As the April 30th compliance deadline for the EU Emissions Trading System (ETS) approaches, an increasing number of companies find themselves in the challenging position of needing to purchase carbon allowances (EU Allowances or EUAs) for the first time. Previously protected by generous historical free allocations, these companies now face the burden of costly compliance carbon purchases. While current EUA prices remain low due to oversupply, the EU ETS landscape is undergoing significant changes that will impact future costs and risks.
Why is the Carbon Market Changing?
The carbon market is currently experiencing deep trouble, with prices at unexpectedly low levels. These low prices fail to provide the necessary incentive for industries to invest in meeting long-term carbon reduction goals, such as the target of 80-95% reduction by 2050. In response, EU politicians are taking action to raise prices and reduce the oversupply of EUAs. One such action is the implementation of the Market Stability Reserve (MSR) in 2019, which aims to remove excess allowances and drive prices upward. Unlike other commodities, politicians want European carbon credit prices to increase.
What about Free Allocations?
For the next few years, it is reasonable to assume that most companies will have their emissions covered by free allocations. However, the generosity of free allocations will decrease significantly in Phase 4 (2021-2030). The leakage list, which determines eligibility for free allocations, will be curtailed, resulting in more installations falling off the list than remaining on it. Companies not on the leakage list will receive only 30% of historic emissions as free allocation, and benchmarking changes may lead to further reductions. Additionally, the Linear Reduction Factor will require a 43% overall emissions reduction by 2030, leading to a decrease in the total pool of available free allocations by at least 2.2% each year.
Taking Action: Managing Carbon Risk
To manage carbon risk effectively, companies should start by understanding their exposure to the EU ETS. Calculating current and future exposure, considering leakage list status, free allocation, and production levels, is crucial. Seeking independent price forecasts is also recommended to anticipate price movements and their drivers. With a price forecast and carbon position, companies can assess their financial exposure to the EU ETS and develop a risk management strategy.
Getting Started
While some aspects of managing carbon risk can be handled independently, seeking guidance from a trusted carbon risk management partner is advisable. They can provide valuable resources and support tailored to a company's specific circumstances. Redshaw Advisors offers an EU ETS Financial Risk Audit, providing regularly updated reports and cost-effective strategies to manage carbon risk.
Act Now: Seize the Opportunity
With carbon prices currently low and expected to decrease further in 2017 and 2018, the next 18-24 months present an ideal opportunity to address carbon risk. By taking proactive measures, companies can navigate the evolving EU ETS landscape and ensure they are well-prepared for future compliance challenges.
