• Alessandro Vitelli

What a long, strange trip 2021 has been

It’s been a year of tumbling records and high anxiety as carbon prices have explored uncharted territory while natural gas and electricity markets have also reached new peaks.


Just look at the energy price index for 2021. Normally a doubling of prices would be considered unusual, abnormal even, but carbon has been cast firmly into the shade by the enormous increases in energy prices.

It's tempting to call events in the gas market a once-in-a-lifetime aberration but if markets teach one thing, it's not to dismiss anything as being out of the ordinary.


Quite a few stakeholders have thrown their hands in the air and confessed that carbon's wild swings don't make sense, and it's easy to see why.


First and foremost, carbon prices stopped driving the energy mix several months ago. I wrote in September about the disconnection between carbon and power, pointing out that the price of EUAs was no longer driving any fuel switching because gas prices were rising out of control.


And this is even more true now. Look at the price of EUAs that's required to switch the stack back from coal to gas:


You could argue that carbon has lost its "anchor". It can't tie itself to fuel switching economics, because fuel switching economics are just completely out of whack with everything.


So what could the current price represent? Compliance demand? Well, sure, but there was compliance demand when the price was €30, €40, €50 and even €60. There's not much elasticity of demand when you're an industrial facing a penalty of €110 a tonne if you don't have those EUAs.


So is carbon now floating in a vacuum? There's no simple economic rationale for these prices, and there hasn't been since the gas price started rocketing.


One possibility is that the market has taken carbon prices to where they were expected to be in 2030. Instead of letting prices gradually float higher as supply diminishes over time and demand eats into that 1.5 billion-tonne surplus that is still floating around this market, the market has simply decided that since €70-90 is where prices are expected to be at the end of the decade, it makes sense to get there as soon as possible.


It's a once-in-a-lifetime opportunity for investors to harvest in just one year all the gains that the market is anticipated to make by 2030.


And that puts me in mind of 2018.


For EUAs at least, 2021 has actually resembled 2018 in many ways: no other year apart from 2018 has seen carbon prices double, let alone treble as they did three years ago – and we got precious close this year to trebling the year-end price from 2020.



And there were similarities in the price drivers too. The 210% increase in 2018 was largely a reaction to the European Commission’s introduction of the market stability reserve. Sure, they’d flagged up the MSR in early 2017, but the market only really started buying into it late that year.


This year, the elaboration of the European Commission’s Fit for 55 package of reforms to the EU ETS has been the key policy driver. The various potential components of the reforms include a steeper annual cut in the overall cap on emissions, a one-off reduction in the cap (perhaps more than 100 million EUAs?) to bring the trajectory in line with the EU’s coal of a 55% reduction by 2030, and the widening of the EU ETS to include maritime emissions.


Any way you slice these, they’re pretty bullish, and the market reacted in much the same way as it did to the MSR in 2017-2018.


Back in 2018, a lot of the buying was done by speculative traders, just as it has been this year. There were plenty of articles in late 2017 and early 2018 reporting the new wave of financial investors and the spectacular gains they were making or which they anticipated, and this year we’ve seen the same thing: Bloomberg in particular has been tracking funds’ activities closely this year.


In 2021 we’ve also seen this investor interest extended to the retail market, with the entrance of a number of exchange-traded carbon instruments from WisdomTree, SparkChange and KraneShares. And there are signs that more of these are on the way, especially into the very different space of the voluntary carbon market, now that the UNFCCC has agreed rules on international carbon trading.


2017 and 2018 were also notable for German’s largest utility RWE hedging its carbon exposure well into the 2020s, as the company itself reported. RWE wouldn’t have been the only ones doing this, and by the time we got to 2020 it was, anecdotally, pretty much fully hedged out to 2030. This begs the question whether others are similarly covered.

It’s hard to really get a handle on what non-utility industrials have been doing this year, but the one thing that everyone seems to agree on is that they haven’t been selling much, if anything. With prices rising steadily all year, and more speedily towards the end, industrials’ buying ideas have been constantly out of date.


The standard strategy for mid-sized industrials who don’t buy in advance or aren’t large enough to get onto the futures market seems to be to try to beat the average price for the year to date. And as the charts below shows, they’ve been behind the eight-ball all year long.

Some industrials have been lucky enough to receive a fairly generous allocation of free EUAs in years past but that’s changing in Phase 4 as well, as the parameters for allocation have been tightened significantly.


Previously, particularly in times of economic pressure, industrials might have been able to either sell some surplus EUAs to raise cash, or do the “borrow” trade, in which they sell a full year’s set of free allowances and use the following year’s free handout to cover their previous-year’s compliance.


