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Carbon price faces volatility

Unclear regulatory and energy outlooks cloud the EU ETS carbon market picture

The outlook for the price of CO2 in the European emission trading scheme (EU ETS) in 2020 could fairly be described as “mixed”. The market faces a variety of both bullish and bearish influences over the next twelve months that could see prices move in a fairly wide range. 

In 2019, EU carbon allowances (EUAs) consolidated in the mid-€20s/t after a 200pc rise the previous year (see Figure 1). The influences that drove that trebling in price—in particular, new measures to curb oversupply—are still present, but much of the speculative buying from investors that drove the year-long rally was unwound in 2019, and, at the start of the new decade, those investors are circling the market and waiting for the right moment to re-enter. 

Natural gas enjoys such an economic advantage over coal that carbon prices have started to follow the gas market

Lining up to drive the price in 2020 and later are a mix of elements: supply-side adjustments, continuing weakness in natural gas prices, policy initiatives, Brexit and the global economic slowdown. 

UK re-entry   

The first influence that could affect EUA prices this year is Brexit. Throughout the extended negotiations over the UK’s withdrawal from the EU last year, the country was suspended from the EU ETS, meaning that the government issued no allowances to the market. 

As soon as the formal UK withdrawal takes place, participants expect that the UK will be restored to the market early in the first quarter, allowing it to prepare for an orderly exit from its membership at the end of 2020. Consequently, the UK will need to issue those allowances that were held back in 2019 as well as EUAs for 2020. 

FIG1: EU ETS price stabilises after 2018 bull-run | Source: Argus Media

Traders expect that the country will spread the sale of both 2019 and 2020 EUAs across the year, minimising any short-term price impact, but Europe’s utilities are thought to have already bought EUAs for this year, so a potential lack of demand for this additional supply remains a negative influence. 

Fuel switching 

The second bearish element is the impact of higher carbon prices on the use of coal and gas in power generation. The 2018 price rise significantly impacted prevailing economics for power plants: burning coal became not just less profitable than burning gas, but unprofitable outright for most plants. 

This led to wholesale fuel-switching across Europe and is expected to have cut CO2 emissions from the power sector by as much as 10pc in some countries in 2019 (data will be published in early May). With coal being replaced by natural gas, which emits roughly half as much CO2, demand for EUAs has been reduced. 

In 2019, while carbon began and ended the year at €25/t, front-month natural gas prices shed 45pc over the year. Front-month coal was also lower but lost ‘only’ 37pc over the same period—the European coal benchmark is less of a global price maker than gas currently is in an oversupplied market, explaining European coal’s greater buoyancy despite its startling demand collapse in the region. 

Macro risks to global economic growth could also translate into emissions trading scheme weakness

This combination of moves increased the impact of higher carbon prices and made coal even more unprofitable. Entering the new decade, natural gas enjoys such a great economic advantage over coal that carbon prices have started to follow the gas market rather than coal as they once did. And global gas is almost universally forecast to have another year of soft pricing—by extension pressurising carbon lower as well. 

MSR plays catch-up 

A third bearish influence could be the ETS member countries’ verified emissions reports for 2019, which are likely to show sizeable decreases due to the widespread switching away from coal. While the official ceiling on emissions decreases as well, it is not in any way keeping pace with rapid falls in reported emissions, creating an EUA surplus. 

In order to try to deal with the surplus, regulators introduced a market stability reserve (MSR), which removes 24pc of the surplus each year from 2019 to 2023. Last year’s fall in emissions—and therefore EUA demand—may offset half of the 400mn t that have been taken out of supply by the MSR, and could result in the MSR having to take a similar volume out of the market again in 2020. Traders might take this as a sign that the MSR is struggling to keep up with the structural decrease in emissions and react by trimming purchases. 

Macro risks to global economic growth could also translate into ETS weakness. While a partial resolution of the US-China trade war provided positive headlines at the beginning of the year, other regions are seeing signs of decline in industrial output, which is a benchmark for emissions demand. Output in the Eurozone shrank by 1.5pc year-on-year in the fourth quarter of 2019, and economists are cautioning against optimism that the trend may reverse in 2020. The longer-term impact of the coronavirus outbreak in China is still unclear but, in the short-term, it is another obvious demand-side headwind.  

50-55pc Green Deal target of reducing EU emissions by 2030

Medium-term industrial policy is also unlikely to help engender bullish sentiment. Germany announced in 2019 a plan to phase out the use of coal for power generation between 2020 and 2038, to be replaced by a combination of increased gas-fired electricity and renewables. 

The policy has significant implications for carbon demand. Germany’s auction reserve for utilities totalled around 170mn t in 2019 and is likely to be similar in 2020. But as coal-fired plants close and only some are replaced with gas-fired units, demand for EUAs could decline faster than supply in coming years. 

Germany’s plan is to cancel some of these unneeded allowances, and the legislation to establish this mechanism is in preparation. However, market participants complain of a lack of clarity concerning the timing and scope of those removals. If plant closures begin in 2020, the lost demand may not be compensated by reduced supply for a year—or possibly two—leading to lower prices in the short term. 

The bull case 

A bigger policy initiative is the European Commission’s Green Deal proposal, unveiled by the new president of the Commission, Ursula von der Leyen, late last year. This could have longer-term positive effects on the carbon price. 

The Green Deal proposes a more ambitious climate target of reducing EU emissions by 50-55pc from 1990 levels by 2030. This in turn will require regulators to set a more stringent cap on emissions in the EU ETS during its next phase, which runs from 2021 to 2030. 

While the commission is only expected to table legislative proposals on amending the EU ETS in 2021, the anticipation of a tightening of targets—and consequently higher EUA prices—will be part of companies’ longer term planning. It could also encourage strategic investors to enter the market, adding to upward price pressure over time. 

In the more immediate term, though, is the upside risk of any significant increases in power demand. With gas-fired generation now firmly in charge across much of Europe, there is relatively little scope to meet any significant uptick in power demand without restarting coal plants. 

While this winter has been mild to date, a sustained cold snap would necessarily bring coal back into the picture, boosting demand for carbon. 

There also remains the unanswered question of speculative demand. A year of stable prices in 2019 encouraged many investors to take profit, but they remain watching closely from the sidelines. 

Positive sentiment over the longer-term developments outlined above has maintained their interest, and numerous traders speculate that this money is now simply waiting for the right time to re-enter the market. On the other hand, with the outlook as opaque as it has been for a number of years, investors currently waiting for the right moment to enter the market may find themselves waiting a while longer yet. 

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