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Explainer: key price drivers in the EU ETS

EU Allowances issued under the EU ETS trade like a commodity alongside oil, natural gas and coal futures, and are designed to put a price on carbon emissions that incentivises use of cleaner alternatives to avoid emissions costs. 

The below summary covers three key aspects that contribute to EUA prices: market design, supply and demand.

 

This report is designed to give some background to the EU ETS for newcomers, so other reports make more sense.

MARKET DESIGN

 

 

 

 

 

 

 

By 2050 the EUA price should reflect whatever it costs to eliminate the most stubborn of emissions - whether that is €50 or €10,000 per tonne of CO2. 

 

The EU ETS is divided into phases spanning a few years, with parameters for the market set for each phase. In 2021 Phase IV started, running until 2030. 

 

Phase 4 of the EU ETS sets a target emissions cut of 61% vs. 2005 levels for covered sectors, achieved through a combination of the 4.3% LRF and the Market Stability Reserve, a supply limiting mechanism which is discussed further below. If emissions are not cut by 61% in 2030, the EUA price could be expected to be higher to reflect demand exceeding supply. 

Roughly half of EUAs are sold via auctions, held on trading days at 11 a.m. CET by the EEX. In 2023 these typically amount to around 2.5-3 million EUAs sold daily. Revenues go to national governments, and under the Fit for 55 package are to be designated for spending on emissions abatement. 

 

The other half of EUAs are given out for free to industrials and aviators, with the idea of shielding them from the full cost of carbon emissions, so they won’t relocate outside Europe to avoid carbon costs - ‘carbon leakage’. 

 

The quantity of EUAs an industrial receives for free is related to the efficiency of production per tonne of CO2 - the top 10% most efficient producers of a given product covered by the EU ETS set the Benchmark, and receive all EUAs for free. Those exceeding the benchmark can receive a surplus of EUAs, while those less efficient than the benchmark will receive relatively less EUAs and need to top up their holdings by buying EUAs. 

 

When the Carbon Border Adjustment Mechanism is fully introduced in 2026, free EUAs will be phased out for covered sectors. Steel, Aluminium, Fertiliser, Hydrogen and Cement producers, with those EUAs moving to the auctions. CBAM is a border levy based on the carbon intensity of imported goods into Europe, tied to the EUA price. This implies an increase to daily EUA buying demand from these expensive to abate sectors. 

Historical oversupply 

Since the Global Financial crisis in 2008, the EU ETS has suffered from a problem of oversupply. Enough EUAs were distributed for free that when industrial production and emissions dropped as a result of the Financial Crisis, companies were left with surpluses of EUAs in their accounts. 

 

 

 

 

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As a result the EUA price dropped from €30 per tonne of CO2 equivalent to just above €5, and stayed there through to 2018.

 

 

 

 

Compounding the problem was the introduction of international carbon offsets into the system - each company had an allowance of Certified Emissions Reductions (CERs) issued by the UN that they could buy and submit instead of EUAs. This cut EUA demand further as CERs traded under €5 each - dropping to around €0.20 in the late 2020s - representing a real bargain vs. an EUA price of €20 for those who hadn’t taken advantage of the opportunity to use CERs for compliance previously. CERs were excluded from the system at the start of Phase 4 of the EU ETS in 2021. 

 

While there is oversupply of EUAs on a cumulative basis, a large proportion of these EUAs are held by companies who retain a surplus of EUAs or have a long term bullish outlook for the EUA price. These are unlikely to come to market therefore, unless EUA prices seem attractive enough to prompt selling. 

The Market Stability Reserve

The Market Stability Reserve was introduced in 2019 to combat the problem of historical oversupply of EUAs compared to emissions since the global financial crisis in 2008. The MSR may have been more politically acceptable than an outright change to the rate of reduction to EUA supply at the time.  
 

The EU had previously attempted removing EUAs from the market to boost the EUA price - “backloading”, with a muted response in the EUA price. The MSR works by looking at the historical surplus of EUAs (TNAC - Total Number of Allowances in Circulation) and cutting future auction supply by 24% of that TNAC figure. As such, the MSR will continue working through at least until 2030, ensuring the market stays tight - even if there is an economic downturn, emissions cuts, or a shock like covid. The MSR withdraws from the market down to a surplus of 833 million EUAs. Under that threshold the MSR stops, and reintroduces an unspecified number of EUAs to the market if the TNAC drops under 400 million EUAs. These withdrawals apply from August to August each year - therefore 24% of the TNAC after 2022 would be cut from auctions from August 2023. 

