Phase 4's starting pistol misfires
The last week has seen a couple of significant changes to the predicted supply schedule for the start of EU ETS Phase 4, and while they may not be big game-changers in the long term (overall supply in 2021 won’t be affected), they do have the potential to change the market dynamic in the first quarter at the very least.
The first change relates to the start of the auction programme. The European Commission issued a statement on November 17 stating that “due to technical reasons, the auctions are estimated to start at the end of January or early February 2021.”
Between 2013 and 2019 the first sale invariably took place in the second week of the year; 7 January was the most frequent start date. Based on Phase 3 auctions data, a delay of at least three weeks represents a loss of between 54-76m EUAs, but since the Commission hasn’t confirmed free allocation or auction volumes for 2021, it’s hard to give an accurate estimate of the delayed volume for next year.
Combine this delay with the three week auction hiatus that normally takes place in December and January, and we’re facing at least seven weeks of no daily supply to the market.
The second announcement came yesterday (25 November) when EU officials confirmed that the issuance of free EUAs to industrial installations would be delayed into the second quarter.
Specifically, the officials said the implementing regulation on benchmarks – which determine the free allocation to industrial sectors – could be adopted by February, while a Commission decision on the National Allocation Tables – the final step before allocation – could be adopted in Q2. These free EUAs are normally issued starting from February each year.
Because installations may not use Phase 4 EUAs for their 2020 compliance, this delay has little impact on likely Q1 demand for EUAs by industrials. In fact, it may instead have an impact on supply: some industrials might have been thinking of selling some 2021 EUAs to generate cash, but they simply won’t be able to until Q2 next year.
The combination of the two delays reinforces the point above that there will be no Phase 4 supply until February at the earliest though again, none of this supply has any relevance for 2020 compliance. It’s unlikely that utility hedging will be much affected by the auction delay since they will most likely buy in the futures market.
But speculators may feel the pinch. We’ve seen a sharp increase in hedge fund participation in the market in recent weeks, and it’s likely that they and other new entrants would be looking at the early sales of 2021 vintage EUAs to build positions. But they will have to compete with compliance buyers.
We also have to bear in mind that there will be a two-tier market in Q1 next year. In order to provide a market for EUAs that are eligible for Phase 3, EEX and ICE Futures have both confirmed they will establish separate Phase 3 and Phase 4 spot markets.
Equally, futures contracts that expire before the end of March will also be restricted to delivering Phase 3 EUAs only. From April onwards, after the compliance deadline has passed, there will be no further need to separate Phase 3 and 4 allowances.
So the spot and futures markets in Q1 will need to be supplied from allowance balances that have been built up in 2020 and before, which means finding sellers who have spare EUAs. It's safe to assume that banks have big physical positions, and some utilities as well. Speculators too will have plenty of Phase 3 stock.
It might be worth keeping an eye on how many EUAs get delivered into the expiring Dec 20 futures contracts. If expectations are that there will be significant demand for Phase 3 EUAs in Q1 next year, then the easiest source of supply is either existing physical inventory, which can come from Dec 20 deliveries.
The roll of existing Dec 20 length into the Dec 21 contract has started in earnest this week, with Dec 20 OI dropping by 21m EUAs in the last five days. At the same time, Dec 21 OI has risen 20m EUAs.
As I've noted elsewhere, front-Dec open interest at the date of expiry is falling steadily. The final OI in the Dec 2015 contract was 437m EUAs, while last year it was 249m. If we close the Dec 20 contract with a higher delivery next month, it could suggest that a lot of speculative buyers are taking delivery ahead of anticipated Q1 demand.
The lack of Phase 4 EUA supply until February, and the focus on compliance demand until April, means that Phase 3 EUAs will probably trade at a premium to what is likely to be a purely notional Phase 4 market for some time. In fact, I’d hazard a guess that ICE and EEX might not even bother to launch their separate spot EUA contracts until there are spot Phase 4 EUAs in circulation.
So what does this suggest for the price? Until today, EUAs had made heavy weather of aligning with the strength in other energy markets. Cal 21 API2 coal is up 9.5% since last Thursday, cal 21 German power has gained 5.3% and cal 21 TTF gas is up 5.5%. On Thursday carbon added 1.7% to stand 9.5% higher week-on-week.
The €28 barrier has proved to be pretty sticky so far, and while prices did peak today at a two-month high €28.32, it’s going to take a few more days to be convincing. There still seem to be a fair few sellers who are willing to part with EUAs at current levels.
But if carbon does establish a new floor around these levels, there’s no reason we can’t test €29 and above as the implications of the seven-week supply hiatus start to sink in. Analyst predictions of €30 by the end of the year don’t see quite so far-fetched as they might have done three weeks ago.