No time to be tinkering
An excellent article by Carbon Pulse published today reveals that members of the European Parliament are concerned about excess price volatility in the EU ETS and are planning to consider ways to dampen speculative activity in the market.
This sudden concern arises from the market’s steep rally from a low of €14.34 back in March to a peak of €29.93 a couple of days ago, as the psychological impacts of Covid-19 lockdowns wore off and central banks began pumping more money into the system.
The latter stages of the rally appear also to reflect some forward thinking by strategic investors and speculative traders; the former looking ahead to reforms of the EU ETS as part of the Green Deal, and the latter simply happy to ride along.
The headline number of course is the doubling of prices, but that’s misleading.
Let’s strip out the Covid-19 impact. On March 5, more or less the day before energy commodities started their Great Covid Sell-Off, the EUA market stood at €23.81. So the increase to €29.93 would be more in the order of 25%.
For sure, the price collapse to €14.34 offered a terrific opportunity to build some length at well-below average prices, and industrials as well as utilities and investors were all involved in March, April and even into May.
And you could say the same thing for other energy markets too. If you look at the price charts for energy commodities in general, all of them reacted in the same way as carbon. The divergence only begins in the middle of June, when power, coal and carbon had recovered to 95% of their pre-Covid prices.
So we should probably discard all the price movements that happened up to then.
Since June 16, carbon has risen 28%, power has gained 11%, while coal had natural gas have added 7% each. This is the movement that we should be focusing on, rather than the "doubling" of carbon prices.
The volatility in the EU ETS is driven by the anticipation that the EU will start applying additional regulatory fixes to the single biggest problem the market has – a historical oversupply that is not being drawn down quickly enough.
This year alone, Covid-19 has cut demand for 2020 by around 200 million tonnes, analysts say, while over the next decade coal phase-outs are going to cut demand for EUAs from one of the largest emitting sectors in the market.
In Phase 4, which starts next year, we already have a tighter cap, reduced free allocations and a steeper annual reduction in the overall cap. The Green Deal negotiations will launch yet another review of the EU ETS, including whether to boost the 2030 target to 50 or 55%, whether to extend the MSR’s 24% withdrawal rate, new sectoral coverage, etc etc.
When the EU starts to discuss such reforms, people naturally expect that supply will get tighter and prices will go higher. I mean, what else would anyone logically conclude?
There’s plenty of anecdotal evidence to suggest many of the participants have been buying into the market recently are looking for long-term exposure to a carbon price, expecting that as the cap tightens, prices will go higher.
Up to now price formation in the EU ETS has been dominated by the economics of fuel switching from coal to gas for power. - arguably the cheapest source of abatement. But with more than 13 member states now committed to phasing out coal, what will be the next source of emissions cuts? We need to start working out the economics of abatement in other sectors. And most people expect the price will need to be higher to bring steel or cement emissions down.
The EU can’t have it both ways – they can’t build a market mechanism that aims for a certain volumetric target (a 50%/55% reduction in CO2 emissions by 2030, for example) and not expect prices to reflect growing or ebbing confidence that this will be achieved.
Any effort to restrict price volatility, for example by setting a price corridor, means that the market no longer *is* a market. It becomes the equivalent of a policeman escorting a very old man, very slowly, across a crowded street.
In 2018, prices trebled over the course of the year as investors, utilities and speculative traders all piled into the market after the MSR was approved. By the late summer prices reached nearly €25/tonne and some member states began to call for an intervention in the market.
Under the EU ETS rules there is a mechanism that can lead to an injection of additional supply if prices rise by a certain amount. The methodology is explained in the EU ETS directive Article 29a here.
However, the methodology is contestable, and two prevailing interpretations have emerged, as follows.
As the chart shows, however, we are nowhere near reaching the “multiplier” required to trigger a consideration of an intervention. If the multiplier did not trigger an intervention in 2018, when prices trebled, why should it work now when prices have only gone up by around 25%?
You cannot create a market, and wish participants to treat it as such, if you’re going to take away, or muffle, the price signal that drives activity. The entire problem with the EU ETS has always been that member states do not have the courage or political will to set a tough enough cap. Now, when the market is behaving as if there is a tough cap – or at least, that the cap will be tough very soon – is not the time to start getting cold feet.