One of the pillars of the European carbon bull market during 2021/22 was that emission allowances (EUAs) would become more and more scarce.
The thesis was pretty simple.
The Market Stability Reserve (MSR) acts to cut the TNAC by 24% per annum, reducing the free float available for obligated emitters to meet their annual compliance obligation. Meanwhile, the annual emissions cap declines by 2.2%, potentially accelerating to 4.2% based on ‘Fit for 55’ proposals. This means less EUAs available at auction each year going forward.
Banking as many allowances as you can became the correct strategy. Better to buy them now than risk paying a premium in the years ahead. If you were one of the lucky industrial emitters that received a free allocation of EUAs then hoard them. Don’t whatever you do use them as a short term cash cow.
The demand from obligated emitters would always be there of course. Failure not to provide sufficient EUAs based on your emissions would incur a fine. However, far from being a slap on the wrist, an obligated emitter would have to purchase the required EUAs in the next compliance year.
Then you add hedge funds, banks, other financial institutions and individual investors into the mix. Each could buy physical EUAs and hoard them. Self-reinforcing expectations among market participants would drive the market higher. Higher prices, more buying, compliance buyers get scared, more buying, prices move higher,…and so on. That’s what we saw in the carbon market in late 2021 and early this year as carbon prices neared €100 per tonne.
If a strong positive feedback loop developed, it was anyone’s guess as to where the carbon price could go.
Positive feedback loops eventually collapse
Feedback loops can either be positive (reinforcing), or negative (correcting). According to George Soros, positive feedback loops result in the views of participants diverging further and further away from objective reality. This can carry on for longer than many expect, until it reaches a point where it collapses in on itself:
“It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium or what may be described as far-from-equilibrium conditions. Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction.”
In order to show how this might be reflected in financial markets, Soros states that the price of an asset is determined by two factors, the underlying trend and prevailing bias, both of which are, in turn, also influenced by asset prices. According to Soros the interplay between asset prices, the underlying trend and the prevailing bias has no constant.
“Typically, a self-reinforcing process undergoes orderly corrections in the early stages, and if it survives them, the bias tends to be reinforced, and is less easily shaken. When the process is advanced, corrections become scarcer and the danger of a climatic reversal greater.”
The reversal
As so often happens its an event with apparently little relationship to the market that snowballs into something very important. We are now experiencing that climatic reversal.
As Russian shells began to rain down on the streets of Ukraine suddenly carbon traders suddenly questioned the objective reality supporting the market at levels in excess of €80 per tonne.
As I outlined in Collateral damage, there are four channels through which the Ukraine-Russia war could impact EU carbon prices - financial, economic, political and social. Each channel would vary in its immediacy and ferocity of impact, and the potential legacy it may leave in its wake. Over the following 10 days the price of carbon fell by up to 40% as the market digested the implications.
It may not stop there.
If the underlying trend and the prevailing bias - as Soros describes them - now generate negative (i.e. correcting) feedback loops then the markets perception of EUA scarcity may start to evaporate.
Instead of holding onto their free allocations for subsequent years, industrial emitters may decide that better to cash out now and buy back at a cheaper price in the future. Afterall, many industrials emitters may be under significant financial stress, or anticipate that they will be soon. Instead of thinking that EU policy will keep to the prevailing trend on EU ETS reform as seen prior to the conflict, they may wonder whether the process will be delayed or watered down.
Financial institutions may also step back from the EU carbon market. Happy with the returns they have made over the past couple of years, concerned by proposals to tighten Article 29a, and wary that calls for greater transparency may open them up to even greater criticism. Financial institutions and investment funds have been a source of demand for EUAs. If much of that ends up back on the market then the perception of scarcity diminishes even further.
As long as the European Commission don’t tinker with the underlying fundamentals - outlined at the start of this article - then scarcity will, once again become an issue at some point. That will be the point when prices suddenly develop a strong positive feedback loop. But that’s a story for later.