Understand the latest market characteristics and EUA price developments: A liquid alternative asset class with uncorrelated returns, a strong track record and further upside due to regulatory tailwinds.
Executive Summary
The EU Emissions Trading Scheme (ETS) is the world’s largest cap and trade market, covering approximately 43% of the EU’s emissions. It covers energy-intensive industry, power and heat generation, as well as intra-EU flights. The regulator is currently reviewing an expansion of the scheme to include all transportation and heating, which would double its size.
Market characteristics
European Emission Allowances (EUAs) are sold via government-run auctions on an almost daily basis. In addition, a liquid secondary market has developed, valued at €190bn in 2020, which much of the volume driven by the Intercontinental Exchange (ICE). On average, €860million is traded daily in the secondary market. The primary and secondary markets are in sync, with a 0.07% average price difference between auction settlement and the secondary market prices.1
EUAs represent an uncorrelated asset class, although more recently there is an increasing correlation with equities (YtD 0.51 correlated with MSCI World) as markets mature and attract more inflows from investors.
Selected correlations of daily returns over the last 3 years:
EUA Price Developments
After the financial crisis in 2008/9, the EUA price plummeted and traded range-bound in the low single digits. In response, the regulator introduced two reforms, absorbing surplus from the market and installing a resilience mechanism called the “Market Stability Reserve”, which automatically manages the market balance by absorbing surplus allowances in case of external shocks.
With these reforms, and regulatory tailwinds resulting from a more ambitious carbon reduction target, EUA prices almost quadrupled from 2017-2020, posting annualised returns of >140%.2
The EUA price has proven volatile, with an annualised standard deviation of ~50% since 2013 and a 65% Sharpe Ratio over the last 3 years.3
Since the price forecast is less sensitive to emission changes (as the MSR balances larger effects), over the next decade, the main price driver will be how the supply of allowances is curbed, as per the following three scenarios:
- The MSR manages the market balance on a daily basis. Currently the regulator is considering i) increasing the rate at which surplus allowances are withdrawn and moved to the reserve and ii) lowering the threshold that constitutes as surplus
- The EU Green Deal requires more emissions abatement in the EU ETS, which would cut the volume of allowances handed out annually
- The additional cancellation of EUAs to address the mandated coal-fired power phase outs
All of these reforms would be bullish for the EUA price. The materialisation of such price rises hinges on the regulator implementing these changes, as well as the market “pricing in” future developments via investors who enter the market early.
