The price of European Union Allowances (EUAs) can be highly volatile around the EU ETS compliance deadline, which occurs on April 30th each year. In 2016, for instance, the price of EUAs spiked to €7.07 just before the deadline, only to drop shortly afterwards. The rest of the year did not come close to reaching those highs. This year, the backdrop to the compliance deadline is marked by a rise from approximately €8.00 at the beginning of January to a high of €13.04 on March 22nd. Despite this, many industrial players delay purchasing EUAs until after the verification process. To assist those yet to buy and those aiming to capitalize on the volatility, we explore the key indicators that influence EUA prices.
Year-on-Year Increase in Compliance Buying
Traditionally, participants in the EU ETS were over-allocated, but the amount of freely allocated EUAs is gradually decreasing. As a result, more companies are finding themselves short on allowances. While prices increased throughout April 2016, they remained relatively flat in April 2017. This suggests that the influence of once-per-year compliance buying on carbon prices is not yet clear. However, it is expected that every year will see increased interest in compliance buying around this time, leading to price increases.
Political Intervention (Actual and Anticipated Rule Changes)
Politics have a significant impact on EUA prices, as demonstrated by the correlation between politics and price movements in the past. However, the influence of political factors on the EUA price is unpredictable in terms of timing and market effects. For example, when the backloading policy was introduced in April 2014, which significantly reduced the volume of EUAs available for auction, the price of EUAs went down. Additionally, the French government’s proposal of a carbon price floor tax in April 2016 caused power prices to soar, subsequently driving up demand for carbon. The March 2017 announcement of the Market Stability Reserve (MSR), doubling its intake rate, provided bullish news but initially led to a drop in market value. Therefore, policy changes must be handled with caution, as their timing and influence on prices are uncertain.
Release of Emissions Data
The European Commission typically releases the previous year’s ETS emissions data at the beginning of April. Although it may seem tempting to attribute the price rises in April 2016 to emissions data showing a year-on-year increase, the reality is different. In fact, the 2015 emissions turned out to be 0.5% lower than those in 2014. Therefore, while emissions data may impact prices in specific cases, it is not a reliable leading indicator of price movements.
Fuel Fundamentals
The price of carbon is closely tied to the relative prices of fossil fuels, particularly coal and gas. If the price of EUR coal drops compared to gas, coal-fired power generation becomes more favorable, leading to an increased demand for EUAs. The same applies to the strength of Clean Dark and Clean Spark Spreads, with short-term strength often correlated with carbon buying as utilities aim to secure higher profit margins. While there is a connection between fuel prices and carbon prices, the timing of fuel price movements does not necessarily coincide with the compliance deadline. Therefore, April should be treated no differently than other months when monitoring fuel prices.
Late EUA Allocations
One of the most unexpected yet influential factors affecting end-of-year EUA prices is the delayed allocation of EUA allowances to power generators in Eastern Europe. These allocations, known as derogation volumes, aim to subsidize the transition to low-carbon generation. Their timing can disrupt the short-term supply-demand balance. In April 2016, several power generators in Southeastern Europe had not received their free allocation as the compliance deadline approached. In response, they purchased several million EUAs as an insurance policy to protect against fines. As the deadline approached and the free allocation did not materialize, increased buying caused prices to rise significantly. The prices reached their peak on April 27th and closed the month 84c lower after the allocations were finally received.
Conclusion: What to Expect in April 2017?
In April 2016, multiple factors coincided, such as late free allocations, French power price jumps, and increased compliance buying. This resulted in EUA prices trading at levels significantly higher than the annual average. However, in 2017, despite bullish political factors and increased compliance buying, prices did not show substantial movement. This year, prices have been steadily rising since January, largely due to increased interest from the wider investment community. The expectation that carbons prices will surge once the MSR becomes active in January 2019 has created a self-fulfilling prophecy. However, there is a risk of a major correction in the market, with the potential for EUA prices to halve, like what happened in 2014.
Therefore, investor interest seems to be the most influential factor in 2018, outweighing other influences. The introduction of the MSR in 2019 will likely bring further volatility as the market adjusts to being short on allowances. Only then will end-of-year compliance buying potentially have a significant impact on prices. It is important for companies to avoid storing all their buying requirements until the last minute and consider effective risk management strategies.
As always, the EU ETS presents unpredictable situations, so staying vigilant for unexpected developments is crucial.
