Competing forces

Published at 16:11 31 Mar 2017 by

In March, EUA prices traded with increased volatility. EUA’s closed all the way up at 5.91 €/t on 1 March in response to the surprisingly early Council agreement on its ETS Phase 4 position, itself more bullish than had been expected. The result was that the market now has negotiating texts from the European Parliament and Council that agree on a number of very bullish proposals.

Both bodies agree that the injection rate of allowances into the MSR will be 24% in at least the 2019-2022 period and that at least 800 Mt of EUAs in the MSR will be cancelled at some point in the next phase. Both proposals are bullish, but it is the increase in the injection rate from 12% to 24% that fundamentally alters the market supply and demand balances from 2019 onwards. In 2019, we see the annual balance falling to a 365 Mt short and 316 Mt short in 2020. The upwards price pressure on the market will be considerable and will continue during the subsequent years.

Almost all the 1 March gains from the bullish news were lost virtually immediately, and the market continued to soften as Europe started to come out of the heating season, curtailing power demand and some short-term buying. Prices stayed above 5 €/t until the announcement that Polish auctions of EUAs were restarting after a break of almost six months, then fell to around 4.75 €/t when factoring in yet more weekly auction volumes, and 86 Mt more across 2017.

As something of a surprise, the start of formal Brexit negotiations between the EU and UK had little to no effect on the market at month-end. We see the fate of UK installations in the ETS as being inextricably linked to how the negotiations themselves progress. A ‘soft’ Brexit, which retains a deep trading relationship between the UK and the EU, would almost certainly result in UK installations staying in the ETS. A ‘hard’ Brexit, where WTO rules govern trade between the two, would almost certainly result in those installations coming out.

If the installations do leave, we think that this will not happen before late 2020 at the earliest. As such, we expect UK facilities to stay in the system at least for the rest of Phase 3. We think that formal notice to UK installations that they will be withdrawn from the ETS will kick–off a fairly rapid sell-off of 200–250 Mt of EUAs held as future hedges—certainly bearish for the year such notice is given. However, given its post-2020 schedule, the market is sanguine on this risk for now.

On 3 April, the EC will release the initial cut of verified emissions data, which are expected to confirm that emissions saw a chunky reduction of 2-3% over 2016 as the fuel switching we have forecast ever since 2015 became a reality. Given the lagged nature of the data, and that there is still a healthy EUA inventory, the market rarely moves on this data release.

We have maintained our bearish forecasts for 2017. We have revised our price forecasts upwards, with prices expected to rise to an average of 4.8 €/MWh in 2018, up from 3.9 €/MWh. While the 2018 outlook has not fundamentally changed, the strength of the 2019 potential short, which we largely discount for 2017, should have a greater pull. The fundamentals have shifted drastically for 2019 given the expected changes to the MSR, so our prices forecasts have increased from 5.5 €/t to 9 €/t in 2019 and to 15.6 €/t from 8.2 €/t in 2020. By 2021, they are over 20 €/t, which is the last price needed to exhaust all the potential fuel switch available in Europe.

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