The sword of inelastic supply cuts BOTH ways
The EU carbon market is no stranger to volatile prices.
Compared with other commodity markets EU carbon market volatility is broadly comparable with crude oil or coal, but tends to be significantly less volatile than natural gas (see The changing fortunes of the EU carbon market).
Over the past four weeks EU carbon prices have surged by almost one-third, hitting a new record high just shy of €100 per tonne. However, over the past two days carbon has dropped €10 per tonne to around €90 per tonne.
What explains the current bout of volatility?
The supply of EUA’s is essentially fixed in the short-term. Auctions take place daily according to a predetermined calendar. Auctions are paused between 21st December and 10th January but otherwise they continue throughout the year. In August auction volumes are cut by 50%, reducing the primary supply of EUA’s onto the market. Overall then the supply of EUA’s is likely to be highly price inelastic, and especially so during August.
If you combine this with parabolic increases in natural gas and power prices then even a small increase in demand can result in a sharp rise in the price of carbon. Utilities seek to hedge their future power generation by either purchasing allowances, or by hedging that requirement using the carbon futures market (D1 to D2 in the chart below).
Up until recently the focus was on natural gas, but over the past few weeks its been European power prices that have stepped into the limelight, but for all the wrong reasons. A combination of low hydro generation, nuclear plant maintenance in France, logistical issues related to the River Rhine and strong demand due to high temperatures have supported electricity prices.
Nothing we didn’t know before the summer break. What has changed though is that the whole of the forward curve - both for power and natural gas - has jumped sharply higher. This means that utilities need to consider their hedging requirements for next winter and the winter beyond, especially if they may need to burn more thermal coal in order to meet demand.
The EU carbon market has also been in somewhat of a political vacuum with policymakers having long since downed tools for the summer. Without any new news on the “Fit for 55” package or the RepowerEU proposal, and in the absence of ‘forward guidance’ from EC politicians, carbon prices have been left with only one way to go.
However, as former Goldman Sachs commodity trader, Michael Kao likes to say, “The sword of inelastic supply is very sharp and it cuts BOTH ways”.
If compliance buyers or other market participants (e.g., financial institutions) are constrained in some way then carbon prices may reach a point at which only a small amount needs to be sold for the market to quickly move sharply down (D2 to D1).
For example, an extended shutdown by industrial emitters could result in them offloading EUA’s or closing their hedges. Industrials may also seek to cash in their allowances if they are capital constrained.
Compliance entities have also been caught out by the high collateral requirements involved with hedging. As the price of carbon goes higher, the more collateral needs to be put down in order to hedge any position. If utilities are capital constrained in some way then there may be no way for them to hedge their forward generation.
EUA auctions resume in September, albeit the fortnightly volume will drop from 22.25 million EUAs to 21.89 million EUAs. That will improve the supply situation for EUA’s, while also reducing the angle of the supply curve (S1 to S2), which could reduce price volatility.
In the end it is the European energy market that will ultimately determine where on the inelastic supply curve the demand curve will intersect.
European energy prices are exhibiting these parabolic movements due to extreme scarcity, and the perception that it is going to become even more acute. As the price moves along the parabola it holds very little in the way of signal, only noise.
And so the message is buyer beware. The sword of inelastic supply is very sharp and it cuts BOTH ways.
