Carbon crash: WTF happened?
EU carbon allowances suffered their worst one day decline on Friday, falling 14% at one point late in the day before rebounding slightly to end the day down 12.7%.
So what happened, and where do we go from here?
First, it’s worth noting that the carbon price has only retreated to levels last seen on the 30th November - less than three weeks ago. In that sense it’s worth reflecting on the scale of the surge in prices that we have witnessed.
The carbon price broke out of 6 month trading range (between €50 and €65) on the 10th November when prices were around €61 per tonne. Over the next few weeks it surged by one-third to around €80 per tonne as gas prices increased. Thereafter the market went into overdrive, adding €10 per tonne in the space of a few days.
In a previous note, The witching hour approaches, I highlighted the role that the options market had on the carbon market, the expiry of call options this past week helping to drive prices higher as investors bought the underlying futures contract.
Retail euphoria also had a role to play in those last few days as prices reached into the 90’s. In part this has been driven by some of the same market participants involved with increasing investor adoption of cryptocurrencies. For example, I’ve seen the carbon trade described as, “The slam dunk trade in today’s green movement.”
There is no such thing as a slam dunk trade. Everything has its price, even the climate.
And then the market had a crisis of confidence.
Under pressure to cushion their citizens from the rising cost of energy a number of EU member states directed their ire at the EU carbon market. At a summit held in Brussels on Thursday 6 member states - France, Spain, Poland, Hungary, Latvia, and the Czech Republic - objected to the European Commission’s assertion that there were no irregularities in the EU carbon market.
Leaders demanded that the EC carry out more rigorous checks on the nature of speculation in the carbon market, while also suggesting the introduction of a ceiling price to manage upside volatility (presumably they are ok with downside volatility).
The meeting finished in the early hours of Friday morning. Without agreement. That the meeting ended without a formal set of words spooked the carbon market when it opened for trading, a few hours later.
Where do we go from here?
Well, first the next meeting of the EU member states is scheduled for the end of March. While there may be some choice words of criticism from aggrieved member states in the interim (as there were before this weeks meeting), nothing of any consequence is likely to be said in the meantime.
Nevertheless, it’s worth restating that the EU carbon market is THE tool by which EU leaders have assigned responsibility to achieve their legal climate ambitions - to which they are committed to both politically and legally.
When uncertainty resurfaces I look to my geopolitical framework and the demands of the median voter. To that end, nothing has changed over the past few months. EU citizens appetite for accelerated climate action has not wavered in the face of higher energy prices.
President of the EU Commission, Ursula von der Leyen underpinned this commitment by tweeting this chart below showing that carbon has played only a minor role in the face of higher electricity prices in comparison with natural gas, while also highlighting the measures that member states have taken to shield vulnerable people from higher costs. Note that the latter is only possible because of money generated through carbon allowance auctions.
Recall it was only 4 weeks ago that the German government announced that they would introduce a national carbon floor plan of €60 per tonne, and push for an EU wide floor if carbon prices fell below this level. The day this was announced carbon prices increased to around €72.50 per tonne. As it happens that is close to the price that the market closed at on Friday.
From a technical perspective the Dec-21 futures contract expires on Monday 20th December. The last few days before the Christmas holiday often means that trading volumes are light. This means that trading could continue to be volatile, especially on Monday.
Fundamentals will start to reassert themselves though.
Natural gas prices are likely to stay high, especially with the prospect of cold weather over the next month or two. This will drive increased coal burn to help meet demand, in turn increasing demand for carbon allowances to offset the emissions.
Unplanned nuclear shutdowns in France and planned shutdowns in Germany next year mean energy needs to come from somewhere. Part of it will come from increased renewable generation, but much of it is likely to be fuelled by gas and coal.
The end of the compliance year will also underpin fundamentals over the next few months. Firstly, over the Christmas period there is a long period where there are no action of allowances. This lack of new allowance supply is a bullish factor. Secondly, as I note in Thursday’s note, To infinity and beyond!, there is a shortage of allowances for those that need them - this year and in subsequent years, and its driven by constraints baked in to the EU ETS. This scarcity will be a powerful driver over the next few months. EU policymakers have no discretion over how this is handled.
The events of the past week would have been disorientating for investors comfortable with seeing carbon prices track up and to the right at 90 degrees. However, we are still very early in the development of the carbon market, especially in terms of its impact on emission abatement. Investors in the carbon market know that their hard earned cash is helping to accelerate that transition as high prices incentivise the technology required.
There will be bumps along the way but there really is no other path than higher prices over the long term if society is serious about making a dent in climate change.