November finally saw the conclusion of the long and winding legislative path of EU ETS Phase 4 reform package. Agreed at trilogue at the sixth attempt, the bill retained its bullish components and was made slightly more bullish by a rule that is set up to automatically deepen the ETS caps by cancelling a potentially large volume of EUAs in 2023.
The package was approved by the Council despite some concern that the UK might throw a spanner in the works given its deep unhappiness over the Brexit clause that was smuggled into the rules extending international aviation’s exemption from the ETS. The UK held back, however, amid reports that the European Commission was softening its proposed registry regulation in light of a compromise proposal by the UK—to bring the 2018 compliance deadline forward by enough time to remove any risk of UK installations dumping all of their 2018 EUAs in the event of a very hard Brexit.
The policy ructions helped Dec-17 closing prices trade in a range that was higher m/m between 7.35 €/t and 7.90 €/t, averaging around 7.57 €/t, up by 4% m/m and by 34% y/y. The passing of such bullish legislation might have been expected to do more to prices, but almost all of what was agreed has been expected now for months, so there was little upside in the event.
Looking at trading patterns, one of the more interesting developments of the last month saw ICE open interest (OI) go higher y/y for the first time in 2017. Intriguingly, this increase is mostly concentrated in the Y+2 (Dec-19) and later contracts rather than the Dec-17 and Y+1 contracts. By late November, the further-dated contingent of Dec-delivered contracts is up some 25% (64 Mt) y/y.
At the same time, there is no convincing evidence that utilities are opting for higher hedging further out on the curve. If anything, Q3 17 results suggest they lower hedging, with Uniper having seemingly abandoned its pattern of uniformly high hedges over a three-year horizon, reverting to much lower levels (and historically more usual) for the Y+2 and Y+3 contracts.
The higher demand in these future-dated contracts has been reflected in a widening out of the markets contango, which has gone out from an implied cost of carry of 0.4% per year between the Dec-17 and the Dec-18 to as wide as an implied 1% per year between the Dec-17 and the Dec-20 contracts seen this month. The width of that spread seems to be attracting some in the market to arbitrage that cost of carry against their cost of funds and bring it in to 0.8% per annum, still well above the more prompt spreads and the levels of contango seen over the last few years.
Given these above trends, it seems that there has been some return of proprietary investors in the carbon market. Certainly, with everyone bullish as the MSR is promising to significantly tighten the market, the still low level of implicit borrowing in the market provides an obvious temptation to go long into the period—just one year away now—when the fundamentals will be influenced by a 24% MSR withdrawal.
We continue to expect no meaningful downwards price correction from current levels, although December will have half a month with no auctions and will see the expiry of the Dec-17 contract, which certainly feels more biased to proprietary length than shorts. Those two developments are likely to have opposite effects, which should keep prices trading in the current range, with a good chance that the EUA market sees prices head above 8 €/t as we head into January.