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CO2 shrugs off the Covid-19 slump

Future policy assumptions support the EU ETS after initial hit

European energy markets have been thrown into turmoil by the coronavirus pandemic, with prices for some commodities falling by more than 50pc as demand has plummeted during the enforced lockdown.

A combination of housebound workers and a slowdown in commercial and industrial activity has also tipped countries into recession, blighting the economic outlook for the coming months and even years. But European carbon allowance markets are remaining robust, reflecting growing confidence that a long-term economic recovery will focus on low-carbon and sustainable policies.

The sudden and sharp decline in economic activity since March did, admittedly, feed through to Europe’s emissions trading system (EU ETS), where lost production is increasing a surplus of allowances that has dogged the market for a decade. Climate thinktank Ember estimates the pandemic cut EU-wide power demand by 14pc in April, and reduced carbon dioxide emissions from the sector by 39pc, as renewable sources took a larger percentage of the reduced pie.

“We forecast that [ETS] emissions in 2020 will be likely down [by between] 217mn and 290mn t, excluding aviation,” Tabet, Sandbag

Lower power output—particularly concentrated on coal and gas-fired plants—means lower carbon emissions, while the impact on industrial output is expected to be even larger and last for longer, analysts believe. Energy information firm Icis estimates the pandemic will cut emissions by 13pc, or 204mn t, in 2020 compared with its pre-Covid assumptions. About 80pc, or 160mn t, of this decrease will come from reduced European industrial production, and overall emissions will return to a ‘normal’ trajectory only by 2024, Icis predicts.

Others see the reductions being more evenly shared between power and industry. “We forecast that [ETS] emissions in 2020 will be likely down [by between] 217mn and 290mn t, excluding aviation,” says Eliot Tabet of climate group Sandbag. “Industrial emissions will drop by [between] 102mn t and 150mn t (15-21.5pc), constituting almost half of this drop.”


Current EUA market activity does not particularly reflect this bearish outlook for emissions. For sure, during the ten weeks since lockdowns began in Europe, carbon fell from €23/t CO2e to as low as €14/t CO2e, but it has recovered to trade within 8pc of its pre-virus levels. The price of EUA futures for December delivery currently stands at a little over €20/t CO2e.

Any drop in emissions in 2020 means growth in the surplus of allowances in the market. At the end of 2019, the European Commission calculated this excess at 1.38bn t, and the pandemic will add as much as 300m EUAs to this glut. So why have EUA prices not collapsed in view of the growing surplus?

“Economic activity is picking up again,” says one trader. “Certainly not to pre-Covid levels, but I think industry is at 60-80pc of capacity right now.” And participants report that there remains fairly healthy short-term demand from industrial installations. For some, recent prices below €20/t CO2e were too cheap to resist, particularly considering that prices were nearly €30/t CO2e as recently as last July.

Others are looking ahead to the annual compliance cycle that takes place in the first quarter of every year. Traditionally, factories have been able to ‘borrow’ EUAs handed out each year in February to cover their emissions for the previous year.

But after 2020, as the current eight-year phase of the market comes to a close, there will be no borrowing allowed, so any company that has been living hand-to-mouth in recent years must now go out and buy from the market if it hopes to meet its compliance targets next spring.

And those annual free handouts will be getting much smaller from 2021, as the Commission tightens the permitted CO2 cap as part of its longer-term goals. So building a reserve of relatively cheap permits today is seen as good risk management.

€20/t CO2e – EUA futures for December 2020

A second, short-term factor is the reliability of French nuclear plants. Operator EdF has scheduled a large number of maintenance outages over the coming autumn, which may require German fossil-fired plants to run in order to balance the northwest European power market. This is offering support to carbon allowances as German generators will need to cover their mainly coal-fired generation with additional EUAs.

Market tightening

Longer-term, many participants remain optimistic that the EU ETS’ in-built supply balancing mechanism, the market stability reserve (MSR), will clear away the surplus over time. The MSR automatically removes 24pc of any surplus in excess of 833mn t from the market each year; in the period between September 2020 and August 2021 it will withdraw 332m t from the market.

That brings us to the second factor underpinning trader confidence in robust prices. The EU’s Green Deal—the bloc’s plan to reform its entire economy along sustainable and low-carbon lines—will most likely require more drastic tightening of the EU ETS market.

The Green Deal envisages a steepening of the emissions-reduction target for 2040 from a 40pc cut from 1990 levels to a 50pc or even 55pc reduction, with a final goal of achieving net-zero emissions by the middle of the century.

To achieve this target, the EU ETS would require an accelerated decrease in the cap each year and fewer industries to receive free emissions allowances.

In addition, it is likely that the Commission would take the opportunity to make reforms to the MSR, either to extend the period in which it removes 24pc of the surplus, or even increase its withdrawal rate for a period of time. Traders may be betting that these reforms would speed up the rate at which oversupply is soaked up.

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