The general bearishness in the European fuels complex has not proven any sort of barrier to another bull run in the EU carbon market. With the EU ETS in a bullish mood and Dec-19 adding some 5.5 €/t (25%) since the start of April, has the current bull run merely been driven by some short-term supportive technicals, or has it been grounded in longer-term buy-and-hold behaviour? At this stage of the rally, it is hard to know; the current bull run can be explained by either, and we expect that both will have played a role. Just how much is shorter-term volatility trading against the buy-and-holds will determine just how long the bull run is sustained.
The genesis of the bull run comes from the early April political developments, which, for the time being, removed the risk of a no-deal Brexit. A no-deal Brexit was the big remaining bearish risk hovering over the carbon market, and its removal triggered a palpable relief rally. As the market went higher, any short positions had to be covered, and delta hedging of EUA call options (25.6 Mt at 25 €/t and 71 Mt at strikes up to and including 30 €/t) had to increase. Some last-minute compliance buying could have been happening in the background, and breaking through the long-term technical resistance level of 25.7 €/t further fed the market bulls.
The sudden move up was the first sustained push to a new higher level since September 2018 and did come up against a set of less-bullish market fundamentals. Verified emissions surprised a little to the downside, showing a 63 Mt y/y reduction, which was around 10 Mt below our expectation on deeper reductions in the power sector. 2019 power is not looking any more supportive, with another 40 Mt or so of reductions likely to come from wind, nuclear and more coal-to-gas switching. Together, that all suggests power sector compliance demand over the two years will be almost 100 Mt lower than in 2017, also lowering future hedging demand.
It has not all been bearish, as some fundamental support could come from the UK. UK installations must now cover 2019 compliance needs in the absence of UK auctions, which will not be scheduled while no-deal Brexit risk is still possible. The absence of UK auctions—which is likely to persist well into Q4 19—is taking another 7.1 Mt/m of supply out of the current market.
Still, the size of the move means much of the move was more proprietary. The argument that more longer-term buying was contributing to the move comes from the market mantra that 2020 will be a tighter year in the EU ETS. The cumulative impact the market stability reserve (MSR) will have on removing surplus capacity is behind the belief of future tightness, which is undoubtedly true, as the market will start 2020 with fewer EUAs in surplus and the MSR will cut supply by another 400 Mt. Even if there are factors dampening the impact (greater Polish selling, falling emissions), the market is gradually being tightened.
Given the speed of the rally, we do expect the upward move to end before it gets to 30 €/t as some of the short-term capital takes profit. However, it does feel like the market has been reset to a higher level and will begin to trade in a new range. We expect that EUAs will cycle in a 24-28 €/t range for the coming two quarters. This is a revision upwards on our previous forecast of trading in a range of 18-24 €/t but is largely a move back to our forecasts from the start of the year. We had grown sceptical that there was sufficient speculative capital around to drive this market upwards, a scepticism that in hindsight was not warranted. We stress that while no-deal Brexit risk has been moved further down the road, it is not off the table.