Collateral damage revisited

Four days after the Russian invasion of Ukraine I published Collateral damage. In the article I discuss the main factors investors need to pay attention to when considering how the crisis could impact the EU carbon market:

No market is immune from a crisis, no matter how compelling the underlying fundamentals may be.

Rather than closing your eyes and hoping for the best, it is my intention in writing this article to illustrate some of the risk factors to be aware of. Even the most unlikely scenarios have a non-zero chance of occurring. It would be foolish for investors not to consider them in their analysis. As things unfold I will return to cover each in detail to update you on where things stand.

There are four channels through which the Ukraine-Russia war could impact EU carbon prices - financial, economic, political and social. Each channel varies in its immediacy and ferocity of impact, and the potential legacy it may leave in its wake.

Lets take a look at each of these four channels in turn.

In less than one month, the EU carbon price collapsed from almost €100 per tonne in early February 2022 to ~€60 per tonne. Once the initial market volatility subsided, turmoil in the continents energy markets continued to have an impact on many of Europe’s utilities, with some putting their hedging activities on ice as market liquidity evaporated and margin calls soared. For now at least it appears that the battle to stop markets from boiling over appears to have been contained.

During the first few weeks after the invasion the term on everyone’s lips was “demand destruction”. It seemed inevitable that the spike in energy prices would cause a nasty recession. In the end, governments stepped in to help support households and businesses through the ‘energy crisis’, alleviating the worst fears. However, with European manufacturing data showing signs of renewed weakness in early summer 2023, it doesn’t look like we’ve seen the last of the economic impact.

Europe’s political leaders were quick to reiterate their support for the EU carbon market in the weeks after the invasion. Later in 2022, member states even succeeded in raising the level of ambition while also signing off on the worlds first carbon border tax - the CBAM. It wasn’t all plain sailing though. The debate around raiding the Market Stability Reserve (MSR) to help fund an acceleration in the bloc’s energy transition raised concerns that they would undermine one of the foundations of the EU carbon market.

Although I describe each of the three factors separately, it’s clear that they are inextricably linked.

Lets turn our attention to the fourth, the social impact. It’s here where the impact is felt last, but from which the biggest impact on the EU carbon market may eventually reverberate from. Here’s how I describe some of the social issues to watch out for back in February 2022:

It is now common knowledge that Europe receives a significant share of its energy needs from Russia, and potentially at the whim of one man, President Putin. Turning its back on Russian energy will inevitably result in higher European energy prices. That will come at a cost, one which the European public may be unwilling to bear.

The real test will be changing public opinion.

Will EU member states be prepared to ramp up their support for households and businesses hit by high energy costs? In the long run, open ended subsidies by the state increases sovereign debt risks.

Will EU citizens recognise the impossible trinity at the heart of net zero, and now favour energy security and affordable energy versus net zero? The shock from recent geopolitical events are likely to reverberate long after the conflict comes to an end, whenever that may be.

From the perspective of EU climate policies and the EU ETS, the most important location to monitor for signs of social disturbance is Germany. High energy prices have savaged German industry given its historical reliance on Russian natural gas, and the energy intensive nature of its industrial complex, although up until now at least the impact on unemployment has been muted (see Chemical reaction). The country has also experienced an influx of migrants from Ukraine seeking asylum, estimated to be almost 1 million in 2022, as well as from other countries, that is putting increasing strain on the country’s cities.

Meanwhile, support for climate policies is faltering in Germany as energy prices have increased, with many citizens increasingly critical of the governments approach. Continuing to phase out nuclear power generation in the midst of the energy crisis and recent proposals (since watered down) to ban the installation of gas or oil fired boilers in new homes has come in for particular criticism.