The EU ETS has had little impact on the European gas market in recent years. Having lurched into a period of oversupply after 2011, carbon prices have languished in single digits. While 2017 still looks overwhelmingly bearish for carbon markets, policy changes to the ETS rules that are now being negotiated raise the spectre that EUA prices could triple, with the rise starting from 2018 onwards. Such a considerable increase in the carbon price is bound to impact European gas.
At the end of February, the European Council agreed its negotiating position for the Phase 4 (2021-2030) ETS Bill. While its views are not yet hard-coded into the bill, there is broad legislative consensus on a number of key ETS issues that will have an impact on price formation.
The most important issue from a price perspective is an agreement to double the rate of injection into the market stability reserve (MSR), which was previously agreed in 2015 and will start operating from 2019 onwards. It is now effectively agreed that the MSR will remove surplus EUAs from the market at a rate of 24% of the total surplus per year from 2019 to at least 2022.
The impact on our balances is most pronounced in the period from 2019 to 2022, when the MSR is removing allowances from the market at a high rate. In both 2019 and 2020, a 24% rate would see the MSR remove just over 400 Mt of EUAs from the auction pots and inject them into the reserve. This would equal 1.3 Gt of EUAs in the first four years – current total annual emissions of installations under the EU ETS is around 1.75 Gt.
This tightens annual supply and demand balances—we now forecast shorts of 365 Mt and 316 Mt in 2019 and 2020, respectively. The market will balance by drawing on the existing EUA inventory, but the upward price pressure will be considerable. All our price forecasts after 2017 are bullish, with 2019 up at 9 €/t, 2020 at 15.6 €/t, and 2021 rising to 20.8 €/t.
The upward pressure will be sustained regardless of what happens with Brexit, although that creates downside risk. We think any debate over removing UK installations from the ETS will take time and that the chances of UK installations leaving are still evenly balanced. However, even if the UK facilities were to be withdrawn, it is unlikely to occur before 2020.
Bullish news for the carbon market is inherently bullish for the gas market. Higher carbon prices will push up the coal-to-gas fuel switch triggers, supporting higher gas prices in Europe. Given current fuel prices (coal at 70 $/t), a TTF fuel switching trigger price currently at 16.7 €/MWh would move up to 18.7 €/MWh with an EUA price of 10 €/t and 23 €/MWh with a 20 €/t EUA.
An implication of higher fuel switch triggers is that the arbitrage window between the US Henry Hub and European gas hubs is likely to be kept open for longer.