Deflationary expectations
Welcome to Carbon Risk — helping investors navigate 'The Currency of Decarbonisation'! If you haven’t already subscribed please click on the link below, or try a 7-day free trial giving you full access.
By subscribing you’ll join more than 3,000 people who already read Carbon Risk. You can also follow my posts on LinkedIn and benefit from my referral program. Thanks for reading!
Estimated reading time ~ 8 mins
The EU ETS emissions cap declines by 4.3% in 2024, an acceleration from the previous year-on-year decline of 2.2%. The Linear Reduction Factor (LRF) as it’s known continues at 4.3% until 2028 before increasing to 4.4% to 2030. Under the normal mechanics of a cap-and-trade scheme (i.e., a reduction in the supply of EUAs available at auction) this would be considered bullish for the price of carbon.
However, the decision to auction additional EUAs to help fund the energy transition has overwhelmed the rise in the LRF and undermined the bullish narrative. Almost one year ago, members of the European Parliament (MEP’s) voted in favour of the sale of €12 billion worth of EUAs from the EU Innovation Fund, and the front-loading of EUA auction volumes from later this decade to generate €8 billion. The sale of EUAs from the Innovation Fund would be partly compensated for by the transfer of 27 million EUAs from the MSR.
To recap, the driver behind this decision was the publication of the REPowerEU package by the European Commission (EC). The document outlined how the bloc was going to secure energy independence from Russia, and accelerate the decarbonisation of the European economy. An initial sum of €300 billion was tabled, although this was later increased.
In an article at the time (see Out of ammunition: What can the EU do to stop carbon prices surging over €100?) I queried whether the EU was making a classic central banking error. By adding €20bn of additional EUAs on the market had they fired too many bullets too soon, leaving nothing in reserve should emissions (and hence demand for EUAs) prove stronger than expected. A statement from Peter Liese, the lead lawmaker steering EU ETS reform through the European Parliament, drew attention to the price dampening impact of the REPowerEU financing (my emphasis):
"All of these three measures were highly controversial, among other things, because they will cause the price of emission allowances to not increase over the next few years. However, in my view, this is an intentional effect. The price is now already at almost 100 EUR and no company can drastically reduce its emissions within a few weeks.
Liese went on to highlight how REPowerEU should give Europe the time it needs to build up its capacity in renewables, while also implementing the improvements it requires (training, raw materials, etc.) to meet the 2030 target. He concludes by adding that there will be no excuses if you leave it too late to invest:
That's why I believe the compromise is the right response to the crisis and the long-term challenges we face when trying to achieve our climate targets. In the context of emissions trading, we have even increased the target for 2030. The agreement also takes account of the fact that we now have to burn more coal in the short term in order to become independent from Russian gas, but that we will have to increase our efforts again by the end of the decade. By then, we will be in a position to achieve this because the excuse that there is a shortage of materials and skilled workers will no longer hold true in a few years' time. If you have not invested by then, it's your own fault."
In the following four weeks after I published Out of ammunition the EU carbon price broke through the €100 mark three more times. But lacking any conviction to go any higher, that’s as high as it went. What followed was a grinding move lower to around €90 in late September, an acceleration in the sell-off during the fourth quarter, a brief reprieve in the dying trading days of 2023, and then another dramatic fall during the first three weeks of the new year to around €60-65.
It’s fair to say that the EU did enough to stop the price of carbon surging above €100. Over the past six weeks or so the annual rate of change in the EU carbon price has turned negative. Deflation has set in for the first time since the pandemic induced lockdowns of spring 2020, with carbon prices down some 20% over year earlier levels.
Europe has met most of the short term REPowerEU targets according to the Center on Global Energy Policy. The continent has successfully pivoted away from Russian natural gas supplies and towards American and Qatari LNG, while households and businesses have succeeded in cutting their gas consumption - some of it voluntarily. Overall, European emissions are estimated to have declined by more than 20% between 2022 and 2023 due to higher renewable energy generation, a switch away from coal and towards natural gas, and a decline in industrial demand - the latter in part a result of high energy prices (see The only number that matters).
Meeting the longer-term targets though to 2030 is going to need more work. Wind generation capacity, renewable hydrogen use, and biomethane production are not on track to meet the 2030 targets. Solar is close but further policy support may be needed to achieve the target, such as reducing the time required for permitting. With Europe not on track to meet its longer-term REPowerEU targets it raises the question of whether additional funding will be required to help bridge the gap.1
Up until a year ago compliance entities (i.e., those emitters legally obliged to purchase EUAs to cover their emissions) were fearful that a scarcity of allowances would force them to pay ever higher carbon prices in the future. The reverse dynamic may now be true with signs that deflationary expectations have set in.
European utilities are hedging less as power consumption falls and the share generated by renewable energy increases. One major utility who had hoarded EUAs in anticipation of needing them for future compliance needs recently confirmed they had closed that strategic position. Furthermore, a new wave of global liquefaction capacity is likely to lead to a significant increase in LNG supply from 2026 onwards, potentially resulting in much lower natural gas prices, and pushing thermal coal further out of the merit order (see Boiling over).2
There are also signs that industrials may be holding back due to concerns over demand and in the expectation of lower EUA prices in the future. In a sign of underlying physical demand from compliance entities, daily auctions of EUAs are regularly settling at levels below the prevailing spot price along with low cover ratios. Finally, speculators continue to hold a record net short position, taking advantage of the occasional rebound to add further shorts, increasing their exposure to carbon prices falling.
The EU has until the end of August 2026 to raise the necessary funding from the sale of the EUAs. If it reaches the €20 billion target sooner then there will be no more additional EUA sales entering the market. One concern is that by specifying a € value the EU may precipitate a downward move in the market that might be difficult to stop. Raising €20 billion at an average price of €80 requires 250 million EUAs to be auctioned. However, if the best average price they can achieve is only €60 then 333 million EUAs will need to be sold. It gets worse. If the price were to drop to €40 then 500 million EUAs would enter the market.
Once deflationary expectations set in the rational response for market participants is to delay hedging their future carbon risk until as late as possible. Why worry about securing sufficient EUAs now when prices keep falling, and could be even lower in six months time? Of course that creates a vicious circle that could precipitate even lower prices, and so on.
One of the most important thing investors in carbon markets need to understand are the goals and reaction functions of policymakers to economic and market conditions. European policymaking proceeds slowly and deliberately. Achieving consensus around something as important as the sale of additional EUAs at auction took many months of negotiation. Officials hate being pushed into a U-turn. Reversing course is not something they like to do. Far better they might reason, to wait, deliberate, and act slowly, than risk being late.
Therein the chance of a policy misstep grows larger.
https://www.energypolicy.columbia.edu/publications/repowereu-tracker/
https://www.rwe.com/-/media/RWE/documents/05-investor-relations/finanzkalendar-und-veroeffentlichungen/2023-cmd/cmd-2023_presentation.pdf