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European Carbon Allowances at Record Levels: time to drive more abatement

June 3, 2021 in Markets

The cost of emitting carbon dioxide in Europe is at near-record levels after a six-month rally doubled the cost of EU Allowances (EUAs). Analysts predict further increases as the European Commission prepares to table aggressive reforms that will tighten the market.1

EUA prices have been on an upward trend since early 2018 when the EU agreed a first round of reforms to its carbon market, including the introduction of the Market Stability Reserve (MSR) which removes a portion of the market’s historic surplus each year.

The MSR and other reforms were aimed at decreasing the supply of allowances in the market, forcing industrials to consider investment in carbon reductions to avoid ever-higher EUA prices.

Investors also saw in those reforms the scope for significant price increases and many of them began to accumulate larger positions.2

EU Carbon Benchmark Price 2016-2021
Source: ICE Futures Europe, rolling front-December futures contract

Even the Commission itself is warning of higher prices. The EU’s climate chief, Frans Timmermans, said in April that “if we want to achieve our goals, I think the price should be much higher than it is, even at €50.”3

Given that Covid reduced emissions significantly in 2020, why are EUAs trading at record highs? The EU Commission reported that in 2020, emissions dropped by 13.3% in the EU Emissions Trading System.4

First, the Market Stability Reserve will automatically adjust allowance supply to keep the market tight. The Commission calculated that auction supply would be slashed by 378 million as of September 2021.5

Secondly, over the last year there has been a significant influx of investors into the market. ICE Futures reported this month that since 2017 the number of participants trading ICE’s carbon markets has increased by more than 40%, with the number of North American participants jumping more than 70%.6

So far, investors tend to prefer holding futures to physical EUAs, since accessing the physical market is more difficult. However, investors would have a far greater impact on the market, and preserve the growth potential of their investments, by taking physical delivery of EUAs.

By buying and holding physical allowances, investors restrict the supply to the rest of the market, forcing industrial emitters to choose between paying higher prices for permits or investing to reduce their own emissions.7 Simply holding futures positions without taking delivery of EUAs cannot achieve this.

Physical holdings of EUAs also help to inflate the surplus calculation which triggers allowance reductions via the MSR, since the Commission’s calculation does not take account of futures positions. A larger calculated surplus means a larger withdrawal into the Market Stability Reserve, thereby speeding up the process of tightening the market, bringing more abatement to bear, and improving our pathway towards decarbonisation.

1 https://www.bloomberg.com/news/articles/2021-01-19/europe-carbon-market-emissions-permits-set-price-records-in-2021

2 https://www.bloombergquint.com/business/hedge-fund-northlander-raising-money-to-bet-on-carbon-price-rise

3 https://www.reuters.com/article/eu-carbontrading-idUSL4N2MU2O1

4 https://ec.europa.eu/clima/news/emissions-trading-greenhouse-gas-emissions-reduced-2020_en

5 https://ec.europa.eu/clima/news/ets-market-stability-reserve-reduce-auction-volume-over-378-million-allowances-between_en

6 ICE launches UK Emissions Futures

7 https://sparkchange.io/the-rise-of-impact-investing-sparkchanges-role-in-boosting-climate-ambition/

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