A combination of factors has driven EUA prices above €100, causing some concern in the markets. Regulators want to ensure stability in the ETS, while companies are concerned about prices in the current environment. Many will need to buy credits to comply with the GHG emissions reduction targets set by the EU’s ‘Fit for 55’ legislation and REPowerEU proposals.
- The price of the benchmark EU Allowance (EUA), the main currency in the EU Emissions Trading System (ETS) exceeded €100 per ton of CO2 in February 2023.
- EUA prices are mainly driven by demand factors such as economic activity, and fuel switching, but have also been affected by high gas prices. There is also increasing compliance demand from (GHG) emissions reduction targets set by the EU’s ‘Fit for 55’ legislation.
- Spot prices may decline in the near term, as the EU issues more allowances, but futures may remain high. This is because most of the factors that led to the spike persist, which may proved costly for EU businesses.
The EU’s emission trading system (ETS) is an example of a compliance or mandatory carbon market, requiring companies to reduce their emissions. It is viewed as a key part of helping the EU achieve its Fit for 55 goal by 2030, and net zero by 2050. The ETS is a ‘cap and trade system’ which requires entities to buy or receive emission allowances that can be traded among them as needed.
The price of the EUA appreciated rapidly between early 2018 and early 2022, rising from below €10 to above €90. According to research by the European Central Bank (ECB)four factors led to this increase.
The first was cold temperatures in Europe during the winter of 2021, which resulted in a rise in energy demand. The second factor was the ETS being recognised as a central tool for the EU’s decarbonisation tool after the European Council’s ‘Fit for 55’ package of legislative proposals were announced.
A third factor contributing to the rise in EUA prices was a reduction in their availability in 2021, which also saw the beginning of a new phase of the ETS being implemented, bringing with it a more stringent cap on annual emissions.
The fourth, and possibly the most significant factor affecting the market in the short term, was the spike in gas prices, which drove electricity producers to switch from gas to coal-fired power generation.
What drove EUA prices over €100 in 2023?
The persistence of the same factors that contributed to the increase between 2021 and 2022 also drove the spot price for carbon credits above €100 in the EU. A prolonged war in Ukraine may keep gas supplies constrained, as seasonal energy demand increases, while the looming ‘Fit for 55’ deadline in 2030 may support higher EUA demand and prices in the medium- to long-term.
The ‘Fit for 55′ initiative, part of the European Green Deal, is crucial to Europe becoming the world’s first climate-neutral continent by 2050. It consists of a series of measures to make the bloc’s climate, energy, land use, transportation and tax policies suitable for reducing net greenhouse gas (GHG) emissions by 62% by 2030 compared to 2005 levels.
In the near-term spot prices may recede, as the Commission plans to provide more EUAs by auctioning allowances as part of the REPowerEU to diversify its energy supplies. The ETS auctions are expected to finance 40% of the €20 billion agreed to by Member States to fund REPowerEU.
This will have the effect of injecting fresh supplies of EUAs in the near term and ease tensions in the market, which could lower spot prices. Futures prices above €100, however, may prove to be a psychological level for the carbon market, meaning market participants might regard it as a level that they may have to live with over the long term.
Futures provide access to major global carbon credit markets such as the ETS
Futures are a type of financial instrument representing a contract agreement to buy or sell a specific commodity asset or security at a set future date for a set price. Carbon futures have several use cases, including providing a reference carbon price and serving as means to hedge – which, for companies, is guarding against rising carbon credit prices, while, for investors, is a way to reduce exposure to heavy emitting assets in their portfolios.
Among the most prominent carbon futures markets is the ICE Global Carbon Futures Index (NYSE:ICECRBN) from the US-based environmental marketplace Intercontinental Exchange (ICE). This provides a measure of the performance of carbon futures across the four most actively traded global carbon markets.
The four markets in the index are the EU ETS, the UK emissions trading scheme, the Western Climate Initiative, which is California’s cap and trade programme, and the Regional Greenhouse gas initiative of the North-eastern US.
The EU ETS accounts for 90% of the total carbon market trading value and is the most liquid of all. The ICE carbon futures indices are derived from ICE’s quoted carbon markets and account for 95% of global exchange-traded volumes.
While futures trading provides wide access to carbon markets, they may also allow some financial operators to speculate in the market, especially if there is heightened price volatility. A key factor that has been identified by the ECB in the rise in EUA prices is the role of financial operators, and the part that speculative trading may have played in it.
The role of financial operators in the EU ETS
Since their inception, EUAs have been traded by banks and hedge funds, which have accounted for the largest trading volume in the market. Some of them have also provided important services, such as serving as intermediaries, providing market intelligence, engaging in market-making activities and acting as counterparties for future trades.
