Caught between a glut and a hard place
Europe’s goal to become carbon neutral by mid-century requires a steep pace of emissions reductions. Perhaps as steep as 10% per year – every year – until the target is reached. This is the main reason prices on the EU Emissions Trading System (EU ETS) are expected to climb substantially in future. They could roughly double to EUR 150/t by the end of the decade, according to LSEG. The financial data provider estimates a 90% reduction in EU emissions by 2040, as proposed by the European Commission, could in time even drive that price to EUR 400/t.
The end of the coming decade may seem like tomorrow for a steel producer considering what to do with an aging smelter. But it is eternity for the trading community – and for now, this market faces a glut.
Abundance – for now
The benchmark price of carbon hit a 31-month low of just above EUR 50/t in February and it is yet to recover above the EUR 80/t it still fetched at the start of 2024. An economic slump that has accompanied the energy crisis in the wake of Russia’s war on Ukraine has slashed industrial production. The factories and power plants obliged to take part in the cap-and-trade scheme saw their emissions tumble 16% last year, a record decline. The drop in factory output across Europe was still underway in the first quarter of this year. Hope for a gradual recovery is focussed on the latter half of 2024. Germany, the bloc’s biggest economy, may only grow 0.2% this year, according to its official panel of economic advisors. A lacklustre recovery was expected to continue into next year. A cleaner power mix is also sapping demand for allowances. More renewables, better nuclear availability, less electricity demand and cheaper gas coalesced to drive European power emissions down by almost a fifth in 2023. A record 56 GW of solar additions across Europe has started to compound the pressure with arrival of spring.
Money grab
These are just some of the factors that have weighed on sentiment this year. Another is an effort to raise extra money from the trading system, conceived at a time when prices were sky high.
Europe’s RePowerEU plan aims to help wean the continent from Russian fuels. Some EUR 20bn for the programme is supposed to come from the carbon market. A swathe of this money will be generated by bringing forward carbon allowance auctions that were scheduled for the latter part of this decade. One of the problems is the exact number of allowances to be sold remains unclear. The revenue target means the more prices fall, the more allowances need to be sold, which in turn amplifies the downward pressure on prices. The European Commission assumed an average sales price of EUR 75/t when it proposed the plan. This is well above the roughly EUR 60/t auctions have averaged so far this year.
The feedback-loop is one of the main reasons carbon prices entered a “downward spiral” earlier this year, according to Markus Krebber, the head of German utility RWE, whose fleet of coal plants in the past made the company one of the market’s biggest buyers.
“Our concern that this could affect the reliability of the ETS has unfortunately materialised,” Krebber said during a conference on 2023 earnings.
Perhaps it is no wonder speculative investors accumulated a huge concentration of bets prices should fall. By mid-February, investment funds held more than 77 million short positions compared to 36 million long positions for a record high net-short position of 41 million allowances – worth roughly EUR 2.4 billion at the time. [Amended exchange data published on 5 June revised this record slightly lower].
Shortage takes shape
But it is always darkest before dawn. The market knows this perfectly well, its main question is one of timing. For the bigger the glut becomes now, the tighter the likely shortage will turn in future. This is due to a reform introduced to the system in 2019 to mop up excess allowances – the Market Stability Reserve (MSR).
This adjusts auction volumes based on the total number of allowances in circulation (TNAC) in the prior year. Roughly a quarter of the TNAC is placed in the MSR if it exceeds a threshold of 833m allowances, depending upon how close to the cut-off it comes in. If the TNAC falls below 400m allowances, it releases allowances back into auctions. Last year’s TNAC came in at 1.11bn allowances, about 23m lower year on year.
As a result, the MSR will trim 267m allowances from auctions between September 2024 and August 2025. With RePowerEU sales slated to end by August 2026, the MSR may end up cutting into already-reduced auction supply in the coming years. Indeed, the annual supply balance was likely to swing from a surplus this year of up to 100m allowances to a deficit of around 300m allowances by 2027, according to emissions data firm SparkChange. Historically, the company notes, the carbon market has responded to looming regulatory-driven supply changes 1-2 years in advance. Pressure to anticipate a rally could emerge as early as this summer, according to the company’s head of sales, Billal Ismail.
“We have never entered a period of supply deficit with investment funds holding a net short position, let alone such a record net short position,” he said. This may be one reason the net short position of investors has fallen 63% from its peak to less than 15m allowances as of mid-May. “We’re in the sweet spot in terms of an inflection,” Ismail said.
Yet timing is everything. For now, the market is caught between a glut and a hard place.
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