5 EU carbon market risks you can’t ignore in 2015

Well-informed companies make better risk-management decisions because they have the confidence to know when to trade. To complement our New Year Offer of a free carbon risk consultation we have brought together 5 critical facts for companies with exposure to the EU ETS to take into consideration for the year ahead:

  1. The Market Stability Reserve (MSR) is well supported and an early start is increasingly likely

The MSR is a market-reform proposal initiated by the European Commission. The proposal has the goal to resolve the issue of over-supply in the market, which is largely caused by lower-than-expected growth in the EU along with the mass importation of cheap offsets. In short the MSR aims to remove 100 million allowances from the market every year, by reducing auction volumes, in order to get carbon prices higher. This is intended to create an incentive to invest in the technology to make emissions reductions. The removed allowances will be returned to the market only when certain criteria are met, on current trends this will only start to happen in or around 2030.

The proposed start date of the MSR is 2021 however, Germany, France, the UK and others are proposing to have implementation earlier, in 2017. In addition all 900Mt of the backloaded allowances (the 900Mt currently being removed from auctions during 2014-2016) would go straight into the reserve rather than being re-injected into the market from 2019 onwards.

Price impact: The MSR will have a significant effect on the market. Current single figure prices reflect the over-supply that back-loading is designed to fix, prices are already grinding slowly higher. The MSR, combined with 40% emissions cuts already approved for 2030, will make this effect a permanent feature and will reinforce it. A 2017 start will cause carbon prices to go up as soon as legislation looks likely to be passed and by as much as 300% by 2020, see below.

Redshaw Advisors weekly market update tracks MSR developments and it is available free to our counterparties (subscribe).

  1. Analysts predict spiralling carbon prices starting in Q1 2015 despite weaker energy prices

Energy prices in Europe are dropping. Bloomberg’s Commodity Price Index is down 16.8% year on year (y/y) and the markets appear likely to stay that way for a while to come. This is great news for most, but in the context of lower commodity prices we must remember that carbon is unique. The simple fact remains that European politicians want the carbon price higher. Because of this, and as a consequence of the intervention, all major analysts are predicting higher prices in 2015.

Bloomberg surveyed 16 trader and analyst estimates in December 2014 and the median showed that carbon prices would rise 61 percent to €11.53 by June 30. The ex-Barclays research team at Energy Aspects maintain their price forecast with Q1 averaging 8.0 €/t and 2015 as a whole averaging 8.75 €/t. This price forecast retains the assumption that the backloaded volumes are not put into the MSR, although it is increasingly likely that they will be. They predict that with early MSR included, 2020’s carbon price will be €21. UBS Group AG issued a report on the 5th of January 2015 predicting that costs could more than double to €15 in 2015 if the proposed MSR reserve is brought forward to 2017. Carbon research authority ICIS predict that prices are set to rise to double digits by mid-2015.

What is interesting is that while German utility emissions look to have fallen by 5% in 2014, economic growth in Europe is uncertain and commodity prices remain weak, all the major analysts are predicting a higher price for carbon in 2015 and beyond. Companies can have an advantage over their competitors by positioning themselves accordingly by mid-year.

Price impact: higher, how much higher depends on final legislation.

To keep on top of analysts projections our counterparties have access, for free, to Energy Aspects’ detailed carbon market research.

  1. International offsets – cheaper CP1 credits must be used by 31 March 2015

Every operator of an EU ETS installation is able to use international credits to meet a certain percentage of their compliance obligations. These are Certified Emissions Reductions (CERs) from the UN Clean Development Mechanism (CDM) projects and Emission Reduction Units (ERUs) from Joint Implementation (JI) projects. “Operators,” as defined in the ETS Directive, can exchange CERs/ERUs for EU Allowances. According to Article 11a2 of the EU ETS Directive, international credits (CERs and ERUs) that were issued for emission reductions for the period 2008-2012 (so called Commitment Period 1 or CP1 credits) are only eligible for exchange until 31st March 2015. After this deadline only the more expensive (as much as ten times more expensive) CP2 CERs will be eligible for exchange.

With international credits trading at record lows, those companies that are still able to exchange them for EUAs can either minimise their company’s compliance cost or generate a welcome windfall profit. New Entrants in Phase 3 are able to use international credits up to a maximum of 4.5% of their verified emissions each year in phase 3. Aircraft operators can use 1.5% as well as any unused entitlement left over from 2012.

There is an opportunity to take advantage of record low CP1 prices, contact us for guidance on how to find out what your remaining offset entitlement is and to help you source them.

  1. Europe heading for recession – will this lead to lower carbon prices?

OECD economic outlook highlights the risk of Europe slipping into a period of persistent stagnation. It means prolonged and subdued growth which in turn depresses aggregate demand. EU Industrial Production growth in the energy-intensive sectors remains relatively slow with year on year (y/y) growth rates modest at best. PricewaterhouseCoopers predicts inflation and growth to remain very low in 2015 and expects the ECB to undertake a programme of quantitative easing in an attempt to boost demand. On the flip side, the benefit of lower oil prices has started to feed through into global oil demand. Falling energy prices will aid any EU recovery.

If energy remains low the consumption of fossil fuels goes up and it becomes more costly to switch to renewables. However Energy Aspects forecasts that power and heat emissions, by far the largest grouping in the EU ETS, will be down y/y by 95 Mt (-7%) due to a mild H1 14 and lower gas prices. Industrial emissions should increase by 4Mt (1%) y/y, on higher, but slowing industrial production.

Price impact: reducing emissions should, at face value, lead to a fall in carbon price but artificial intervention by the European Commission removing the equivalent of around 30% of utilities’ carbon requirements (via backloading), analysts are still predicting the opposite outcome – higher carbon prices.

  1. Allocations in 2015 are at their lowest and they are falling

By design, the emissions cap implemented by the EU gets smaller over time. Around 10 thousand installations (out of 12 thousand total) will have a smaller allocation in 2015 than they did in 2014, none of the rest have more and the power producers have zero. This trend will continue throughout Phase 3 and beyond. In Phase 4 (2021-2028) the decline in allocation will accelerate with an annual 2.2% reduction required to hit the EU’s 2030 emissions reduction goal of 40%. Based on life-to-date emissions, allocation and offset use around 40% of installations are already short, and by 2020 this number should increase to 60%. When reducing allocation is combined with independent analysts’ predictions of price rises, companies will increasingly compete for the EU Allowances that are still available to buy. The compounding effect that this will have on price will mean that companies’ exposure to the financial risks caused by their carbon emissions will demand a completely new level of attention—never seen before for carbon emissions—from company management.

About Redshaw Advisors
Our objective is simple: to help carbon markets be successful, and to help companies that are exposed to carbon prices to be successful in carbon markets.

We are a carbon emissions trading and risk management business. We provide carbon market access, carbon finance and risk management services & expertise to companies with exposure, or wanting exposure to emissions trading systems, both in the EU and globally.