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EU carbon prices rocket

After languishing at record lows since the onset of the global financial crisis in 2011, Europe’s carbon market has burst into life

Prices for EU carbon allowances (EUA) have quadrupled in the past 15 months, rising from around €5 ($5.82) a tonne in May last year to over €20/t in September 2018. Since last autumn, the EU Emissions Trading System (EU ETS) has seen a significant influx of speculative capital, driving prices higher and surprising traditional participants as investors scramble to build positions in a market that many say is only going one way.

In fact, EUAs have been the best-performing energy commodity in Europe this year, more than doubling in value since 1 January. In comparison, front-month Brent crude has risen 9.5% and API2 coal has declined by 0.3%.

The surge in buying is based on widespread expectation that a long-standing glut of carbon allowances will start to disappear from January, when a new market balancing mechanism starts operating. The so-called Market Stability Reserve (MSR) will slash the oversupply by restricting the flow of new EUAs into the market each year.

Historical oversupply

When the EU ETS was launched in 2005, there was no mechanism to adjust the supply of emissions allowances in the event of external shocks to the system.

The biggest such shock was the global financial crisis in 2011, which led to a sharp drop in EU industrial output and demand for electricity. The resulting decline in industrial emissions created a surplus of EUAs that grew to as much as 2bn tonnes—more than one year's supply for the entire market-and prices dropped to a low of less than €3.00/t at one stage.

The MSR has been calibrated to reduce the glut by 24% each year from 2019 to 2023, bringing the market back into balance. After 2023, the mechanism will boost or restrict supply as needed to keep it within a set range, according to annual calculations by the European Commission. Consequently, the EU ETS will be net short of allowances each year between 2019 and 2023, as the flow of new EUAs into the market each year is throttled back.

EU ETS supply/demand and surplus 2008 - 17 (‘000 mt) Source: Thomson Reuters Point Carbon

Mark Lewis, managing director at analyst Carbon Tracker, believes the MSR will create "the biggest squeeze the EU carbon market has ever seen". Writing in a report published in April, Lewis said the MSR "will slash the EU-ETS surplus for fixed installations...from 1,776m to 496m over 2019-23, a drop of 1,270m (70%)".

"Over these five years," Lewis continued, "we see the market short by an average of 254m per year, and over the two years 2019-20 by an average 354m per year."

Front-running

Even before the reform had been agreed in late 2017, however, far-sighted speculators and even some large utilities had started buying EUAs in anticipation of a tighter market and higher prices.

"It's natural that non-natural participants got involved once they understood the basic idea [of MSR]," says Marcus Ferdinand, a senior analyst at energy consultancy Icis. "MSR is a really strong signal."

Numerous sources say hedge funds represent the bulk of the new money flowing in to carbon, but some utilities have also become more aggressive, hedging against future price rises. Identifying speculators is difficult, since many of them deal through brokers or bilaterally, sources say, but ICE Futures, the main exchange for carbon, lists a number of funds that trade carbon on its exchange including Citadel, Five Rings Capital and Squarepoint.

"There are new players, though only a couple of banks are back in the market," says Trevor Sikorski of Energy Aspects. "There's an appetite from new funds and the type of player who is willing to do conviction trades."

Per Lekander, a former utilities analyst at UBS who joined hedge fund Lansdowne Partners in 2014, told an emissions market conference last year that he'd taken a 10m-tonne long position in EUAs. The move represented a complete turnaround for Lekander who, only a few years earlier, had called the EU ETS a "joke" and predicted prices would be as little as €3/t.

"[The influx of new money] first surfaced with Per Lekander's big call," Sikorski says. "The real price move started in January this year, when the price was still around €7."

Lekander wasn't alone. RWE, Germany's largest power generator, said in an analysts' call earlier this year that it had already financially covered all of its EUA requirements until 2023. The company's power plants emitted around 140m tonnes of CO2 in 2016, according to the most recent European Commission data.

A slow but steady increase from May to December 2017 turned into a pell-mell rally at the start of 2018, as prices gained 13% in January, 8% in February and 31% in March.

"We had originally expected that what's happened in the first half of 2018 was going to happen in the second half of the year," says Tom Lord, head of trading at Redshaw Advisors, a carbon trading and advisory company in London. "We think there's still potential for prices to rise further in 2018, but not as aggressively as in the first half."

Strategic positions

The impact on industrial and power companies, which the EU ETS is directed, has been decisive.

Utilities are active carbon traders but industrial firms such as manufacturers of bricks, glass and paper, as well as small- and medium-sized enterprises in a multitude of sectors, have little desire to be involved in the market daily, sources point out.

"If you've been in this market for some time, you'll know the history and won't want to get burned as in the past," says Marcus Ferdinand, senior analyst at Icis. "You're naturally going to be more conservative when it comes to changing strategy."

One trader explained that over the past seven or eight years, industrials had grown used to EUA prices in the €5-7/t range and were happy to cover their annual requirements during the first quarter, rather than regularly throughout the year.

As a result, the 62% price jump in the first quarter took many industrials by surprise and cost them millions as they scrambled to buy allowances in time for the annual compliance deadline of 30 April, numerous sources say.

This experience has driven small and medium-sized industrial buyers to become "more strategic", Redshaw's Lord says. Typically, it was only the largest industrials which took a strategic view and actively managed their risk. "There's a gradual shift in mentality; [industrials] are starting to ask questions and think about how to manage their exposure," he adds.

Calmer outlook

Many participants think the majority of the MSR-related tightness in supply has now been priced in, and that the market will fluctuate or increase more slowly. "I think we're done with the large-scale buying," says one US-based trader. "It feels like the interest has dropped off."

Bernadett Papp, an analyst at Vertis Environmental Finance in Prague, also believes hedge funds have completed the bulk of their buying for 2018 and are now managing their exposure and waiting for prices to rise further: "They'll maintain and protect their positions, but I don't think they'll increase their gross length much."

Prices usually decline as the expiry of the benchmark December futures contract approaches and traders cash in profitable positions. Sikorski of Energy Aspects says, "this year there are a lot of speculators in the options market" which increases the risk of a larger price correction. Therefore, there's "a risk of mass unloading of positions and a sizeable sell-off in December".

So far though, "the MSR has only changed expectations of future prices", since it only starts to operate in January, Sikorski says. "I don't know how much carbon will rise to, but definitely more than it is now."

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