Looking beyond the short-term turbulence: The promising long-term horizon of the EU ETS and carbon pricing

Last week, I talked with a representative from the French government about the  European Union Emissions Trading System (ETS) - he described the market as myopic. 

• Most participants are only focusing on the very short term. They overreact to temporary changes, introducing short-lived price moves.
• They tend to ignore the longer-term market structure and fundamental demand-and-supply dynamics. 

Presently, European Union (EUA) prices are on a decline due to this short-term bias. They opened the year at €78.02 and have lost almost 30% ever since. Yet, the long-term fundamentals underlying EUA levels remain unchanged - carbon allowances are designed for price appreciation. This is highlighted in a recent report from SEB Bank in Stockholm, who singles out EUAs as one of the great opportunities of 2024.

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A shortsided EU ETS market: why have EUA prices been falling recently?

‍A reduced EU ETS demand from compliance entities

EU ETS compliance buyers are those who purchase EUAs because of a compliance obligation to match the volumes of CO2 that they emit. Historically, they have often been a main demand driver, bringing carbon prices up - just like  at the end of 2022 and beginning of 2023. At the time, EUA prices grinded from €65.4 (September 2022) to almost €100 (February 2023), driven up by such compliance demand. Industrials were buying to protect themselves from expected EUA prices on the rise - they were concerned that a shortage of allowances in the future might lead to continually increasing carbon prices down the line. They were also emitting more CO2 from coal-based power generation: Lower emitting gas was very expensive due to Russia’s war on Ukraine. 

Compliance buyers have been purchasing less EUAs recently, bringing down demand and having a negative impact on carbon prices. 

On the one hand, Industrial activity has been deteriorating. The Euro Area Manufacturing PMI, a proxy for European Factory output, has been decreasing - it peaked at 63 in 2021 and is now at 46. Industrials have still not resumed their usual levels of activity after the start of the war in Ukraine and the ensuing energy crisis. They are reconsidering their financial strategies to account for the economic disruptions - for example, in November 2023, one of the biggest EUA compliance buyers, the German utility RWE,  announced that they are suspending their systematic buying of carbon allowances. 

Beyond the financial considerations and modeling, lower industrial activity simply means that less carbon emissions are released during production processes. In turn, there is less need to buy carbon allowances to match the tonnes of CO2 produced. For instance, in Europe, the electricity, gas, steam and air condition supply sectors were responsible for the release of 207 million tonnes of CO2 in the last quarter of 2021, this figure decreasing to 127 million in the second quarter of 2023 (a 39% decrease in a year and a half).

Gas markets and the EU ETS - an almost perfect correlation

EUA prices and Euro Gas prices were declining at the same pace at the end of 2023. Then, EUA prices and Euro Gas prices started to stabilize at the beginning of 2024… still at the same pace.

One of the explanations of this correlation is the link between gas prices and the expected level of CO2 production. To simplify, power generators can choose between using gas or coal for their activities. Opting for gas is a less carbon-intensive option, so it is implied that the more gas is used, the less carbon will be emitted, resulting in a reduced need for carbon allowances to match the emissions. On the other hand, the use of coal for power generation produces large amounts of CO2, engendering a bigger need to buy EUAs. So, whenever gas prices go up, industrials choose to use more coal. An increase in the demand for EUAs becomes expected, respectively bringing EUA prices up. 

Gas prices have been at the decline this winter. There is a comfortable supply level - according to data from the Gas Infrastructure Europe (GIE), inventories across Europe and the UK were at 996 TWh at the end of 2023 - a seasonal record, 30% above the 10-year average. 

Gas prices are getting lower because of the reduced demand for heating energy. Northwestern Europe is the primary gas consumption area and has seen record high temperatures this winter - for example, temperatures in Frankfurt were 2.3°C above the October to December average, this excess being at 1.1°C for London. 

Gas prices are very dependent on seasonalities and temporary macroeconomic dynamics. As gas and EUAs are correlated, those short-term trends are also visible through the myopic carbon price fluctuations. 

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The far-sighted view of the EU ETS market: nothing has fundamentally changed

The two major EU ETS reforms from the past few years have been:  

• The introduction of the Market Stability Reserve (MSR), operational since 2019;
• The Fit for 55 climate package to revise the EU environmental target, proposed in 2021. 

Both of them include the aim to make the climate targets more ambitious, reduce the EUA supply at a faster phase, phase out the allocation of free allowances quicker, and enhance the market appreciation more broadly. 

The essence and the engineering of the EU ETS has not changed. Commodities analysts from the Skandinaviska Enskilda Banken (SEB) state that “Forward 2026/27 and onward fundamentals are thus still as strong as they were previously which calls for a minimum price of EUR 100/ton or more by that time-horizon.” This implies an annual average growth rate of over 13% from current levels. 

