Why the next recession will not break the world largest carbon market

A decade after the financial crisis sent prices under Europe’s cap-and-trade emissions scheme cratering, experts say reforms made in the interim will ensure the mechanism is not neutered by the coronavirus pandemic and its economic aftermath.

Set up in 2005, the EU Emissions Trading System, or ETS, is the world’s largest carbon market and Europe’s flagship tool to force companies to cut their emissions efficiently. It covers around 45% of the bloc’s total emissions, produced by more than 11,000 installations, including power stations and heavy industrial plants, as well as flights between EU countries. Companies receive a certain amount of allowances for free and buy the rest in regular auctions, or from each other, to cover their needs for any given year.

Following the economic shock of the global financial crisis, an oversupply led prices under the scheme to languish at a low level for almost a decade. Now the coronavirus has had a similar impact, sending prices for emission allowances, so-called EUAs, about 40% lower in mid-March as industrial production shut down, power demand contracted and flights remained grounded. Although prices have recovered slightly since then, analysts expect more downside could be on the horizon.

But experts on the carbon market say the latest economic shock will not wreak havoc on the scheme as it did a decade ago, even though the IMF now expects the coronavirus recession to be far worse than in 2009. That is because of both concrete measures taken to avoid a repeat of the ETS price crash, as well as the EU’s long-term climate ambitions.

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“It’s not going to ruin the market in the same way,” said Coralie Laurencin, a senior director at IHS Markit, an information provider that closely tracks commodity markets. “The ETS is not going to go down a negative spiral like in 2009.”

One big reason for Laurencin’s optimism, shared by other carbon experts, is the Market Stability Reserve, or MSR, a mechanism introduced to reform the ETS at the start of 2019. By gradually removing the oversupply of carbon allowances that built up over the past decade, it already helped lift prices before it came into effect — from less than €10/tonne in late 2017 to as high as €30/tonne in 2019. Each EUA covers one metric tonne of CO2-equivalent.

“It’s designed to prevent that sort of slump reoccurring, with the relatively low prices over a long period. That is why it was introduced,” said Peter Vis, who helped develop the ETS as an official in the European Commission and is now a senior adviser on climate and energy policy at Rud Pedersen Public Affairs, a consultancy.

Price plunge

The MSR keeps the market tight by reducing annual auction volumes by 24% whenever the surplus of allowances — the amount above what all installations and airlines are allowed to emit — rises above 833 million tonnes. This will equally apply to any surplus generated as a result of the coronavirus-induced slowdown. In addition, the overall cap of allowances under the ETS also declines by about 2% each year.

The plunge in EUA prices in March was partly driven by lower economic activity and power demand, but analysts say so-called non-compliance investors — speculative traders who are in the market voluntarily — also sold off allowances in droves, amplifying the effect. Aside from utilities, industrials and airline operators, participants in the carbon market range from investment banks all the way to individual retail investors.

Prices have been rising again more recently, which analysts attribute to growing confidence that lockdowns will soon start easing across Europe, as well as some last-minute compliance buying before the deadline for covering 2019 emissions ends at the end of April. Carbon has also been moving in line with stock markets and the oil price, as investors look for broader market signals.

“It’s a bit of a relief rally,” said Tom Lord, head trader at Redshaw Advisors, a carbon trading and risk management firm. But with gas prices falling and some extra EUA auction supply coming to the market this year as a result of the U.K.’s exit from the scheme, bearish factors still abound for now, Lord added. “I still think there is more downside to come,” he said.

Market observers point out that it is still unclear how long national lockdowns will stay in place, a major uncertainty factor. IHS Markit said EUA prices could average as low as €5/tonne for the rest of this year in its worst-case scenario for the economic shutdown, before the MSR brings the market back into balance in 2021.

“We’ve got the MSR in place, which will help cushion the shock,” said Mark Lewis, global head of sustainability research at BNP Paribas Asset Management and the former managing director of the Carbon Tracker Initiative. “That being said, the sheer scale of the demand shock here is terrifying.”

Vis said worries about the depths of a potential carbon plunge are somewhat misplaced, since lower prices simply reflect the economic reality: with airlines grounded and factories lying idle, companies need fewer allowances because they are simply polluting less. If prices had stayed at €25/tonne, companies would justly be complaining about the additional burden.

“If it didn’t have [this] built-in relief provision, we’d all be screaming,” Vis said.

Long-term uplift

More long-term, market observers also take solace from the EU’s push for net zero emissions, which could have a more significant structural effect than any short-term disruption, even on the scale of the coronavirus. That should also attract speculators back into the market.

“That will entail, at some point … a significant further tightening of the cap. And it’s coming,” said Lewis. The European Commission is preparing to present plans for a higher 2030 target to lower emissions later this year, which will increase its current 40% goal to between 50% and 55%. The expected drop in emissions as a result of lower economic activity during 2019 will make it easier to argue for a more stringent emissions cut, Lewis argues.

“Given the scale of the demand destruction and the impact on GDP, we could see the biggest ever drop in ETS emissions this year,” he said. Wood Mackenzie, a consultancy, expects global emissions to drop between 5% and 15% this year as a result of the coronavirus crisis.

In 2019, emissions covered by the ETS already declined by more than 8%, the sharpest annual drop since 2009, thanks in large part to lower coal-fired power generation in countries including Germany and Spain. That is evidence the market is working: coal plants are usually the most polluting source of power generation, so they suffer most from higher carbon prices.

Vis, the former EU official, said the past success of the ETS stands for itself, pointing out that, even under the low prices seen until 2018, ETS emissions dropped by almost 30%. With the EU on a trajectory to only increase its environmental ambitions, that should help hold off the scheme’s critics. Countries including Poland and Estonia have recently argued for a suspension of their obligations to ease the economic shock, and some fear companies could also lobby to weaken the scheme.

“Tell me another sector that has done that? This is something that is proving to work,” Vis said, referring to past emissions cuts under the ETS. “It is an instrument that, if we didn’t have it today, we would like to invent.”