In terms of how the MSR has impacted the EUA price so far, we saw a bull run from €5 to a high around €32 over the course of 2018 as investors bought in in anticipation of the start of the MSR in 2019. Since then, the MSR contributed to the recent price increase from €30 to €100 - as the MSR applies last year’s TNAC to next year’s EUA auctions, a drop to emissions like the one caused by covid and then subsequent rebound as society got back to normal, contributed to the sharp price increase we saw in 2021 - with reduced supply meeting higher EUA demand. The market can be expected to remain tight in long term, on this basis.  

In H2 2023, EUA auctions have gotten approximately 500 thousand EUAs larger as a result of a smaller TNAC for 2022 than for 2021 or 2020 - from 2.5 million to 3 million EUAs a day - so the MSR can have both a bearish and bullish impact on the market. 

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Fit for 55

 

Fit for 55 updates the EU ETS to put it on a more ambitious trajectory to a 62% emissions cut by 2030 vs. 2005 levels. The most relevant reforms relevant for the average EUA buyer affect supply of EUAs are:

  • 4.3% yearly reduction to EUA supply vs. 2010 emissions baseline, 4.4% from 2028. This amounts to approximately 84 million less EUAs every year. 

  • Two scheduled removals of EUAs from the market in 2024 and 2026.

  • Factories must implement emissions reductions or risk their free allocation being cut.

  • Free EUAs for aviators phased out - meaning more daily buying activity on average.

 

These updates are known and reflected in current EUA prices; it remains to be seen if further updates are to follow in coming years.

From 2025 the European Commission starts to discuss the EU ETS post-2030 - at present the system would deliver zero emissions by 2039 if parameters were kept the same, so the design of the market may prompt some volatility as carbon removals are factored in towards a 2050 net-zero goal. 

REPower EU

The EU's REPower EU plans, intended to help wean Europe off Russian gas, have implications for EUA supply also. €20bn is to be raised from EUA sales before 2027, which implies sales of around 200 million EUAs. 

These EUAs are to be taken from EUA auctions scheduled for after 2027, rather than by introducing any new permits into the market. This means that supply of EUAs will be higher before 2027, but tighter after 2027, prompting some analysts to adjust their forecasts to show weaker EUA prices in near term, strengthening towards 2030. 

Crucially, extra EUAs sold at auction in the near term contribute to the Total Number of Allowances in Circulation, and therefore some of these EUAs will be taken from the market each year - contributing additionally to a tightening of supply after 2027. 

Inclusion of maritime shipping

Similarly to REPower EU, the inclusion of maritime shipping in the EU ETS from 2024 will mean a loosening of EUA supply in the short term, and then tightening towards the end of the decade. 

This is the case because while approximately 90 million extra EUAs will be auctioned in 2026 to correspond to the maritime sector's ETS covered emissions, shipping companies will only need to buy 40% of those in 2024, and 70% in 2026. Modelling based on IMO data on decarbonisation suggests that maritime sector EUA demand will exceed the sectoral emissions cap by 2026 however, making shipping a net buyer and adding further bullish momentum by the second half of the decade. 

 

 

 

As the EU ETS is a cap and trade system, easiest / cheapest emissions reductions should come first. At present that means the energy sector is the most relevant source of emissions and emissions abatement, with approximately 50% of total EUA demand coming from power and heating.

Power sector EUA demand

Renewables and the relative costs of coal, natural gas and electricity are key concepts that dictate EUA demand. 
If the sun is shining and the wind is blowing, most fossil fuel power generation can be expected to be displaced by zero carbon power sources - pushing EUA prices down. 
Natural gas emits roughly half the ETS covered emissions of coal - meaning the EUA price impacts natural gas fired power production half as much as it does coal fired electricity. If the cost of generating natural gas fired electricity given the gas price and carbon price is less than generating coal fired electricity, lower carbon natural gas should be favoured - generating relatively less demand for EUAs than from a coal fired power plant. 

This concept is Fuel Switching - from coal to gas, coal to renewables, or gas to renewables. Reverse Fuel Switch would be a shift to a more carbon intensive fuel. 

 

 

 

 

Profitability of a coal plant is known as a Clean Dark Spread - a calculation of coal, carbon, transportation costs vs. the power price. The profitability of a gas fired power plant is calculated as natural gas cost plus carbon cost vs. the power price - the Clean Spark Spread. 