This trade wasn’t possible in 2021 – that is, industrials couldn’t borrow their 2021 handout and use it for 2020 compliance, since the market was shifting into Phase 4 and this specific trade was not permitted. But from now to 2030 it will be possible.


However, the “borrow” trade this year has been complicated by delays in the handout of those free EUAs. As of last month, the European Commission said only 23 of 27 EU member states had given out allowances representing 53% of the total for the year. Some of the remaining countries may not get around to handing any out until early next year.


Sure, the Commission has said – with its tongue firmly in its cheek, I hope – that companies don’t *need* these EUAs until the compliance cycle starts in Q1 2022, but this has meant that the “borrow” trade hasn’t really been possible. After all, would you risk not having *any* EUAs in December when the 2021 compliance deadline is in March 2022?


And equally, there are plenty of utilities out there that don’t have the sort of mandate that allows them to pile into the futures market to hedge multiple years of forward power generation, as RWE has done. Instead, they buy as they burn, so there’s always a steady flow of utility demand in the market.

2022

So yes, 2021 was a little bit different in terms of both supply and buying activity. The delay in issuance of free EUAs means that Q1 could be a little hectic as industrials work out what they might need to buy and when to buy it.

It’ll also be interesting to see how the free issuance works in 2022. There’s been one big change to the whole process, which is that industrials have to submit activity reports for each calendar year by the following March.


These reports are used to work out whether individual installations saw their output rise or fall by more than an average of 15% over the previous two years. If output fell, then there would be an adjustment to their free allocation. If it rose by more than 15%, then the allocation could be increased.


The 2021 free issuance was held up by a combination of installations and member states getting used to this new activity report business, and the Phase 4 adjustment of the benchmarks that dictate the level of free allocation by industrial sector.


You’d expect the whole process to speed up as countries and companies get used to compiling and analysing activity reports each year, but the addition of a whole extra set of data harvesting and documentation could mean that free issuance doesn’t happen by the end of February each year.


That’s important because the handout by late February is what makes the “borrow” trade possible. By issuing this year’s tranche of free EUAs before the deadline for last year’s compliance, it allows companies to “borrow”, for example, 2022 EUAs to pay for 2021 emissions.


If the issuance is delayed past May, then the borrow trade can’t happen. Sure, industrials could still sell and then buy swaps in the market: buy prompt EUAs and sell back some of their next set of free allowances when they’re issued. But it’s not very neat and tidy.


In 2020 some countries did hand out their free EUAs in time, or at least not too late, but with the proviso that they might have to take some back if the activity reports showed an average 15%+ drop in activity over 2019 and 2020.


That’s all well and good, and it would at least allow the borrow trade to continue, but would risk management see that as a good idea? Would it be smart to sell some EUAs for cash if you might need to give some back?


Beyond the purely practical, there’s the politics. 2021 has been the Year of Allegations of Excess Speculative Activity, with Poland maintaining its long-standing tradition of accusing investors of driving the cost of carbon higher to the point where it fed into power prices and even triggered inflation.


Their complaints became loud enough to prompt the European Securities and Markets Agency to take a look, though their preliminary report in November didn’t find any signs of market abuse. However, the full report will come out in the spring of 2022, and given the arguments that characterised the EU Council meeting this month, when member states couldn’t agree on what to do about high energy costs or the carbon market, this story still has legs.


We’ll also refamiliarise ourselves with the Fit for 55 package in 2022. The European Parliament is now looking through the legislative proposals and will start reporting back before long. The market usually reacts to statements and reports on issues like these, so we’ll all need our Twitters switched on.

And of course a lot will rest on what happens to energy, in particular natural gas. Without going into all the various reasons for the five-fold increase in gas prices in 2021, the story isn’t over by a long chalk. Nord Stream 2 is complete, it’s being filled with gas, as if to suggest that any time Europe decides to approve the pipeline, the gas can start to flow within minutes. So near and yet so far…..


And one final observation. After EUA prices jumped 200% in 2018, the following year saw the market slip by 1.5%. It’s entirely possible that, now that the market has seen and felt a €90 EUA price, there could be an assumption that we’ve reached the promised land, the level at which new technologies are competitive.

For a start, with power prices in excess of €200/MWh, renewables are more competitive than they have ever been, and should be incentivising a whole new raft of investment in wind and solar.

Carbon prices of around €70-80 are also near the level where green hydrogen becomes economically competitive as well. The European Commission suggested if we could get to these prices by 2030 then zero-carbon hydrogen would be a snap, but it looks like the market is in a hurry to get these new technologies off the drawing board and into the ground.

So there may not be all that much reason for carbon prices to go much higher from here.

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