The gravity-defying wonder of EUAs
Updated: Mar 6, 2020
The chart below shows how European carbon prices have outperformed the rest of the energy complex so far this year. EUAs are down just 1.7% since January 1, while coal, oil, natural gas and power have all fallen between 7% and 21%.
Some of this is due to demand destruction caused by the Covid19 outbreak – oil prices in particular have taken a bath as factories in China have closed or are working short hours. Natural gas prices are drowning in a sea of LNG as US exports find their way to every corner of the world, and coal is… well, coal is just on the way out.
Since carbon prices are theoretically a bellwether for industrial output and demand for electricity, surely EUAs should be a lot lower than they are?
Well, yes and no, traders say.
For a start, bullish factors on the supply-side are stacking up like a busy day at Heathrow Airport. The MSR is working away at cutting the oversupply, withdrawing 24% of the calculated market float every year. Germany is planning some sort of mechanism to cancel EUAs equivalent (or so they say) to lost demand from coal plants that will close between now and 2038.
Phase 4 of the EU ETS sees a steeper reduction in the cap – 2.2% instead of 1.74% – each year from 2021. Free allocation of allowances to industry will start to decrease faster, and benchmarks for those freebies will be tightened up.
The EU’s Green Deal sets a seriously ambitious goal of net zero emissions by 2050, and to get there will require retooling the EU ETS, beefing up the Renewables and Energy Efficiency directives, both of which mean a greater impact on EUA demand from overlapping policies.
A border carbon tariff would protect domestic industry from imports from countries that don’t have emissions caps. In turn, the EU could end the practice of giving out free EUAs to those industrials that are at risk from carbon leakage.
The growing public awareness of climate issues has also led to a significant uptick in interest from the corporate sector as well. We’ve seen the likes of Shell and BP commit to some form of net zero in recent weeks and months, while numerous non-energy enterprises too are adopting strategies to minimise their carbon footprint.
This is driving interest among investors to find a way to get exposure to the climate market: there are exchange-traded funds that offer exposure to EU carbon prices, spread-betting services are including the EUA price on their sites, and even the humble carbon offset market is seeing a surge of popularity as more financials look to service their client interests in achieving net zero.
So that’s the bull case. Notice however that very little of it is immediate; regulatory measures will happen at some point, for sure, but not this year, or next. The MSR still has at least a couple of years to go before it starts to make a real dent in the oversupply – a dent that takes us down to the upper threshold of 833 million tonnes.
This hasn’t prevented strategic investors, speculators if you like, from taking an interest in the EUA market. Prices are being strongly supported at around €23.30 at the moment, which a lot of traders attribute to these investors: depending on who you talk to, they’re either buying more at this level, or are prepared to defend their long positions when prices drop to €23.30.
Now for the bear case which is, in short, anything fundamental. Gas is cheaper than mineral water, coal is a loss-maker pretty much across the board, renewable power continues to eat into the fossil share of the power market, industrial output and energy demand are looking shaky and the coronavirus has hit everything pretty hard, if commodity prices are to be believed.
Uncertainty over how EU member states will deal with the fallout from coal plant closures – destruction of EUA demand – means that a balanced outcome to the phase-out cannot be guaranteed. Even Germany has not made it 100% clear that it will cancel 100% of unneeded EUAs.
The resumption of UK auctions and allocations in 2020 adds more supply to the market. UK utilities hedged their 2020 generation from the secondary market, and it’s questionable whether they will need to hedge any 2021 exposure. Some people suggest that they’ll continue to buy EUAs to cover whatever UK-based carbon regime succeeds the EU ETS, which might take care of half the UK auction supply, but surely the UK will have an alternate system in place by 2022?
So. We have lousy fundamentals today, and the promise of better ones at some point in the future. For the moment carbon has, it seems, thrown in its lot with the bulls.
This aligns well with what traders and analysts were suggesting in December. The general outlook back then was that there’d be a drop in prices in the first quarter or first half of 2020, after which things would start to improve as the impact of the UK’s return to the market was absorbed.
But let’s go back to the expected timeline for all those bullish elements. We’re talking YEARS before the EU ETS adopts tougher caps, before the MSR is reviewed and its 24% withdrawal rate extended, before industrials are required to buy all their EUAs like utilities do.
And yet people in the market remain outwardly bullish, the price continues to hold above €23. Any potential downside move in EUAs is expected to be short-term and will anyway trigger a lot of bargain-hunting among compliance and strategic players, traders say.
So is this as low as we go?