Below the fuel switch cost for EUAs over the past couple of years is shown, along with the gas price - note that gas prices were high enough to a) contribute to dragging the EUA price from €30 to above €90 as EUA demand rose, and b) far exceed carbon costs - coal remained the cheaper option. 
 

The TTF Gas and API2 coal contracts are therefore relevant as they’ll determine the relative costs of generating electricity from different sources, and therefore the overall level of emissions that would need to be bought on the market. Global flows of gas, demand from other major markets like Asia, and development of new resources, like additional gas production coming online in the UAE in 2026, are therefore relevant to the EUA market. 

Fuel switching, mostly to renewables, and low electricity demand mean that in 2023 fossil fuelled power generation has been sharply reduced vs. 2023, as shown in the below graph from Ember. This has bearish implications for EUA prices through weaker demand, though the market remains short of supply by a good 100 million EUAs at least in 2023. 

Industrial EUA demand
In 2023 the economic outlook for Europe and figures on industrial performance can be illustrative of EUA demand. Fertiliser and ammonia production - two large sources of EUA demand - have been cut back substantially due to the high gas price - even in late 2023 around 3x the gas price in 2019. 

Larger industrials engage in speculative trading, but the majority of factories across Europe take a more conservative approach of buying dips and generally aligning buying activity to production. 

 

With BASF shutting one of their plants in Ludwigshafen in Germany, Europe could gradually deindustialise in response to high energy prices - whether this can cut 84 million tonnes of CO2 a year however remains uncertain - some EUA price forecasts do reflect this potential cut to demand however. 

Hedging behaviour

Industrial buyers
Most industrial compliance buyers buy spot EUAs to roughly align with emissions produced as part of their production of goods. Anecdotally, few are willing to sell their EUA holdings. Approaches to buying the EUAs vary, but many companies will buy regular tranches of EUAs and compliment this with orders placed at regular intervals, designed to capture lower prices as they appear. 

As roughly half of emissions come from the energy sector, however, their approach to hedging can be instructive as to EUA price developments, so viewing public reporting from major refiners can give an impression of industrial demand. 

Power sector
As a basic rule, utilities buy EUAs to correspond to the amount of electricity they are successful in bidding to generate. The EUA, along with the fuel (typically coal, lignite or natural gas) represent ingredients in producing electricity, and they sell the electricity at the power price - with the leftover profit representing the Clean Dark or Clean Spark Spread. 

Electricity markets price according to the marginal power producer. This means bidders for power generation are ranked from cheapest to most expensive until demand is met. The power price is set for all power producers at the price of the most expensive source of electricity. As EUAs are factored into power prices, this a) implies carbon costs filtering into power prices and b) props up power prices, to the advantage of renewable power generators who don’t have to buy EUAs, but receive a high power price anyway. 

 

If that marginal power producer changes - perhaps there is a lot of wind and sun, or perhaps the gas price falls sufficiently or the EUA price increases sufficiently to push coal out of the electricity mix - then the amount of EUAs a utility has hedged would also change - they’d buy or sell EUAs. 

 

Utilities often use hedging ratios for forward power sales - buying most or all EUAs needed in the current year, and a percentage of the requirement for next year, and the year after that and so on. Some utilities publish this data - for example, the Czech utility CEZ, as shown below. Changes in hedging ratios can have implications for the EUA price, and suggest that market fundamentals (gas, coal price) in the front year should have more impact than those for coming years. Interestingly, in spite of EUAs hitting new all time highs over the past year, utility reporting suggests that they’ve been under-hedging their EU ETS risk, with a focus on maintaining their natural gas and coal futures positions amidst the energy crisis. 

                                                                                      CEZ EUA hedging activity (in millions of EUAs) - from 2023 financial results here

A 2021 ESMA report on speculative activity in the EU ETS suggested that a large proportion of speculators are in fact compliance buyer utilities - so the actual picture may be more complicated as utilities trade short term fundamentals. 

 

Speculation

The participation of investors in the EU ETS was a hot topic during the Fit for 55 discussions as the EUA price moved from 30 to 90 euros. Ultimately the European Securities and Markets Authority (ESMA) found no evidence of manipulation, but speculators do have an influence on EUAs. 

Typically investors are the ones that are most likely to sell EUAs if there is a shock - like Credit Suisse's collapse, or like covid. Equally, unlike industrials who tend to simply buy EUAs and hold onto them, if the market moves against speculators, they can tend to want to get out of their positions - leaving the market prone to short squeezes. 