A pickup in speculative activity by financial operators, however, was not observed until 2017-18, according to the EP report, when rising prices attracted new players looking to generate faster gains by indulging in both short-term, and long-term speculation.
While short-term speculation can cause price fluctuations in the near term, long-term speculation, such as buy-and-hold strategies have the potential to disrupt the market if they occur on a large scale. The effect of hoarding allowances is that supply gets squeezed, resulting in price inflation, while the sudden need for liquidity by one or two players can result in market collapse.
The analysis provided by the European Parliament, as well as that done by the European Securities and Markets Authority, has shown that volumes held for long-term investment are relatively small, which suggests that had little to do with the rise in prices in late-2022 and early 2023.
The report concluded, however, that the longer-term, buy-and-hold strategies should be monitored closely, in case they require intervention. It suggested to manage this risk in the future by mandating position limits and setting up an independent market authority.
The potential for actions by financial players to be detrimental to the EU ETS does not come from EUA inflation, but volatility, which invites speculative behaviour, according to the report. Provisions in the EU’s REPowerEU package and the requirements of the Fit for 55 legislation are also factors that affect EUA price fluctuation.
How are Fit for 55 and REPowerEU affecting the supply of EUAs?
The study by the European Parliament also looked at the role of financial operators and the impact of the Market Stability Reserve (MSR) mechanism on the recent price volatility and price action in the EU ETS.
The supply of EUAs in the EU carbon market is controlled by the MSR mechanism. Its purpose was to absorb excess carbon allowances by the EU that were driving down carbon prices, which helped provide support to the market and also served to buffer it against volatile price fluctuations.
The way it does this is to balance the flow of the total number of allowances in circulation (TNAC), usually within a band of between 400 million and 833 million allowances, which is set by the European Commission. As energy producers and corporate buyers use allowances to hedge their future revenues, this band is also called the ‘hedging corridor’.
According to the report, the TNAC has stood far above the hedging corridor in all the years the MSR has been in operation – at 1.45 million in 2021, well above the upper limit, resulting in 24% of the allowances being placed into the MSR.
In the fourth phase of the development of the ETS, which runs between 2021 and 2030, the intake level of the MSR has been maintained at 24%, while cap, or annual reduction factor for GHG emissions, has been raised from 1.74% to 2.2%, with a further proposal to raise it to 4.2%.
The proposed increase in the cap is to align with the EU’s raised decarbonisation ambition in its Fit for 55 legislation, which now calls for a 62% reduction by 2030. The 2.2% cap was first set to align with the EU’s 2018 ambition, which called for a 40% reduction in GHG emissions by 2030.
The adoption of the REPowerEU proposal by the Commission in February 2023 resulted in an increase in the supply of EUAs. While this implies a shift towards more renewable energy, higher energy savings, and less EUA demand, it will also reduce the inventory of allowances in the MSR, which may be needed for future auctions or to regulate prices.
The long-term impact of lowering EUA demand is not included in the ETS cap proposed as part of Fit for 55. The consequent surplus of allowances in the EU ETS could also lead to price drops and possible price volatility.
If the EU continues to pre-emptively auction allowances, it could also impact hedging activities by large entities, such as state-owned utilities. They may have reduced their positions because of increased uncertainty in the market, but also risk needing allowances in their transition to a low-carbon economy.
What does this mean for long-term carbon prices in the EU?
Taken in combination, most of the factors that contributed to EUA prices rising above €100 will likely remain relevant in the near future. Climate change impacts are going to continue to influence the need for energy, both in the summer and winter, while a prolonged war is likely to keep gas prices high.
As the deadline to comply with the EU’s raised ambition of reducing GHG emissions by 62% by 2030 approaches, there will be greater pressure on companies to comply. If the cap on annual emissions is raised from 2.2% to 4.2%, it will further add to this pressure, leaving the MSR as the EU’s only option to influence EUA prices by adjusting supply.
Three of the four factors that affect EUA price levels seem to suggest that demand for credits will continue to rise. Whether the fourth factor manipulating the MSR is enough to keep prices within a reasonable range until 2030 remains to be seen, although for companies the message appears to be to accelerate their transition.
Faced with rising carbon prices and economic uncertainty, the prospect of hedging their emissions by using EUAs may be less appealing for non-financial European companies looking to meet the Fit for 55 targets.
A less risky proposition may be to accelerate their transition, for example by using more renewable energy, which is also the long-term aim of the EU and why it has implemented the REPowerEU programme.
