Brexit finds its Bojo

Published at 16:02 21 Jun 2019 by . Last edited 11:18 22 Aug 2019.

Brexit risk is back. The UK Conservative party’s process to find a new leader continues. The overwhelming favourite to win, Boris Johnson, has a campaign pledge that the UK will leave the EU on 31 October, with or without a deal. The next step is that Boris Johnson and the candidate that came second, Jeremy Hunt, will face a vote on 22 July from Conservative party members to see which is elected party leader. With the odds heavily in favour of Johnson, the EUA market has responded by trading in a modestly lower range (23.7 to 26.5 €/t) and is making more attempts to go lower than higher.

With no-deal Brexit risk back, the impact of an abrupt exit of UK installations from the EU ETS is coming back into focus. The impact of a hard Brexit would be seen in both the short- and the long-term. The short-term impacts would be driven by a combination of factors. One, UK installations, particularly in power, would sell forward hedges that will no longer be needed. We think that this could amount to as much as 100 Mt, largely from UK generators that are not part of a wider European portfolio. Two, there will be selling of EUAs by speculators, which itself will be a combination of proprietary length coming out of the market and heavy short-selling that will happen as a no-deal Brexit would be big risk-off event for Europe, and the market will go net short very quickly. With open interest in futures having dropped heavily y/y so far this year, the total length left in the market is unlikely to be significant, but short-term shorts would be expected on the day to push the market significantly downwards. After a no-deal Brexit, we could see prices drop well below 20 €/t, which would then reset the level from where the market would then trade.                                

There would be a long-term impact on the EU ETS from both the macroeconomic downturn that would likely develop and the change in the supply and demand balances. In terms of the macroeconomic impact, the historic precedent is the European recession of 2008-09, when EU ETS emissions dropped by 230 Mt y/y. While the size of macroeconomic dislocation should be lower with Brexit, even a quarter of the impact would be bearish. Regarding EU ETS balances, the UK exiting would remove a country that has been a net seller of around 30 Mt/y of EUAs over the last few years, given the country’s carbon price floor has reduced emissions. However, with the MSR removing some 25 Mt per year from auctions in 2019 and 2020, that surplus was likely to be small anyway in the next couple of years and eventually reductions in the cap would catch up with the country’s emissions reductions. Still, the exit of the UK will not change the reduction in auction supply across the EU as a whole due to the MSR, so the would-be 25 Mt cut in auction supply for the UK would just be reallocated across the remaining member states, which would be moderately supportive for EUAs.         

Our base case is that the UK Brexit saga will roll on through to October, meaning a significant repricing either upwards or downwards is unlikely to happen. We expect EUAs will cycle in a 23.7-27.8 €/t range over Q3 19, a narrower range compared to last month as we have reduced our assumption for upside potential. If we see the market break out of that range, we think it will be to the downside. But even if that happens, we would be surprised to see a move below 20.5 €/t given the lack of other market events outside of Brexit that could act as a trigger for a sell-off.   

The extension of Brexit risk means we have revised our EUA price forecast for 2019 to now average 24.8 €/t, from 26.5 €/t previously, with our Q3 19 and Q4 19 price forecasts dropping on our expectation that prices will stay in a lower range, at least until Brexit is resolved.

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