The ICE Commitment of Traders can give some insight into how speculators are positioning themselves by showing how many EUAs long or short investment funds are. A large short position can indicate pessimism in the market, but can also leave EUAs prone to a sudden rebound if the market does not drop as the speculators had thought - a short squeeze.

Speculators are likely good sources of liquidity also, given their interest in selling and buying EUAs - at times when speculators are absent, the market becomes noticeably more choppy - making it hard to secure volumes of EUAs at a reliable price. 

Does carbon pricing really lead to emissions reductions? 

While the market may be designed to deliver EUA prices that reflect actual decarbonisation costs, this doesn’t guarantee that decarbonisation will go ahead - risks associated with installing new technology - of something breaking and risking customers taking legal action for non-delivery of goods, can make it easier to absorb carbon costs into prices by buying EUAs, rather than decarbonise, even if decarbonisation is cheaper. 

 

As such, carbon prices may not be sufficient alone to prompt abatement to meet the EU’s 2030 emissions target, and one might have a bullish outlook if sceptical that abatement amounting to 62% of 2005 emissions will happen. 

 

ICIS show that while significant emissions abatement potential exists at an EUA price of €70 to €100, only a proportion of this is planned - the majority of it coming from efforts to decarbonise steel production using hydrogen. 

As such, there is no guarantee that buying, selling or decarbonisation activity will match changes in underlying fundamentals, nor that Europe will meet its decarbonisation goals on the basis of the carbon price. 

In broad terms, the question is one of whether it will be possible to eliminate more than 84 million tonnes CO2 per year - roughly the decrease to yearly supply. 

If there is a substantial drop to emissions in any given year, the MSR will, within a few years at most, tighten the market again - therefore without some sort of political intervention, the EUA price should stay meaningful. 

Supply looks set to increase as REPowerEU and the inclusion of maritime shipping in the EU ETS loosen the balance between EUA supply and demand, though from 2026 onwards, supply tightens again and that near term bearish influence should go away. 

The question then turns to future sources of emissions abatement - what will it cost to reduce sufficient emissions from heavy industry once most power sector emissions cuts are completed? 

From 2025 discussions start on the ETS post-2030 - which looks likely to feature carbon removals as a feature. The EU ETS is front-loaded in terms of ambition to deliver a 61% cut to emissions vs. 2005 CO2 levels, leaving the other 39% for 2030-2050 - but if emissions reductions do not happen in the 2020s, this would make the decarbonisation task harder post-2030. More details should start to emerge in 2025. 

Contact us for EUA price forecasts and more analysis of future developments in the EU ETS

 

Trading the EU ETS: how fundamentals impact the market

Since 2021, the EUA market has shown significant volatility, in 2022 exceeding 6 euros from the mean and in 2023, 5 euros. The tight balance between supply and demand leaves the market prone to volatility, but has also meant that even as gas prices fell over the course of 2023, EUAs have struggled to move below €80, likely due to the MSR and strength of Fit for 55 proposals. 

Dec23 EUA prices

Meanwhile, tight global energy markets - for LNG, coal and for oil, also take their toll, with energy prices prone to spikes as Russian gas and oil deliveries have been severely curtailed due to their invasion of Ukraine. This has made fuel switching harder - with coal still favoured over natural gas for winter 23/24, whereas before the energy crisis, gas supplies were abundant and cheap, pushing coal to the margins of European energy generation. Fuel switching is a financial calculation - you can expect activity in the EU ETS market when the economics of a gas fired power plant improve beyond those of a coal fired power plant, and vice versa. Tracking the fuel switch price can therefore be instructive as to EUA price movements.

 

As a result EUA prices are high and volatile, but the high cost of energy is driving inflation, and hurting industrial performance - which can have a bearish mid to long term price impact on the EU ETS. 

Uncertainty is also a key driver of price movements in commodity markets - the price of an EUA currently reflects the above discussed points - political reform and the general level of ETS-covered emissions in Europe. While in Q3 2023 most political developments are complete and represented in the current EUA price, further updates to the EU ETS for 2030 could generate yet more volatility if they exceed, or fail to meet whatever expectations the market has. 

In the short term, besides following gas and coal prices, additional auctions of EUAs under the REPower EU scheme represent a key point of uncertainty on supply of EUAs, and could generate volatility that could present buying opportunities. 

EUA auction supply is cut every December and August - in December due to the Christmas and New Years' holidays, and in August auction volumes are halved to account for summer holidays. Holidays can lead to increased volatility as prices jump around with few buyers and sellers. Typically EUA prices can be expected to rise in December and in August. 

