Although we did not expect the record gains of 2018 to be repeated this year, but the sharp all in carbon prices surprised many market participants. The benchmark carbon contract plummeted by 24.3% from 31 December 2018 until 22 February 2019, although the market stability reserve just started reducing the (auction) supply from January this year. In brief, the following reasons might have contributed to the sharp losses in the carbon market:
• The reforms have been priced in already last year.
• 2019 free allocation process under way.
• Mild winter reduced the demand for heat.
• Investors afraid of UK installations selling in the case of hard Brexit.
• Speculators reducing their long positions.
Market participants had more than one year to react on the reforms of the EU ETS and the tightening supply of emission allowances. All the changes to the system were well known one year ago already and as the chart shows, the market participants started pricing in the reforms immediately. The price more than tripled last year.Installations with a compliance obligation in the EU ETS were first shocked when the price passed the double digits threshold and accelerated their purchases. As a consequence, most of the installations covered their 2018 emissions during the last year already.Some of them with free cash even started purchasing allowances for 2019 and 2020, as they changed their hedging strategy from a short sighted one to one with a long term view. It would be logical to expect that installations show a higher demand for emission allowances as the compliance deadline (end of April) approaches, but this is not the case this year, because the installations covered their emissions earlier already at lower prices. The expected last minute compliance demand doesn’t seem to realize this year.
The demand of the compliance entities is also reduced by the fact that member states have to distribute 2019 free allowances until 28 February. Installations that find the current carbon price too high to purchase allowances, decide to use the received allowances for compliance (so called borrowing), although on the long run this might be an expensive strategy if the price of EUA increases further by the next compliance period in 2020.
The weather did not support a carbon price rally either. The first two months of the year were exceptionally mild with temperatures several degrees above the seasonal average. The high temperaturesreduced the demand for heating. Both gas and coal prices turned lower and the carbon price followed suit. Ports in Europe reported record coal inventories as utilities used their own stocks and didn’t ask for more volume. At the same time, January and February posted record renewable energy production that could be used to satisfy electricity demand. The high availability of nuclear capacities was also different from previous years when French and Belgian reactors under safety checks had to be taken offline at times of peak demand.
Investors also consider Brexit as a risk factor to the carbon price as the EU ETS has a direct exposure to the UK through the compliance obligation of the British installations. In the case of a hard Brexit, UK installations would not have any compliance obligation in the EU ETS from 2019 on and could therefore sell the surplus allowances they accumulated in the past. This volume could be between 60 and 100 million allowances, 24-40 times the daily auction supply this year (equivalent to 1-2 months extra auction supply). The indirect effect of a hard Brexit on the European GDP and industrial production is also seen by the market participants as a threat, because it could result in lower emissions and less demand for emission allowances.
Last, but not least there was one important reason for the price rally in the carbon market last year: the appearance and high presence of the financial institutions or speculators. As the carbon market is no novelty to them anymore, their positions are built up and the same demand we saw last year from their side will not repeat this year. Those who wanted to enter the carbon market did already in 2018 and they are just managing their positions. In view of the Brexit risk and the act that the EUA price tested the 26 euro level several times, but was not able to break above that level, the speculators might decide to reduce their positions in the carbon market and sell (at least part) of their allowances. As they do not have any compliance obligation in the EU ETS they can do so at any time of the year when they are not satisfied with the return of their investments or if they find a safer or higher yielding opportunity. This is a constant risk in the carbon market and the decline of the open interest in the December 2019 contract might be an indication for that. According to data by the Intercontinental Exchange (ICE) the open interest in the benchmark contract fell to 472,999 lots by the end of February from the 486,144 lots on 2 January 2019 (-2.7%).
As for March, the risks mentioned above prevail in the carbon market. The EU member states accelerate the distribution of 2019 free allowances to the installations with a compliance obligation. Importantly, the UK is running out of time to secure an ordinary exit from the EU. If the Brexit plan of the Prime Minister May is not adopted by the British parliament (in its current form or amended I the EU shows flexibility), the country falls from the EU 29 March.