EU carbon price surges up-wards – but sends a warning

16 November 2018

Recent changes in the EU carbon price, varying around a generally strong upswing, have led to a range of cautious forecasts for the years ahead. Staff report

On 3 October Reuters reported that analysts had raised sharply their forecasts for carbon prices in the EU Emissions Trading System (ETS) to 2021 after the market surged more than 40 % over the preceding three months, but warned that a correction may be on the horizon in the short term.

EU Allowances (EUAs) were expected to average 23.01 €/tonne in 2019 and 26.96 €/tonne in 2020, according to a survey of eight analysts polled by Reuters. The forecasts were up 24% and 30%, respectively, from prices given in July, when the projections were for 18.59 in 2019 and 20.76 in 2020. Forecasts for 2021 were increased to an average of 26.11 €/ tonne, up 19%.

The ETS charges power plants and factories for every tonne of carbon dioxide they emit. Prices have more than doubled this year, with utilities ramping up hedging ahead of supply cuts coming into effect from 2019 and as more speculative traders entered the market. “With the market being driven upwards by speculative capital, and with no obvious trigger to arrest the bull run, we expect it will largely continue” commented Energy Aspects analyst Trevor Sikorski.

The ETS has suffered from excess supply since the financial crisis, but this will be addressed by new measures starting next year, such as the Market Stability Reserve, which will remove some surplus allowances from the market.

In the shorter term, several analysts warned that current prices, around 21.50 €/tonne, could undergo a correction. “Just looking at the number of options ‘in the money’ you get the idea that if there is a bubble in the market it may burst soon,” commented Matteo Mazzoni, an analyst at Nomisma Energia. Mazzoni, and analysts at Refinitiv (formerly the Thompson Reuters Financial and Risk business) noted that there were nearly 170 million tonnes of open interest, in-the-money call options with a December expiry date.

“This is a main bearish risk factor for the Q4 price. We might even see the sell- off take place before December since a sell-off after option expiry is widely expected,” said Refinitiv senior analyst Ingvild Sorhus.

Refinitiv report

In August 2014, Refinitiv predicted that the European carbon price, then at €6/tomme, would rise sharply within the next decade, owing to factors which had led some analysts to question the credibility of EU’s climate policy. Refinitiv’s report on EU policy asserted that stricter regulations, driven by the EU’s efforts to reform the European Emissions Trading System, would raise the EU carbon price to an average of €23/tonne in real terms between 2021 and 2030. This conclusion was based on Point Carbon’s base case price forecast, which assumed the EU would adopt a 40% emissions reduction target, a 27% renewable energy target, and a 30% energy efficiency target for 2030, along with the Market Stability Reserve then proposed by the Commission.

In January of that year, the Commission had presented a legal proposal for a Market Stability Reserve, which would adjust the supply of permits depending on changes in demand, making carbon prices more stable. Refinitiv’s analysis of the proposal suggested that such a mechanism would play a major role in supporting the future European carbon price. Without it, it saw the carbon price averaging €14/t in the 2021-2030 period.

Updated analysis

On 16 October 2018 Refinitiv published a new analysis entitled EUA price forecast: A new era for European carbon or calmer waters ahead?

It noted that European carbon prices have seen an extraordinary development over the past year. Since the crash in early 2016, prices lingered in the area between €5/t to €7/t, amidst policy discussions to strengthen the market balance and revamp the trading system. The climb started from a modest base over summer 2017, and since then the arrows have pointed in one direction – upwards (Figure 3). The Dec-EUA contract has risen 150 % in one year, and the rally has only accelerated over time – reaching as high as €25/t in early September.

Refinitiv sees the price rally as sparked and mainly driven by market participant’s expectations of the start of the Market Stability Reserve from 1 January 2019, curbing auction volumes by 40 % compared to 2018, with the rally further supported and reinforced by an overall bullish energy complex limiting coal to gas switching in the power sector.

While the direction of the past year’s price rally was expected, the magnitude and the speed of it far exceeded what was anticipated. Less than a year ago, as EU policy makers had agreed on the rules for the fourth trading phase in the EU ETS, Refnitiv had forecast that prices would reach €8 in 2018. Observed prices have far exceeded expectations at the beginning of the year – average 2018 prices are likely to be at €18/t, €10/t above the projections.

In this analysis Refinitiv provides an update to its annual carbon price forecast until 2030 including an analysis of the significance of the Market Stability Reserve in affecting the market balance and why it thinks the EU ETS is about to enter a new era when the MSR starts in 2019.

While still oversupplied on a cumulative basis, the market will be short on an annual basis once the MSR starts to operate. Figure 4 shows the development of the balance, with the line depicting the cumulative balance, ie counting in the oversupply in the market, and the bars showing the relation between yearly supply (from auctions and free allocation) and expected emissions from the power and industry sector in a given year.

The mechanism will soak up in total 1.6 Gigatonne from auction supply over these years, on average 325 Mt per year – starting at 386 Mt in 2019 and 380 Mt in 2020. This will lead to shortages in 2019 and 2020 of, respectively, 315 million tons and 215 million tonnes. 

The Refinitiv report – main points

  • The 2018 EUA price rally is primarily driven by the anticipation of Market Stability Reserve (MSR) market surplus from 2019 onwards. The re-entering of financials into the EU ETS has accelerated that price rise, as have the front-running of forward EUA hedging and the limited fuel switching potential due to a tight European gas market.
  • For the period 2019 to 2030 EUA prices are forecast to average €23/t, up €1/t compared to Refinitiv’s long term forecast in June. Refinitiv has revised its price forecasting methodology, assuming prices to converge with abatement costs during the years with annual shortage.
  • Looking at annual shortages as the reserve holds back 24% of the market surplus from the auction supply during the first five years of operation, abatement costs again become relevant for EUA price setting. With prices forecast to average almost €24/t over these years, peaking at €25/t in 2020, the report estimates that emission reductions in the order of 300 Mt will be triggered in the power and industry sectors, up 100 Mt compared to Refinitiv’s previous forecast.
  • Refinitiv forecasts a slightly declining price path in the period from 2022 to 2027. This reflects the twin effect of the MSR intake rate being halved to 12 % from 2023 onwards and the declining emissions pathway due to increased phase-in of renewables for power generation.
  • As a result, the EUA surplus starts to grow again after dropping to lower levels in 2023.
  • In anticipation of higher abatement needs in industry sectors towards 2030 after their cumulative surplus is depleted, Refinitiv forecasts prices to pick up in the final years of phase 4, ending at €26/t in 2030, €3/t down from our previous forecast.
  • The Market Stability Reserve will soak up 2.6 Gt of the market surplus over the 2019-2030 period (in addition it contains backloaded and unallocated phase 3 volumes). Despite this it is expected that it will fall short of creating a balanced market.
  • With its current design parameters, the MSR is not set up to cope with the falling emission paths due to the more ambitious targets on renewable energy and energy efficiency. While significantly reduced from today’s levels of 1.7 Gt, there will still be a market surplus of more than 1 Gt in 2030 – growing from a low of 680 Mt in 2023.

Figure 3. Base case EUA price forecast. Source – Refinitiv
Figure 4. EU Energy Trading Scheme balances. Source – Refinitiv
Figure 2. EUA price (front-year contract) €/tonne January 2017 to August 2018 €/tonne. Source – Bloomberg
Figure 1. Historic carbon prices €/tonne April 2008 – November 2018. Source - Sandbag

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