since non-compliance participation has decreased recently, bid-offer spreads are wider now than they have been for a long time? 5-10 cent spreads and more are not uncommon today, compared to 1-3 cents as recently as February.
And interestingly enough, the European Securities and Markets Agency issued its final report on trading in the EU ETS this week, finding no evidence of any abnormalities in the market. It did find a few things it doesn’t like in the over-the-counter market, and indeed in the auctions, but there was no finger-pointing at any individual category of participant.