Consensus break

Published at 09:24 21 Feb 2019 by . Last edited 11:18 22 Aug 2019.

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Over February, the EUA market finally broke out of its fairly well-established trading range, but it did so to the downside, despite the start of the much-anticipated MSR in 2019. The lack of a price rise in Q1 19 so far could well shake the consensus belief among proprietary market participants of a bullish carbon story for 2019, which would lead to a year of limited upside.

After the move up in EUA prices following the expiry of Dec-18 options, the underlying EUA market spent a good seven weeks cycling in a wide 21.3-25.7 €/MWh range, set by two key technical price levels. On the fundamentals side, resistance to the upside came from two risk factors with potential for bearishness.

The first was the anticipation of the German coal commission’s recommendations on the timing of Germany’s exit from coal-fired generation. When the recommendations came at the end of January, the headline numbers were that 12.5 GW of coal-fired capacity (5 GW of lignite and 7.5 GW of hard coal) should be closed by 2022. This was underlyingly bearish as lignite is otherwise hard to shift out of the merit order and closure would mean the removal of highly carbon-intensive baseload capacity. How bearish it will be depends on how Article 12.4 of the EU ETS Directive, which allows member states to voluntary cancel allowances from their auction pots if they have other policies that reduce power sector emissions, is interpreted. The coal commission recommended cancellation, but it is really up to the member state to determine how many EUAs to cancel (a maximum is specified) and for how long—and the market has no clarity on that yet.       

The second risk event that could be market-moving for carbon is Brexit. While we did not expect to still be writing about Brexit risk in mid-February 2019, we are, as the UK government is still struggling to agree on what it wants and yet refuses to rule out a no-deal Brexit. A hard no-deal Brexit will be a significant risk-off event for European assets, leading to equities, currencies and EUAs being sold by funds and investors. That fast dumping of EUAs that would have previously been bought by conviction buy and holds would trigger most of the longs out of the market, and we would expect at least a 10 €/t drop in EUA prices on the day. With less than two months to the 29 March Brexit deadline, such an event cannot be ruled out.

Adding into the bearish risks, the key development in European energy markets since November 2018 has been the increasingly relaxed balances in the European gas market, stemming largely from a significant rise in LNG supply. With the gas market easing, it has priced down in relative terms, going to the level where a gas-fired plant with just a 5% efficiency advantage over a coal-fired plant gets into merit. With prices at this level set to persist for all of summer 2019, the bulk of the available European coal-to-gas switch is going to be delivered regardless of the CO2 price. For the entirety of 2019, this is likely to cut EU power sector emissions by 50 Mt y/y, which would follow the 50 Mt y/y drop likely recorded in 2018. These two years alone could potentially reduce the compliance need of the power sector by 100 Mt and will cut the demand for EUAs for future hedges as well. 

Given all of this, we have moved our price forecast down from an average of 27 €/t for 2019, to 20.0 €/t, and prices along the rest of the curve are now expected to hit our previously forecast price points one year later than originally thought. It is not that the upside will never come—it will just be delayed by a year.   

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