RepowerEU temporarily boosted supply in the EU ETS

The MSR aims at balancing the carbon market - it ensures that the difference between demand and supply remains in healthy ranges. As a reminder, It automatically adjusts the total number of allowances available based on the prevailing market conditions (the current difference between demand and supply). It does so by introducing an annual adjustment to the number of allowances in circulation. The “EUA surplus” is the difference between the total number of allowances in the market (the EUAs that have been issued but have not been surrendered), and the number of EUAs surrendered by the installations.

• If the surplus is above the buffer MSR level of 1096 Mt, the MSR will hold back 24% of the surplus.
• If the surplus is between 1096 Mt and 833 Mt (the upper threshold level), the buffer MSR kicks in. The number of allowances placed in the MSR will be the difference between the total number of allowances in the market, and 833 million. 
• If the surplus is between the upper threshold 833 Mt and the lower threshold 400 Mt, the MSR is muted and there is no intake to the reserve.
• If the surplus falls below the lower threshold of 400 Mt, the MSR releases allowances to the market and 100 Mt is placed to the annual auctions.

The MSR ensures that any market surplus above 833 million EUAs is erased in the span of 2-3 years. There is currently a market surplus of 1.1 billion allowances in part due to the RepowerEU package. This document was drafted as a response to the beginning of the war in Ukraine and the subsequent energy crisis. EU regulators are working towards achieving energy independence from Russia - they are allocating the necessary funds to accelerate this transition. In this context, the European Commission modified the timing of the distribution of carbon allowances. 

As previously discussed, within the EU ETS framework, regulators have set a limit of the volumes of carbon allowances (and EUAs respectively) that can be issued until 2050. The geopolitical situation from the past 2 years was an emergency and required a change in the timing of issuance of carbon allowances. To simplify, the European Commission has “taken out” from the budget anticipated for the future and has injected them earlier in the economy. Indeed, €20bn of additional EUAs are now being added to the market through the RepowerEU scheme.

This surplus is to be erased by the MSR in the next 2-3 years to come -the demand-and-supply dynamics will be back to normal by 2026 - 2027. As per the chief analyst commodities at the SEB, “The supply of EUAs will as a result rise slightly in 2024 and 2025. This will likely have a bearish impact on prices in 2023. But this frontloading will also lead to an even sharper decline in supply from 2026 onward. It is a bit like kicking the can down the road. Softer now and equally tighter in the future.”

The Fit for 55 package bolstered the long term EU climate ambitions, irrevocably

The reglementary reform increased the emissions reduction target within sectors covered by the EU ETS to 62% below the 2005 levels by 2030. To achieve this, regulators have introduced a faster pace of decrease of carbon allowance supply, as well as a quicker phasing out of EUAs given away for free. So, more industries will have to purchase their allowances, while facing decreasing volumes offered. 

As discussed above, some compliance entities were buying EUAs in order to use them in the future - we call this approach “hedging”. So, as a response to the decreasing amounts of freely available carbon allowances, industrials will revisit their carbon allowance strategies again. According to the SEB, the “hedging EUA ratios” will increase as a reaction to the news from the Fit for 55 (18% for January 2024, 35% for July 2024, 49% for December 2024). In simple terms, commodities demand for future usage is likely to pick up again. 

On top of the increased ambition in emissions reduction, new sectors were added to the EU ETS coverage - the maritime sector is part of the scheme from 2024 on, and the aviation sector for international flights (outside of the EU) is likely to also be included. As more sectors are part of the system, more entities are starting to seek EUAs to match their emissions. The maritime sector will account for 112 million tonnes of CO2 to be matched between 2024 and 2030. 

“[RepowerEU] led to front-loading which is giving the market some breathing room before tightening rapidly.” says Bjarne Schieldrop.

The market has not yet factored in the long-term structural effects of reduced supply and higher demand in the years to come. Prices are falling as participants are still myopic, distracted by short term trends. Expert carbon analysts forecast on average EUA prices to reach €70.55 by the end of the year, a 21% increase from the current level. The SEB has a current forecast of €105 for the year-end. Their chief analyst commodities suggests that this level is not entirely pricing in the dynamics that we just discussed - a “full pricing of the overall EU ETS market tightens to 2030 should probably place the EUA price in 2024 closer to EUR 130/ton.”

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Sources:

The European Commission, 2022. REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition

The European Commission, 2023. Our ambition for 2030

Eurostat, 2023. The EU economy greenhouse gas emissions: -5.3% in Q2 2023

Reuters, 2024. Europe's gas price falls to encourage more industrial use: Kemp

Skandinaviska Enskilda Banken, 2024. Buying EUAs on the cheap will likely be one of the great opportunities of 2024

Skandinaviska Enskilda Banken, 2024. The EUA price could drop to EUR 40/ton and then be picked up by Airliners, Shipping and Utilities

Skandinaviska Enskilda Banken, 2024. The value of an EUA spot contract is at least EUR 80/ton

Trading Economics, 2024. Euro Area Manufacturing PMI

Trading Economics, 2024. EU Natural Gas TTF

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