European Carbon Market Faces Volatility Amidst Coronavirus Impact
Amidst the global sell-off triggered by the coronavirus pandemic, the demand for European carbon allowances experienced a sharp decline, posing a significant challenge for a new market mechanism aimed at addressing oversupply. The price of carbon dioxide credits, mandatory for major polluters like power plants in Europe, plummeted by over a third in early March, hitting a low of €15.05 per tonne on March 18. However, the market has shown signs of recovery since then, with prices rebounding and closing at €21.09 on Thursday.
Analysts and traders estimate that the demand for emissions allowances could decrease by 100 million to 388 million tonnes this year, representing a decline of 6-24% compared to normal demand, due to the measures implemented to contain the spread of the virus. The market was already under pressure due to lower energy prices and an influx of credits from UK-based companies following Brexit, and the impact of the coronavirus further exacerbated the situation.
Louis Redshaw, founder of Redshaw Advisors, a carbon consultancy, described the coronavirus situation as a significant blow to the market, reinforcing the existing pressure. Nevertheless, Redshaw anticipates a price recovery to around €25 by the beginning of next year, supported by the implementation of a new intervention mechanism.
The European carbon market underwent a design change in January 2019, introducing the market stability reserve (MSR) to prevent a repeat of the prolonged period of low carbon prices experienced after the 2008-09 financial crisis. If the number of credits in circulation exceeds a certain threshold, the regulator will absorb part of the surplus through the MSR. This mechanism considered the first real test of its effectiveness, is expected to absorb the surplus allowances that currently lack demand.
The MSR gradually reduces the surplus credits by 24% annually, effectively shrinking the market. Financial investors in the carbon market, who had anticipated continued price growth, have faced challenges this year as prices fluctuated. Hedge funds and banks entered the market during the surge in carbon prices in 2018 and 2019. Notably, aviation emission credits, a subset of the EU Emissions Trading System, have been severely affected as airlines grounded their flights, leading to one large auction in the UK failing to clear on March 25. However, a smaller aviation auction for the Polish market successfully cleared on April 8.
Market observers have expressed surprise that prices have not declined further, with some expecting prices to reach around €11 per tonne. Nevertheless, the MSR was designed to support the market during such scenarios, even though policymakers likely did not anticipate such a drastic and abrupt collapse.
