• Alessandro Vitelli

Growing pains

The UK ETS has been up and running for more than a week now, and while it might be stretching things to say that we can already see a few trends, there are nonetheless a few interesting developments worth noting.

UKAs for delivery in December this year have traded at between £45.10/t and £51.75/t in the eight days that the UK ETS has been operating. In euro terms, that’s a range of €52.00 to €59.76. Over the same period, EUAs have traded between €48.61 and €54.70.

The first auction saw a cover ratio of 4.84; auctions in the EU ETS haven’t had cover ratios that high since 2018.

So demand appears to be pretty healthy, even if relatively few participants seem to be set up to carry out trading yet. The general expectation is that trading will pick up over the next weeks and months as more companies finish jumping through the various regulatory hoops.

The high UKA prices also mean that there is already a risk that the cost containment mechanism will be triggered. The CCM would simply add some supply to UKA auctions in an effort to lower prices.

The UK’s version of the CCM operates in much the same as the EU ETS’ infamous Article 29a does. There’s a rather opaque formula that calculates the rolling average price over the last three months, and compares that to the rolling average of the preceding two years.

(EDIT: The passage below has been edited to clarify the CCM formula)

In 2021, if the mean settlement price of the Dec-21 UKA futures over the last 3 calendar months rises to more than double* the average benchmark price over the preceding two years, then the CCM is triggered and the government must consider whether to bring additional supply into the auctions.

The "double" multiplier will change to to 2.5 next year, and then to 3 in 2023. The same multiplier in the EU ETS is 3 but the front-year price must be above that for six months, which explains why the UK government states that its CCM "will allow quicker intervention in the early years if appropriate".

At the moment the CCM formula uses mostly EUA prices and Band of England foreign exchange rates, but as time passes the EUAs component will naturally become less important and eventually disappear altogether.

Conveniently, the government has done the calculation for us: the trigger price for the CCM was set at £44.74 at the start of the market, implying the two-year average up to the end of April was £22.37. If the Dec-21 settlement price averages more than that during the period from May to July, then the CCM will be triggered in early August.

The trigger will be updated on June 10, with prices needing to hold above that level between June and August in order to trigger a September intervention.

So what we have is an overlapping set of trigger prices, each one in place for three months.

Since UKA prices have closed considerably above the May threshold on each of the market’s first eight days, there is already a potential risk that the CCM could be triggered by the end of July.

According to the regulations, government can boost supply in a number of ways. Firstly, it can bring forward additional UKAs from auctions scheduled later in the same year, or from later years; secondly, it can release up to 25% of the New Entrant Reserve. And finally, at some point in the future when the UK market stability mechanism has any UKAs in it, then these too could be released.

But the last couple of days have raised another possibility, and to understand this we have to go back to the planning stage of the UK ETS.

The original regulation setting out the market parameters indicated that the maximum number of UKAs that would be allocated for free was 58 million. Later this limit was lowered to 39 million, leaving a bank of around 19m UKAs unused.

Those 19m UKAs were set aside to be used in the event that allocations of free UKAs to industry exceeded the market’s cap. Rather than applying a “cross-sectoral correction factor” – applying a ”haircut” to every installation’s free allocation – these UKAs would be allocated instead.

Most recently, however, the government has been considering whether this reserve could be added to the auction reserve this year. Reports emerged late on Friday that the government is considering moving the 19m unallocated UKAs into auctions in 2021. This suggests that the authorities are already concerned at the UKA price premium to both EUAs and to the CCM trigger price.

So right from the start the UK ETS is being stress-tested. Utilities need more UKAs than are coming to market, and industrials may not be minded to sell some of their free allocations as they might have done in previous years. Indeed, a few traders I’ve spoken to have suggested that the lack of any historic surplus in the market and the tightness of the first allocation may mean we see hardly any selling apart from in the auctions.

If I wanted to put my conspiracy theory hat on, I might even suggest that the UKA price is so high because the market really *wants* the government to issue or auction additional UKAs.

A reminder

Just as a reminder of what the supply and demand for UKAs may be:

Total free allocation to around 460 stationary installations for 2021 is 39,091,102 UK Allowances. For the purposes of comparison, those same installations emitted 56,710,701 tonnes of CO2e in 2020 under the EU ETS.

Total auction volume in 2021 will be 83,001,500 UKAs. To date, just 6,052,000 have been sold; the next auction is scheduled for Wednesday June 2.

So supply this year is 122,092,602 UKAs. Again just for reference, total UK emissions from stationary installations under the EU ETS in 2020 were 102,575,278 tco2e. There’s not much to suggest that the number of installations covered by the UK ETS has changed materially from under the EU ETS, so on the surface of it, the market looks a little long.

(And we should bear in mind that the New Entrant Reserve totals 30,249,066 UKAs for the entire period from 2021 to 2030.)

So on the surface of it, the market seems comfortable on a within-year basis (analysts notwithstanding). However, as I explained in the blog on May 10, there’s pent-up demand from utilities to “re-hedge” the last two years of forward power sales.

If we assume that power generators hedge forward sales at a rate of 70% for the first year ahead and 30% for the second year, then that’s basically one whole year of utility emissions on top of whatever hedging they’re doing this year for 2022 and 2023.

So, for 2021 at least there’s actually a shortfall, and this might be what’s pushing prices higher and forcing the government to resort to unorthodox measures to boost supply.

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