Cheap gas stalls EU's carbon price revival
A slump in gas prices has contributed to the denting of the previous rally in carbon prices
European carbon allowances rose three-fold in 2018 as traders bought in anticipation of tighter supply due to drastic reforms to the EU's emissions trading system (EU ETS). However, the rally has stalled this year, with the unexpectedly mild winter and Brexit uncertainties depressing demand.
European carbon prices endured a seven-year slump after the global economic crisis of 2009 dampened industrial production, which led to a glut of EU ETS allowances. Carbon prices dropped from the high €20s/t in 2008 to a low of €2.75/t in 2013 and were still languishing below €5/t in 2017.
But, in 2017, the EU approved reforms to the EU ETS aimed at removing as much as 1.6bn surplus EU carbon allowances (EUAs) from the market. The market stability reserve (MSR) will withdraw 24pc of the surplus each year from 2019 to 2023, and thereafter will maintain a market balance of between 400-833mn allowances.
The EU's approval of the MSR triggered a year-long rally in 2018 and saw prices for EUAs rise from just over €8/t to more than €25/t. Numerous investors, hedge funds and speculative traders piled into the market to build long positions during the rally, while industrial companies and utilities also started to buy more EUAs in anticipation of a higher cost of compliance.
The rally had been expected to continue into 2019, but the climb came to a halt in the first two months of 2019 as a number of new factors began to influence the market.
Chief among these has been a slump in natural gas prices. Front-year futures prices in the bellwether Dutch TTF gas market had increased steadily throughout 2018, rising from €17/MWh to over €23/MWh. But a growing glut of LNG in the global seaborne market has begun to impact European prices, and front-year TTF has dropped back down to around €19/MWh since the turn of the year.
Improved power generation margins
At the same time, coal prices have also declined due to ample global supply and high European stockpiles. Front-year API 2 coal futures rose from $85/t at the start of 2018 to a high of €99/t, but slumped back to $76/t in March.
The impact of the fall in fuel prices, combined with higher carbon prices, has been to improve power generation margins for gas-fired power plants, to the extent that some utilities are now re-opening gas plants at the expense of coal units. And, because gas is half as carbon-intensive as coal, this means utilities need to buy half as many EUAs to cover emissions.
The so-called clean spark spread, the gross profit margin for gas-fired power after fuel and ETS costs, for power generated in 2020 has steadily gained since the middle of 2018, and briefly exceeded the clean dark spread, the equivalent gross profit margin for coal, at the turn of the year. While coal and gas are neck-and-neck for calendar year 2020, gas has better margins for balance-of-2019 contracts, and this has encouraged utilities, including Germany's RWE, to bring back mothballed gas plants and commit them to at least peak-load generation for the next 18 months.
Milder than average
An additional factor in fuel and carbon's price weakness has been the mild winter. A cold winter in 2017-18 caught out many power generators and encouraged them to build higher fuel stocks in advance of this winter. But temperatures have been milder than average, and this has led to a drop in demand for coal, gas and carbon.
These worsening fundamentals have led some investors in carbon to liquidate long positions that they built up in 2018. The consensus among traders, though, is that there remains a sizeable volume of speculative interest in the market that is waiting for the MSR to cut more deeply into the oversupply.
But, while the trading community anticipates a tighter market, political factors could weaken the impact of the MSR on the market balance. Last year, Germany's government appointed a special commission to examine how the country might phase out coal-fired power. The commission's report, published in January, sets out a phased elimination of coal power, with the last plant to close in 2038.
The commission notes that the forced closure of coal plants would have a significant impact on demand for EUAs, and recommends that the government cancel EUAs to compensate for the lost demand.
The cancellation would be carried out by reducing the number of EUAs the German government auctions each week. Traders are concerned that the government may not be keen to shut down a revenue stream that, at current prices, brings it around €300mn per month.
Coal phase-out plans
Other countries such as Italy, France, the Netherlands and Spain are also planning to phase out coal burning, but, so far, no other nation has committed to cancelling EUAs to match the expected drop in demand.
Increased uncertainty around Brexit is final new element in 2019. Both the UK and EU have set out plans for Britain's managed exit from the market by 2020, but this requires Brussels and London to reach a deal on a withdrawal agreement.
In the event that the UK leaves the EU without a withdrawal agreement in place, the UK will be disconnected from the EU ETS infrastructure. EUAs held in UK accounts will be frozen and cannot be traded.
Market participants are worried about a no-deal Brexit on two fronts: firstly, UK companies might wish to cash in any surplus EUAs they hold before the Brexit deadline. Such a sell-off could drive EUA prices down. Secondly, a no-deal Brexit is generally regarded as a negative risk by investors, and could lead to a cross-commodity sell-off that would include carbon.
Consequently, speculative traders have been reluctant to build long positions, and indeed negative headlines on Brexit have triggered modest sell-offs over the past two months. But, despite the bearish start to the year, market participants remain broadly optimistic that the gradual drop in supply over the next five years will boost prices further.