Optionality

Published at 12:32 22 Feb 2018 by

EUAs have been on a rampant bull run through the last two months, with two distinct but very strong EUA price ramp-ups in the second half of December and mid-January, followed by a third jump at the start of February. All in all, the consistent uptick has added almost 3.0 €/t to the EUA price, leaving the Dec-18 contract trading at just under 10 €/t in mid-February.

However, market fundamentals have largely been bearish over this period—from a mild and windy January to more online nuclear capacity and stronger hydro availability. While our fundamentals analysis suggests a softer market, this only holds until the end of 2018, after which the supply cuts coming from the MSR from 2019 onwards means a fundamentally bullish outlook. What makes this interesting is that everyone is bullish 2019 and that is not so far away. So, should this market be reflecting the soft current nature of the demand side or should it be reflecting the future very short annual market now on the horizon of most participants’ trading decisions?

This month we argue that ‘option theory’ can help explain some of the current price behaviour as it posits that the gap between the price of the front-year contract (Dec-18) and the market’s expectation of prices in the periods of market shortness after 2018 should narrow towards zero as we approach 2019. This leads to two key questions: one, how big is that gap? (i.e. what is the market’s expectation for 2019 prices); and two, how fast will the market erode it? Regardless of the exact answers, such analysis suggests EUA prices should be riding a consistent upward trend over the coming months as the market prices out any remaining time value of the EUA ‘option’.

The numbers for new renewable power capacity installations in the EU in 2017 came in at 23.9 GW, up by 2.8 GW on the level of new builds seen in 2016. Wind additions were a record annual high of 15.7 GW, with onshore wind accounting for 12.5 GW and offshore wind for 3.2 GW. The large capacity additions, led by Germany and the UK, are being increasingly felt in power and will have helped limit the call on thermal power at the end of last year.

Record wind capacity additions set the background for the start of the trilogue on the proposed revision and extension of the EU Renewable Energy Directive. The biggest point of disagreement between the European Parliament and the Council of the EU is on the level of ambition. On the 2030 target for renewables as a share of primary energy, the Parliament is pushing for a 35% target while the Council is looking for 27%. In the power sector alone, this difference of 8 percentage points equates to around 250 TWh/y of power in 2030. Depending on the mix of renewables, that is about 145 GW of installed renewable capacity and could reduce annual carbon emissions by around 165 Mt/y in 2030.

As for the general EUA market, the volatility seen throughout the first six weeks of 2018 has led us to upwardly revise our expected EUA trading range. Given the strength already seen this quarter, we now expect prices to trade in a 9–10 €/t range for the rest of Q1 18. With such a high trading range through the first quarter, and an expectation the market will still trend upwards over most of rest of the year, we have also upwardly revised our price forecasts from 2018 to 2020. For 2018, we are now forecasting a 10.6 €/t average (up from 8.8 €/t last month), with the average for Q4 18 at 12 €/t, up from 10 €/t. We now expect the average for 2019 to be 14 €/t (up from 10.9 €/t), with 2020 at 16.4 €/t (up from 15.5 €/t).

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