The EU Emissions Trading System (EU ETS) has had a tumultuous start to 2021. Prices have risen by 22% to new record highs in the last six weeks as a wave of speculative investment has come into the market, and industrial and utility compliance companies have been shoved to the sidelines.

The rally is part of a longer-term trend that has seen the price of EU emissions allowances (EUAs) soar by 73% since November 2 last year. Over the same period, the number of financial and speculative entities holding positions in EUAs has leapt from 308 to 426, according to ICE Futures data.

EUA CHART

What has driven this wave of investment in carbon?

Many experts attribute the renewed popularity of EUAs to political ambition by the EU. Last year incoming Commission president Ursula von der Leyen announced the 27-nation bloc would adopt a goal of achieving “net zero” emissions by 2050, and implement a Green Deal to transform the European economy.

A significant portion of the burden will be borne by he energy sector, through EU initiatives including directives covering renewable energy and energy efficiency, but industry will also face tougher emissions trading goals.

In 2017 lawmakers agreed to set a goal of cutting greenhouse gas emissions by 40% from 1990 levels by 2030. However, under the Green Deal that target will this year be raised to 55% or potentially even 60% by 2030, and an interim target will be set for 2040 on the way to net zero in 2050.

The European Commission will table legislative proposals to achieve these goals in the summer, and they will represent a significant tightening of the parameters of the EU ETS.

What changes are coming?

According to an impact assessment published by the commission last year, the annual cap on emissions in the EU ETS would need to be adjusted to account for a steeper reduction trajectory to 2030. But because the so-called linear reduction factor (LRF) – the annual reduction – has already been set at a 2.2% decrease from 2021 to 2025, lawmakers will have to consider a much steeper LRF after 2025.

Some experts say the LRF would need to be raised to 6.8% from 2025, or that the EU would need to make a one-off reduction in the cap of 363 million EUAs starting from 2026. For comparison, the EU ETS cap in 2021 stands at 1.57 billion EUAs.

Other elements could include making adjustments to the Market Stability Reserve (MSR), the mechanism that adjusts market supply each year by removing a proportion of the calculated surplus EUAs in circulation.

The MSR presently withdraw 24% of the surplus each year, and is scheduled to continue at 24% until 2023, when it will revert to 12%. It’s possible the EU may decide to extend the 24% rate for an additional period to take up even more of the surplus in a shorter period. As more and more coal-fired power plants are closing,  emissions are expected to drop more sharply in the EU, and a flexible MSR is considered by some to be the best way to manage supply.

The EU is also considering including emissions from maritime transport, buildings and road transport in the EU ETS, though it’s not yet clear what impact these sectors would have on demand and supply.

Analysts have predicted that with these tighter targets, EUA prices could reach as much as €80 towards the end of the decade.

Back to the market…

While the overall trend in carbon prices has been to a large extent a function of political ambition and investors’ reaction to those signals as described above, there are plenty of fundamental drivers that are also driving higher prices.

Chief among these has been energy prices. 2020 saw an armada of LNG cargoes from the US push European gas prices down by as much as 55%. Cheaper gas combined with rising carbon prices helped push coal-fired generation into negative margins.

Since October 2020, all energy markets have enjoyed a recovery that has taken front-month natural gas in particular from around €13.18/MWh to as much as €20/MWh in February, an increase of more than 57%. But because coal prices have risen too, but by only 15%, more efficient coal plants have begun to be favoured, again boosting fundamental demand.

MONTH-AHEAD SPREADS CHARTS

To be sure, coal fired power is still uncompetitive for generation in 2022 and later, and it may well be that once the current spell of colder weather ends, nearer-dated generation spreads for 2021 may also revert to favouring natural gas.

Other fundamental factors are related to physical supply and demand. As the market entered a new trading phase in 2021, the European Commission has had to recalculate the parameters for allocating free EUAs to industries at risk of carbon leakage (relocating abroad to jurisdictions with fewer penalties on carbon emissions).

The process of calculation has taken longer than expected, with the result that industrial installations have not been told how many free EUAs they will receive this year, nor have any been issued. The normal deadline for such issuance is at the end of February, but the Commission has said it may only start to hand out EUAs from the second quarter of the year.

While all participants in the EU ETS won’t need to surrender their 2021 EUAs until April 2022, the psychological impact of the delay may be impacting prices.

Another contributing factor is that installations cannot use 2021-issued EUAs to surrender for their 2020 compliance, which will take place in March and April this year. Typically, companies have been able to “borrow” new EUAs to pay off older compliance debts, but this has been specifically ruled out for 2020 compliance.

Already there are signs of industrial companies that have been caught out by this rule, and the anticipation of “distressed” buying up to the April 30 deadline has helped support EUA prices. Trading sources expect that a premium will emerge for 2020-eligible EUAs in the coming two months.

But most traders agree that by far the biggest driver has been speculative buying. After articles about carbon prices appeared on both Bloomberg and the Financial Times in the same week, prices leaped even higher as new money entered the market and, despite a brief reversal last week, the EU ETS looks set to consolidate its gains in the coming weeks.

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