The price of EUAs can be volatile around the EU ETS compliance deadline, the 30th April each year. For example in 2016 the price spiked to €7.07 just before the deadline and fell away again straight afterwards (see the drop just after point 3 in Figure 1). The rest of the year got nowhere near those highs. The backdrop to the compliance deadline this year is a move from around €8.00 at the beginning of January to a high of €13.04 on 22nd March. Yet many industrials put-off buying EUAs until after verification so, for the benefit of those yet to buy and those trying to capitalise on the volatility, we explore those factors and conclude what we believe are the key lead-indicators for EUA prices.
Participants in the EU ETS were traditionally over-allocated. However, the amount given out for free is slowly reducing and more and more companies are finding themselves short (see Figure 2). With prices rising throughout last April 2016 but essentially flat in April 2017 there’s not yet a clear picture that once-per-year compliance buying is influencing the carbon price positively. Redshaw Advisors find that installations often either buy as soon as their verification is done in February or they wait until April. It is the approaching deadline which forces buyers to buy so creating a price rise in April. However, the volume of ‘late’ buying is difficult to quantify; though this year there is a strong temptation to put-off buying until later (or even to borrow from 2018’s free allocation) as prices have been moving upwards in a more-or-less straight line since January. Nonetheless, it is reasonable to conclude that from now-on, every year we will see more compliance buying interest around this time, meaning its influence will cause an EUA price increase.
Political intervention (actual and anticipated rule changes)
It will come as no surprise that politics influence EUA prices. Figure 1, shows some of the coincidence of politics and price moves. However, political influence over the EUA price is unpredictable, both in timing and its effect on the market. In April 2014 when backloading started the volume of EUAs available for auctions was drastically reduced yet the EUA price went down. And it went down a long way (point 1, Figure 1). April 2016 the French government proposed a carbon price floor tax that sent power prices soaring and with it demand for carbon (point 3 in Figure 1). In March 2017, the market was given arguably the most bullish news in its history: the Market Stability Reserve (MSR), that is already set to start removing EUAs from the market in 2019, will have its intake rate doubled. At the time the market reacted by dropping in value. During Q1 2018 prices have rocketed, but it took nearly a year for the March 2017 decision to be translated into major price rises. We can conclude that not only is the timing of policy changes unpredictable, the influence on prices is too, so this factor needs to be handled with care.
Release of emissions data
The European Commission typically releases the previous year’s ETS emissions data at the beginning of April. It would be tempting, when looking at April 2016’s EUA price rises, to conclude that emissions data showed a year-on-year increase. In fact 2015 emissions turned out to be 0.5% lower than 2014. Clearly there were other factors influencing prices but our conclusions is that outside of the shock of 2006’s surprise revelation that 2005 was massively oversupplied, emissions data is not a lead indicator of price moves.
The price of carbon is normally highly dependent on the relative price of fossil fuels, priced in Euros, in particular coal and gas prices. If EUR coal prices drop relative to gas then coal fired power generation is favoured and more EUAs need to be bought. The converse is also true. The same applies to the relative strength of Clean Dark and Clean Spark Spreads, short term strength is usually correlated with carbon buying as utilities rush to lock-in higher profit margins. In April 2016 there was an appreciable increase in Clean Dark Spread levels as power prices rose. However, there is no causal relationship between fuel price or Clean Spread movements and the timing of the compliance deadline. For example, 2016’s Clean Dark Spread rise was only in the last week of April yet EUA prices rose through the whole month. Carbon traders need to keep a close eye on fuel prices but there’s no reason that April needs to be treated any differently from other months.
Late EUA allocations
The least expected yet probably the most influential compliance year-end EUA price influence is delayed EUA free allocations. The timing of allocations of so-called derogation volumes to power generators in Eastern Europe (all power generators in other countries receive zero free allocation in Phase 3), designed to subsidise a transition to low carbon generation, can materially upset the short-term supply / demand balance. In April 2016, a number of South Eastern European power generators had not received their free allocation as they approached the 30th April compliance deadline. As an insurance policy, to protect against €100 fines per tonne of shortfall, they were rumoured to have bought several million EUAs with a view to selling them back again when their free allocation finally arrived. As the deadline approached and the free allocation didn’t materialise there was increased buying that caused prices to rise. Prices rose by as much as 84c on 26th April, topped out at €7.07 on 27th April and when the allocations came through just before the deadline, closed the month of April exactly 84c lower.
Conclusion: what can we learn from history about what may happen in April 2017?
In April 2016 there was a coincidence of a number of factors, late free allocation saw a few million tonnes of extra EUA demand, French power price jumps added a few million more and compliance buying increased over the previous year. The price reacted by trading at a price much higher than the year’s average (€5.36) as a result of this coincidence.
In 2017 there was a bullish political factor in the form of a doubled intake rate of the MSR and there was increased compliance buying over the previous year. Prices did almost nothing.
This year prices haven’t stopped rising since January. The most relevant factor appears to be the increased interest from the wider investment community that have all been sold on the idea (mainly by utility equity analysts) that carbon prices will rocket once the MSR goes live in January 2019. Their interest has created something of a self-fulfilling prophecy as Commodity Trend Followers (CTFs) have jumped on the bandwagon as various price levels (based on ‘technical analysis’) have given way. Some of this trading is automated so they take no prisoners in what is a small market relative to the more globalised oil, coal and gas markets. The danger for EUAs is that the market is building up to another major correction, if the bubble bursts the trend followers will sell just as aggressively as they have bought and if the investors’ nerve is tested to breaking point we could see the EUA price halve, just as we did in 2014.
So, despite all the other influences, 2018 looks like it is the year of investor interest influencing price more than anything else. The MSR starting in 2019 will be associated with a lot of volatility as the market gets used to being short again. In all likelihood, only then will year-end compliance buying have a chance of being a material influence on prices. Hopefully also by then, companies will have learned to take the advice that we always give to our customers – to not store up all their buying requirements until the last minute and to consider a more effective risk management strategy.
One thing is for sure, no-one can afford to not keep an eye out for the next EU ETS curve-ball as they seem to keep coming!
Louis Redshaw is CEO and Founder of Redshaw Advisors Ltd., a company dedicated to helping companies understand and manage their carbon risk exposure.