European carbon allowance (EUA) prices reached in mid-July a 14-year high of €30.80, just 20 cents shy of an all-time record, as buyers flooded into the market and speculators hedged options positions.
Prices have fluctuated between €26 and €29 since then, as some short-term traders took profit, but there seems to be a strong undercurrent of demand supporting EUAs.
The current market is a far cry from the middle of March, when EUA prices plunged 35% amid a general sell-off in energy. The initial bearish reaction to the spread of the virus and to lockdowns around the world reflected concerns that demand for oil, gas and electricity would be negatively affected.
But from mid-May, as the markets absorbed the real scale of the reduction in demand, prices began to recover. Some of this reflected a surge in liquidity as governments rolled out stimulus programmes to bolster their economies. Equity markets in particular rallied strongly, carrying some commodities with them.
Today, both German power and API2 coal prices have recovered to pre-Covid levels, while crude oil and TTF natural gas are around 15% and 10% respectively below their levels in the middle of March.
Carbon, however, kept on climbing and reached an intraday peak of €30.80 on July 13, its highest since April 2006 and just 20 cents short of the all-time record of €31.00.
Why has carbon recovered so strongly?
The fundamentals of supply and demand in 2020 look very weak: the lockdowns, which are only now being relaxed across Europe, are estimated to have cut around 200 million tonnes of demand, equivalent to more than 10% of a year’s total emissions from installations covered by the market.
The answer lies in a combination of speculative trading and long-term optimism. Next year sees the start of the fourth trading phase of the market (ending in 2030), in which supply will be tightened and fewer installations will receive free EUAs to protect them against international competition.
2021 will also bring a review of the functioning of the Market Stability Reserve (MSR), the mechanism that works to maintain a balance between supply and demand. Until now, the MSR has made small inroads into the glut of allowances; while it has removed as much as 400 million surplus EUAs from the market in both 2019 and 2020, demand has fallen sharply as well, as coal plants shut and are replaced by gas-fired power plants that need half as many allowances.
Regulators will begin next year to consider how to beef up the MSR so that it can absorb larger chunks of oversupply and return the market to balance sooner.
On top of this, the EU’s new Green Deal proposal sets ambitious targets to reach net zero carbon emissions by 2050, and this includes a steeper emissions cut by 2030. Lawmakers will be debating whether to raise the current 40% reduction compared to 1990 levels to a 50% or even 55% cut.
Whatever the outcome, there will be an impact on the EU ETS: it’s likely that from 2026 (half way through the fourth trading phase) the cap will be altered to target the 2030 goal and installations will face much tighter EUA supply.
Trading sources suggest that it’s this longer term view that has begun to drive prices higher, looking past the low demand expected in 2020 and focusing instead on the impact of the Green Deal. If this is true, then we may not have seen the end of carbon’s surge.