Demand for European carbon allowances plummeted during the coronavirus sell-off last month, providing the first significant test for a new market mechanism designed to curb oversupply.
The price of the carbon dioxide credits, which are mandatory for big polluters in Europe such as power plants, fell more than a third during early March, hitting a low of €15.05 per tonne on March 18. The price has since rebounded, closing at €21.09 on Thursday.
Analysts and traders estimates demand for emissions allowances will drop by between 100m tonnes and 388m tonnes this year — a fall of 6-24 per cent in normal demand — because of measures to contain the spread of coronavirus.
“The market was already under some pressure,” said Louis Redshaw, founder of Redshaw Advisors, a carbon consultancy, noting the effects of lower energy prices and an abundance of credits coming into the market from UK-based companies, post-Brexit. “This coronavirus situation gives it a good kick in the ribs on the way down.”
However, Mr Redshaw expects prices to recover to about €25 by the beginning of next year, as a new intervention mechanism starts to kick in.
A change in the design of the European carbon market, which went into effect in January 2019, means that if the number of credits in circulation exceeds a certain threshold, part of this surplus will get mopped up by the regulator.
This system, known as the market stability reserve, was created to prevent a repeat of what happened after the 2008-09 financial crisis, when carbon prices languished for years. That was seen as a failure of the EU’s Emissions Trading Scheme, the world’s largest, which was set up in 2005 to cut greenhouse-gas emissions.
“This is the first real test” of the MSR, said Ingvild Sorhus, lead EU carbon analyst at Refinitiv. “It will soak up some of these extra allowances that you can’t find any demand for now.”
The mechanism removes 24 per cent of surplus credits each year, in effect shrinking the market.
EU carbon emissions tumble during lockdowns
As a result of that support from the MSR, some financial investors in the carbon market assumed prices would continue to climb — an approach that has been painfully tested this year.
“There were a lot of investors in this market and they were exiting their position in one form or another,” said Mr Redshaw.
When carbon prices surged during 2018 and 2019, hedge funds and banks piled into the niche market.
Aviation emission credits, a subset of the allowances in the EU Emissions Trading System, have been particularly hard hit this year as many airlines have stopped flying, with one large auction in the UK failing to clear on March 25. However, a smaller aviation auction for the Polish market did successfully clear on April 8.
Some market observers are surprised that prices have not fallen further. “Our outlook is for much lower prices; we would expect that prices should be getting toward €11 per tonne,” said Coralie Laurencin, senior director for power markets at IHS Markit.
But supporting the market is “what the MSR was built for”, she added.
“Although I’m pretty sure that’s not the scenario policymakers had in mind: such a drastic and brutal collapse.”