After years of blaming the EUTS for being a failed and useless market whose product had a price equal to the one of a sandwich in one of the most important restaurant chains in the world[1], 2018 brought us a new gift: a CO2 market that works. A statement that is as much imprecise and vague as is the current price of European emission allowances (EUA).

The chronicle of the events tells the story of a market that in 8 months witnessed an astonishing increase in the price of EUAs, rising from € 8 / ton at the start of the year to € 25.79 / ton last week. So, the question is: how did the market escape from that lackluster € 4-7/ ton range in which it was trapped from 2012 and triple in value within a few months?

The main merit is certainly linked to the approval of the ETS reform that will regulate the functioning of the mechanism in the next 12 years. Key element: the Market Stability Reserve. The MSR provides a perspective visibility of what could be the annual supply and demand balance of carbon allowances up to 2030, reducing the chances of witnessing a remake of the massive surplus (and possibly of deficit) that has characterized the market for the last 10 years. Designed and introduced with the primary objective of making the supply more flexible, the indirect “desideratus” is the progressive stabilization of the price of CO2.

Three months after its publication, the events of last week, with the price of the EUA that rose from € 20 to € 25 in a few hours and then collapse to € 18 at the same speed, do not seem to give comforting signs of stability. What is happening? Let us try to make order and understand what factors are driving the price of EUAs.

Hypothesis number 1: we run out of CO2 allowances

Analyzing the reasons for the recent EUA hike, the first thing to do is obviously to look at the fundamentals: demand and supply. Looking at the demand, the number of allowances needed is expected to increase also in 2018 due to higher emissions (we currently estimate a 0.6% increase). On the other hand, the supply has decreased this year: both the volume of EUAs auctioned and the quantity of free allowances is lower than in 2017; a reduction of -1.74%. Therefore, the fundamentals seem bullish. However, analyzing the numbers, even if 2018 will record a shortfall, this will dent the total surplus just marginally, falling to 1.57 billion allowances, namely 94% of the overall 2018 allocation. Apparently, there seems to be no evidence of a sudden need of EUAs.

Hypothesis number 2: we are up to run out of CO2 allowances

Let us analyze if the latest rise reflects a future shortage or not. Electricity producers represent around 70% of the market in terms of the amount of permits they have to buy each year. However, their buying strategy is not limited to the current year. In fact, utilities tend to sell the electricity they produce in advance, typically up to 2-3 years in advance. This practice, defined as “hedging”, leads utilities to buy EUAs on futures markets. The price of forward contracts is driven by two factors: the cost of production factors (namely gas and coal[2]) and the expectation of a future scarcity of EUAs. Since the beginning of the year, the gas forward price has increased by 33%, while coal by 4%; the forward price of emission allowances rose by 144%. To the reader the task of drawing appropriate conclusions.

Looking instead at the expected deficit, the starting point is clearly the current surplus of 1.65 billion EUA. This surplus will suffer a drastic reduction in the upcoming years because of the introduction of the MSR, which will reduce the number of permits sold in daily auctions: the total surplus will fall to around 100 million quotas[3] in 2023, when MSR will begin to reintroduce permits on market.

Hypothesis number 3: CO2 allowances have nothing to do with it

Trying to draw conclusions we have found that there does not seem to be an immediate or prospective scarcity of CO2 quotas. The MSR will lead to a rebalancing of the market, balancing supply and demand, and providing stability to the mechanism, and consequently to the operators that operate there. However, the variety of subjects that buy and sell EUAs, both spot and forward, is not just limited to operators who have compliance obligations. Traders, investors and banks all take part in the market, providing liquidity and facilitating the purchase and sale of EUAs, but with goals which differ substantially from those operators with compliance obligations, whose main objective is to minimize the cost of buying EUAs (and in few cases maximize the sale one). It is no coincidence that the return of finance on the CO2 market coincided with a new increase in price volatility.

How much will CO2 prices rise?

Having reached the end of the article, I realize that there is a basic question that I have carefully avoided so far, but it is the one that interests the most: how much will CO2 prices still rise? A question whose answer can only be uncertain. Uncertain because if it is true that it is possible to calculate what is the right price[4] of CO2 for utility and industrial, it is not equally true for the various financial subjects, for which the absolute price level is only a contingent value: volatility is the only important thing.

The fall of Thursday 13 September will not probably be an isolated event. Interesting months await in front of us. Just look at the number of options “in the money”: roughly 168 million options exercisable by the end of the year, whose sale could give rise to immediate profits. Therefore, the interesting question is no longer “how much will the price rise?” but “when will the new players decide to cash in the gains accrued?”.

The rise of the price is not, and will not be, as linear as many expected. Complex systems such as the ETS, are systems full of interdependencies between multiple actors that give rise to non-linear phenomena. The route that awaits in front of us resembles more a roller coaster of a luna park than a walk in the mountains.

 

 

The article is a summary of a Note from our Quarterly Report on the EU ETS (available only in Italian for now)

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[1] It is necessary to use 12 words to get a synonym for Big Mac.

[2] We consider TTF Cal19 and CIF ARA API2 Cal 19 as benchmark price.

[3] Nomisma Energia estimates, September 2018.

[4] The price that makes cheaper the production of electricity at lower emissions, or zero emissions. Typically, the fuel switch (between coal and gas) is used as an indicator. Its value currently ranges from € 22 to € 35 depending on the efficiency of the plant.

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