Collateral damage
“You may not be interested in war, but war is interested in you.”
―Leon Trotsky
The horrors of war are a tragedy for the innocent, caught up in the crossfire.
Nevertheless, as investors it is important to consider what the potential fallout from the crisis is for 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.
Financial
Within minutes of the EU carbon market opening up last Thursday morning, one single trading entity sold the equivalent of €700 million worth of carbon allowances. Those trades and subsequent selling was enough to bring about a near €10 per tonne swing in the carbon price in one day - albeit only reversing the gains seen over the previous several days.
Although the suspicion is that the trade was motivated by margin calls elsewhere in the energy complex (possibly by a hedge fund highly levered to European natural gas and power prices), we may never really know the underlying reason. If so then we know a similar event occurred in early October resulting in a 17% decline in carbon prices over 12-14 days. That proved to be an opportune time for carbon investors. This time may be different.
It comes down to credit, something that has been mispriced for some time. Although credit markets have sold off given expected future hikes in interest rates, they failed to account for increased credit risk. It only needed a major market dislocation for it to jump.
That spark may well be the decision to restrict certain parts of the Russian economy from the SWIFT payment messaging system. Rather than enabling energy and commodities to continue unencumbered, the measure is likely to result in commodity traders self-sanctioning in fear of future sanctions directed at them. In the absence of anyone willing to facilitate the trade, this could mean that energy supplies from Russia stop, very soon. Uncertainty over who has what exposure, and to whom is likely to lead to tighter conditions among those able to gain credit, leading to further margin calls.
If credit conditions tighten then we could also see non-energy holders of EUAs (e.g. financial institutions or even obligated industrial firms) seeking to offload them in order to raise collateral to cover losses and liabilities in other markets, whether related or not. The challenge is we really have little idea of who is holding what, and how motivated they will be to sell under the circumstances.
Economic
Energy intensive industries across Europe have already suffered from high energy prices in late 2021. For example, chemical companies such as those that manufacture fertilisers have been particularly vulnerable, creating knock-on impacts on food supplies. Other energy intensive industries such as cement, steel and other metals now face similar decisions - whether to mothball their plants, or not.
As the cost of near term energy contracts soar (due to perceived or real cuts from Russia), and longer term contracts rise too (as a result of the high cost of pivoting to non-Russian fossil fuel supplies), the opposition to carbon prices may escalate further. This could become especially acute if, as I argue later in this article, that EU member states appear to recognise the need for more burning of natural gas and coal, at least in the short term.
The economic fallout from the Ukraine crisis has only begun.
As I argue in an earlier article while adverse economic conditions have always been negative for EU carbon prices, the impact on carbon prices has declined over time as the structure of the EU ETS has evolved. Central to this was the introduction of the Market Stability Reserve (MSR) at the start of 2019 which acts to automatically reduce excess allowances each year within certain bounds.
The economic fallout may not stop there. It could have political consequences too. It has already.
Political
“Everyone has a plan until they get punched in the face.”
- Mike Tyson
I’ve argued that rather than thinking about carbon as a commodity, investors should think about the carbon price as the currency of decarbonisation. A strong carbon price is a signal that investors, businesspeople and citizens trust their government’s commitment to combat climate change.
In the same way that trust in individual currencies supports investment, innovation and trade, trust in carbon market helps to bring about the capital, skills and long term planning that is required to help meet decarbonisation goals. The carbon market is a utility of the state by which it can influence the private sector case for decarbonisation.
It has taken many years, and lots of blood, sweat and tears for the European Commission (EC) and the EU’s member states to establish credibility in their carbon market. However, just as politicians are tempted to slash taxes and increase borrowing, or to lean on their ‘independent’ central bankers to lower interest rates or print money in order to avoid difficult economic situations, the same political temptation might apply to ETS schemes. Politicians might be tempted to grant more free allowances, or reduce the slope by which the supply of allowances is cut.
Reversing course on the rules of the carbon market devalues the carbon price, and with it the case for decarbonisation. If the EU carbon market loses credibility, the trust placed in it by utilities, industry and investors may never be won back.
Arguably then it will be the political decisions that are made over coming weeks and months that will have the largest and long lasting impact on the carbon market. They may be real, or ones driven by changing sentiment. Either way they could have lasting impacts.
To see how fast things are moving you only have to look at Germany. In only a few days we have seen such dramatic change few would have thought possible for generations. For example, the country had a longstanding practice of not permitting lethal weapons that it controlled to be transferred into a conflict zone. That changed on Saturday when it agreed to send weapons from its arsenal to Ukraine citing the threat to entire post-WWII order across Europe.
Germany’s economy minister announced at the weekend that his government is weighing up whether to extend the life of its remaining nuclear power plants, due to shut down at the end of 2022, in order to reduce Germany’s dependence on imported Russian natural gas. It appears unlikely given technical and safety considerations, but to even publicly consider it represents a major U-turn. What then of Belgium’s scheduled phasing out of nuclear by 2025, enshrined in law since 2003?
More nuclear power generation = lower carbon emissions = less demand for EUAs.
Meanwhile, in another remarkable turnaround the German government announced that they will construct two LNG import plants, enabling them to buy more gas from non-Russian sources - this may take a few years to build based on other projects. In the meantime they also plan to establish a natural gas strategic reserve, and a similar reserve for thermal coal. This from the government, elected only last autumn on a green, zero-carbon agenda.
Of course, Germany also announced a desire to accelerate the adoption of renewable energy generation. It is unclear what this would involve, but any acceleration in the timetable would, if delivered, result in lower than expected emissions in the future and in turn less demand for carbon allowances.
Other EU countries heavily dependent on Russian gas have also shown signs that they will now consider hiver-to controversial fossil fuel decisions. Italian premier, Mario Draghi suggested it may be necessary to reopen coal-fired power plants to meet the country’s energy needs in the short term. However, as I have argued before, the potential to restart previously closed coal plants is much more limited.
What other decisions could member states make a quick 180 on in in the interests of geopolitical and energy security? It is unclear whether recent events will have an impact on negotiations over the ‘Fit for 55 package’. The policies intended to facilitate a cut in EU emissions of 55% by 2030 compared to 1990, and which has, as its core mission to turn the 2020s into a transformative decade for climate action.
What impact will this have on the path of the MSR? Will member states allow it to continue to decline at 24% per annum? Will current events derail discussions over the Carbon Border Adjustment Mechanism (CBAM), scheduled to come into force in 2026? Russia was expected to see the largest adverse impact from its introduction given the huge volumes of carbon intensive commodities it exports to the EU.
We have some sense of how carbon prices have performed during periods of economic stress. We have no reference point as a guide as to what to expect when it comes to major geopolitical dislocations, especially one where energy markets play such a central role. That is where the reaction of the public, and the median voter in particular plays such an important role.
Social
“A strong European Union cannot be so reliant on an energy supplier that threatens to start a war on our continent”
- European Commission President Ursula von der Leyen
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.