• Alessandro Vitelli

"Fasten your seatbelts, it's going to be a bumpy night."

Compliance season is almost over. A large proportion of industrials have by now completed their 2020 purchases, and the market seems to be on the verge of crossing €45/t at the same time.

So we turn to the question of “what next?” Here are some of the factors I think are at play.

Industrial behaviour

Firstly, if the market has been strongly supported by compliance demand, then there’s the possibility that with that demand shortly to disappear, prices will sink back.

Bear in mind that industrials have been big fans of the borrow trade: in the first year of Phase 3 they started with a clean sheet, and on receipt of their 2013 allocation, many will have sold off much of that allocation to generate cash.

When the time came to complete their 2013 compliance, they could use their free allocation for the following year, which is conveniently distributed in February and March each year, well before the April compliance deadline. And so on, all the way to last spring and 2019 compliance.

This “borrowing” is fairly commonplace, and the temporary working capital that those EUAs represent has got industrial companies out of some sticky situations before.

But with the market transitioning from Phase 3 to Phase 4 in 2020-2021, borrowing was not allowed for 2020 compliance. This meant that those industrials that had sold a year’s worth of EUAs to generate capital earlier in the Phase, have had to buy them back.

Or, to put it in literary terms, “Borrowing dulls the edge of husbandry.”

You may choose to believe that not many companies actually did exploit the “borrowing” option, in which case the six-month long market rally that we’ve seen is due mainly to speculative interest and to anticipation of stricter market parameters in the EU’s reform package.

Or you may choose to believe that lots of industrials used the “borrowing” strategy, in which case you could suggest that much of the demand that has driven the market since the start of 2021, or perhaps even since November, may well be due to companies clawing back their “borrowed” EUAs.

The truth is probably somewhere in between. After all, the recent news of some Romanian installations getting caught with their EUA pants down didn’t give the market much of a boost, but it didn’t hurt, either.

However, now that we are starting afresh in Phase 4, industrials have a clean slate, and in June they’ll get their first allocation of free EUAs. Presumably, some or many of them will want to generate that working capital again and so we could reasonably expect some selling pressure over the summer.

Shoe-gazing specs

With that in mind, the speculative traders have to consider their next moves as well. If you discount compliance buying, specs have been the driven force since November, and the Commitment of Traders data back this up: at the end of October investment firms held long positions totalling just over 36 million EUAs. That total rose to just short of 80 million in March. Commercials increased their holdings from 111 million to 155 million over the same period.

Throughout this period the market sentiment was driven by expectations of ambitious reforms, compliance demand, rising markets in energy commodities and other instruments, and the virtuous cycle of speculative investment itself.

But with compliance done for another year, and the prospect of a renewed bout of industrial selling, will funds hold the line? I imagine there’s a certain amount of navel-gazing going on right now.

UK ETS ramifications

In about a month’s time, the UK will hold its first auction of UK Allowances (UKAs). Until then, British power generators have generally been assumed to be buying EUAs to hedge any forward power sales. But once UK auctions start and the UK secondary market starts to trade, many people expect utility purchases of UKAs to be accompanied by sales of EUAs, since these are not eligible for UK ETS compliance.

However, there are two wrinkles here: firstly, not only are UK utilities going to be unwinding EUA hedges for all the power sales they’ve made since December 31 2020, but they’re also going to be hedging any new power sales they make.

And that’s before we try to calculate how much post-2021 power they sold in 2019 or even 2018 (and hedged with EUAs).

UK allowance supply is not huge: the auctions will offer around 6 million UKAs every fortnight, and there are no backdated volumes being offered. Utilities may have to compete with investors, client-facing banks and traders for those 6 million EUAs.

All of which is to say that the liquidation of unneeded EUA hedges probably won’t be a big, bold sell-off, but instead a long, drawn-out drip-drip-drip of additional volume into the market.

A bullish TNAC?

Given the significant decline in emissions in 2020, the Commission’s calculation of the Total Number of Allowances in Circulation (TNAC) is likely to show an increase from 2020, meaning that the market stability reserve will take out more EUAs from the auction reserve than it did between September 2020 and August 2021.

A smaller auction reserve for September 2021-August 2022 should be bullish, of course, though it might be instructive to try to estimate just how much of the decrease will be offset by the flow of EUAs from UK utilities.

Let’s assume that the MSR will remove around 350 million EUAs in 2021-2022 – that’s half-way between what it took out in 2019-2020 and in 2020-2021. That cut of 350 million EUAs would generate a deduction of around 860,000 EUAs a week compared to the current schedule for January-August 2021.

That supply cut could be compensated to some degree by UK utilities selling a theoretical maximum of 3 million EUAs a week as they replaced their historic EUA hedges with UKA hedges, but of course this is unlikely to actually happen. The actual flow of ex-UK EUAs will be somewhat smaller, for sure.

Politics, lovely politics

And finally, politics will soon wake up and start meddling with the market again. The European Commission is expected to table wide-ranging reform proposals for the EU ETS - see here for my round-up of the various possibilities.

Most participants agree that the reform is by nature bullish, but what’s not clear is whether the Commission and its political masters will be tempted to soft-pedal the reforms in the short term while the geopolitics play out. For example, China and the US pretty much disagree on everything at the moment, and the last thing the EU needs is both of them deciding that a Carbon Border Adjustment Mechanism is a Bad Thing, and directing their unhappiness at Brussels rather than each other.

So will a CBAM proposal be as ambitious as expected? Will it start off applying only to the power sector rather than to steel, cement and chemicals?

CBAM apart, a steeper linear reduction factor, perhaps a re-basing of the cap, some tweaks to the MSR are all in the mix, and any combination of these is probably bullish long term. And given what we have learned about funds and inter-temporal efficiency, any strong hints on these proposals would likely be priced in pretty quickly, regardless of when they would take effect.

All these elements make up for a powerful cocktail of volatility. We've just finished a week in which prices fluctuated in their narrowest range since October last year. There's maybe another week of this before the market is cut loose from the predictability of compliance. Fasten your seat belts....

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