Brexit smack up

Published at 11:06 22 Mar 2019 by . Last edited 11:18 22 Aug 2019.

EUA price formation in 2019 has so far been in the grip of downside risks, particularly Brexit, a topic that has dominated the last few weeks. On 27 February, UK Prime Minister Theresa May announced that she was going to hold a series of votes from 12 March on Brexit, which the market interpreted as taking the risk of a no-deal Brexit off the table and promptly led to EUAs jumping from an 18–21 €/t range to a 21–24 €/t range. The market was less enthusiastic about the subsequent political wrangling, with signs that a no-deal Brexit was still firmly on the table taking the market back down a couple of €/t. 

The 29 March Brexit deadline has been extended to 12 April but is still looming large and a further extension to that deadline from the European Commission hinges on the UK being able to indicate a meaningful way forward. As such, a no-deal Brexit is almost tipping to be the expected outcome, which we think would be very bearish for the EUA market given the economic dislocation that event will deliver. We expect a drop of at least 5 €/t—and probably more—if a no-deal Brexit occurs. In the event that a more managed exit is delivered, we would expect a relief rally in the aftermath, although we would not really expect to see prices above 25 €/t being sustained for long.  

The reason that prices will not remain elevated is the bearishness in related markets, which we talked about in Carbon Outlook: Consensus break, February 2019, has only started to intensify and more and more of the coal-to-gas switch is likely to be delivered in 2019. The expected 40 Mt reduction in power sector emissions in 2019 follows a 50 Mt reduction in 2018 that came on low power demand and very strong hydro and wind generation. Together, that would mean power sector compliance demand over the two years would be almost 100 Mt lower than in 2017, which will help minimise the drop in supply due to the MSR. At most in 2019, we think the fundamentals will drive a 200 Mt call on EUAs in storage, but will still leave the market surplus at 1.4 Gt. With fundamentals far less likely to drive strength in the market this year, the question is will speculative capital come back into the EUA market in the same way it did in 2018?       

A big move upwards in prices is another year away and the mantra for more speculative capital is that 2020 will be a tighter year. This is undoubtedly true, as the market will start 2020 with fewer EUAs in surplus and the MSR will be cutting supply by another 400 Mt. As with 2019, some of that will be dampened by additional selling of unallocated EUAs, particularly by Poland, which could sell somewhere between 50 Mt and 100 Mt. Also, we expect further reductions in power sector emissions, although expect the drop to be smaller than seen in the last two years.

However, there are some bullish factors. The end of EU ETS phase 3 means the end of borrowing EUAs from future years, so any installations that have covered short positions by borrowing will need to enter the market to buy. Also, a recent court case concerning free allocation to combined heat and power (CHP) plants could reduce the level of free allocation provided to industrial CHP plants in 2020. We have seen estimates that this could reduce the free allocation by as much 75 Mt, but we expect that number to be lower and for it to only have an impact for one year, given all of the new free allocation rules from 2021.    

We expect an average carbon price of 22 €/t in 2019, rising to 27 €/t in 2020.

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