The substantial speculative element in the market means that EUAs do trade quite technically. Support and resistance levels and trend-lines can be instructive as to determining what a 'good' EUA price is. Another typical market indicator is volatility - a drop to volatility tends to come before a breakout. This is the case for the EU ETS as well, where a wedge pattern of decreasing candlestick size typically precedes a breakout. Given the technical nature of trading, support and resistance levels can be instructive as to deciding when to buy (or sell). Concepts like short squeezes are also frequently referenced in analysis of the EU ETS, where large negative positions held by speculators can be overwhelmed by fundamental buying demand, forcing the speculators to buy back to close out their positions, and boosting EUA prices - and market volatility. As such, the relatively lower EUA prices do not tend to last very long.

Speculators are also typically the ones who sell their EUA holdings when markets receive shocks - when Russia invaded Ukraine EUA prices dropped by over €20, with little to no selling from heavy industry - before staging a quick recovery as compliance buyers bought the dip - and bullish fundamentals took over again. The collapse of Credit Suisse also prompted a price dip - and opportunity for buyers - as the impact of the bank's collapse was swiftly contained - and had little fundamental implications for EUA demand. Apr

Compliance buyers typically view EUAs as a cost of doing business, so will adopt strategies towards managing a budget or efficiently incorporating carbon prices into their sales. Depending on risk appetite and desired time commitment, buyers can adopt a variety of approaches to the market, from matching a reference price to beating the market average, to a more active approach. 

Given the overall 'short' market balance at present, a effective strategy over the past year has been simply to buy dips, to contribute to an overall below market carbon cost. There is potential, however, for EUA prices to move into a new, higher range, in coming years, depending on how decarbonisation efforts proceed, so many buyers will be agnostic on price, and simply try to align purchases of EUAs with their production or activity. 

 

Compliance buyers should consider:

  • The size of emissions that will be covered by the EU ETS. For ship owners, managers or charterers, that would mean all CO2 emitted between European ports, and 50% of that emitted between European and third country ports. 

  • How to price carbon emissions into contracts with charterers or customers. In a rapidly moving market, reference prices are available that could be quoted in contracts. These can allow for transparency, and depending on the approach chosen, will help to achieve a competitive carbon price

  • A strategy to meet the reference price or quoted EUA price in a contract with a customer, depending on a) the nature of voyages - variability in emissions levels, destinations b) risk appetite and c) desired time commitment. What will the cost of such a strategy be?

  • Memberships and accounts required to buy and hold EUAs. 

  • The required payment term and associated costs.


For a free consultation on your Carbon Risk Management Strategy and the outlook for the EU ETS contact us

Sources of EUA supply

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Sources of EUA demand

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What's next for the EU ETS?

Your carbon risk management strategy

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A cap and trade system like the EU ETS is distinct from a carbon tax in that a tax would deliver an arbitrary cost per tonne of CO2, which might not correspond to real carbon abatement costs. 

 

A cap and trade system is designed to a) deliver carbon prices that reflect actual costs of decarbonisation, and b) do this in an efficient manner, with the cheapest, most practical solutions first, with the logic that emitters know their own operations best, and are therefore better placed to make decisions on decarbonisation than government officials would be via targeted subsidies, for example. 

 

The EU ETS does this by limiting supply of allowances, with a cap on emissions set in 2005 roughly corresponding to total emissions (with an allowance to account for forward hedging activity). This cap reduces each year - until 2021 the rate of reduction or ‘Linear Reduction Factor’ was 1.74%, and was boosted to 2.2%, and then with Fit for 55, politicians agreed on a 4.3% LRF, rising to 4.4% in 2028. Under Fit for 55, the ETS should deliver a 62% cut to emissions vs. 2005 levels by 2030, compared to the previous target of a 48% cut by 2030. 

 

The cap will hit zero in 2050 - therefore if emissions exceed the available number of allowances in the market, the price could be expected to increase until those emissions are disincentivised. 

 

EUAs, therefore, get their price based on demand vs. limited supply - as shown in the supply and demand curve to the right. 

At present covered sectors are heavy industry, aviation and power production, amounting to approximately 45% of total EU, Norwegian, Icelandic and Liechtenstein emissions. 

For covered emissions, a rough idea of technological costs per tonne of CO2 avoided can be gained from the graph below. If supply of EUAs is exceeded by demand - emissions - the price should reflect the marginal cost of abatement, or the price at which enough emissions should be cut to balance supply and demand. 

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