27 August, the benchmark carbon contract hit 21.09 euro, a level not seen since October 2008. The carbon price rallied almost 20% in August and almost 160% since 31 December 2017.
This price increase made the emission allowances the best performing asset within the energy mix. German front year power advanced by 28.8%, Brent gained 13.2%, TTF gas contract increased by 23.4% and European coal for 2019 delivery hardly changed year to date (+0.05%).
There are many factors that could explain the rally in the carbon market:
– Market participants started purchasing allowances more actively last spring when the details of the reforms of the EU ETSbecame clear. Companies with a compliance obligation within the European emissions trading system prepare for a scarce supply of allowances already from next year. The market stability reserve has the task of absorbing the surplus of allowances from next January. The reserve has been established by the European Commission to provide flexibility on the supply side of the market and to handle shocks like another financial crisis or any other situation that increases the volume of available allowances in the system. The original removal rate of the market stability reserve has been doubled for the first five years of its operation. This guarantees the fast removal of surplus allowances from the system. In addition, allowances held in the reserve above the volume necessary for hedging will be invalidated from 2023, decreasing the overall cap of allowances. The post-2020 reforms will reduce the available allowances in the future through the higher linear reduction factor (2.2% instead of the 1.74% in phase 3) and the new free allocation rules. Only 50 sectors will be kept on the carbon leakage list instead of the current 170+. The updated benchmarks and production levels will reduce the chances of an overallocation.
– Although electricity producers had to purchase their allowances already in phase 3, many industrial installations managed to cover their emissions with allowances they received for free every year or from the accumulated surplus of the past or probably borrowing allowances from next year’s allocation. This will not be the case in the future, as many industrial companies turned short this year already and they will have to purchase more and more allowances. In 2017, many industrial companiesthat had a surplus earlier ran out of allowances and they started to plan and hedge their emissions more actively,supporting the buy side of the market. At the same time, in view of the increasing carbon price the number of sellers was reduced significantly.
– With the EUA becoming a financial instrument and with the price increase, options became more popular in the carbon market. The open interest in call options jumped from couple of thousands to millions in the last one year. Among those who sold call options, many just did so to get “free lunch” through the premium they received, but they didn’t really think about selling allowances at 18-20 euro. Now that the market reached these price levels, they have to purchase the allowances, because they do not risk having to purchase the EUAs in December when most of the options expire and the market price is at 25 euro.
– In August, we had temperatures above the seasonal average and at the same time many power plant outages, especially in the nuclear sector due to cooling problems. Power prices hit new records and lifted the carbon price as well. Although one would assume that in summer a big part of the electricity demand could be covered by renewables, this was not the case this year as the wind was not blowing. Hydro levels in Nordic countries and in Iberia were higher than last year, but still below the levels necessary to satisfy power demand.
– In addition to the “normal” reduction in the auction supply in August, the European Commission announced the cancellation of the German auctions from the second half of November, because the contract with EEX as an opt-out auction platform expires. More than 20 million German allowances won’t be auctioned this year, tightening the supply further.
– In the first half of August, we saw lower traded volumes in the carbon market, as many traders were on holidays. Utilities ran maintenance and industrial power plants reduced their activity as well due to the holiday season. If those traders come back to the market, they will strengthen the buy side as well, because utilities are net buyers and industrials also turn short on the long run.
– Last, but not least, in view of the rally analysts started to review their forecastsalready and they became even more bullish for the future raising their price expectations starting from a higher base. Analysts at Thomson Reuters raised their price expectations to 25 euro by the end of the year, immediately after the market price hit 20 euro.
In view of the rally, it’s difficult to imagine that the trend could be reversed any time soon. There are, however, some risk factors to the price increase:
– With the emission allowances turning a financial instrument, and moving in an increasing trend since spring 2017, many financial investors decided to open long positions in the European carbon market. Although the exact data cannot be proved because the transactions on the exchanges are anonymous, market assumes that these investors hold millions of allowances on their accounts. As they do not have any compliance obligation in the EU ETS, they won’t keep the allowances, if their financial interests change (the price start a correction or there is another investment opportunity that offers a better return to them). Many market participants are afraid of a bigger correction, should these financial investors (speculators) start reducing their long positions.
– Other risk to the carbon price is a hard Brexit. Should the UK cut its ties with the EU with immediate effect, British industrials would sell their allowances and also utilities would dehedge.