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EU carbon allowance prices on the way back to new highs?

Updated: Dec 2, 2022

The fund realized effective transactions resulting in close to 10% total additional return for the fund, a further recovering carbon market contributed to more upside, adding to a total of 27.9% return in the period of 1 to 30 October.

November looks set to bring renewed interest in the EU ETS after subdued trading in October. Uncertainty over political interventions in the market and industrial shutdowns in response to high gas prices had sent spot EUAs to a low of 63.97 Euros. The breakout through the 70 euro level came as the market apparently ran out of selling interest in week 43. Optimism about the EU's energy market interventions and Europe continuing with business as usual this soft autumn / winter thus far also seems to be playing into the strong recovery for EUA prices.

Market developments and outlook

In the short term, we can point to some fundamental underpinnings to justify higher EUA prices than we have observed recently.

Firstly, the EU's plans for decoupling of gas and power prices has pushed German Power prices down. Relatively lower power prices should prompt additional demand for electricity, and could also incentivice UK imports of cheaper European power. This would encourage utilities to sell more power, and therefore increase EUA demand.

Secondly, the European Council and Parliament seem to have ruled out using EUAs from the Market Stability Reserve (MSR) to raise money for REPower EU (the EU's initiative to accelerate becoming independent of Russian gas imports and other fossil fuel imports). REPower EU was to be funded from EUA sales, according to the European Commission's original proposal from the MSR, which would have brought significant unexpected EUA supply to the market and been solidly bearish for EUA prices. Instead, both European Parliament and Council have declared a preference for front-loading of future dated EUA auctions to raise funds. This implies no additional supply over what had been expected, though more supply in the short term, less supply of EUAs in the long term.

Thirdly, ammonia producers, which represent a significant source of EUA demand, are staging a modest recovery in their production levels as gas prices drop, with current curtailment of production at 45-50% vs. 70% in September. Fertilizer production (large ammonia users) is also resuming as the gas price reduces. The renewed demand should also keep EUAs relatively more supported. Optimism on the chances of Europe making it through winter without serious cutbacks to industrial production looks predicated on a mild outlook for temperatures this winter. Any uncertainty in weather forecasts or a cold spell of weather could draw down natural gas reserves and make the situation look less positive. Gas reserves, however, sit above 93% full across Europe, so without serious geopolitical disruption EUAs could trade back above 80 euros once again in November.

Finally, coal fired power remains firmly favored over electricity generation with natural gas. Coal is about twice as carbon intensive a source of electricity than natural gas. EUAs would need to reach approximately 300 euros for natural gas fired powerplants to be a more profitable source of electricity than coal fired powerplants. Therefore, EUA demand looks set to remain strong.

One bearish potential in short term would be a political pushback against high carbon prices this winter, after European officials had suggested prices under 70 euros would be desirable. Longer term, Fit for 55's sharper rate of reductions in yearly EUA supply (4.2-4.4% less EUAs every year looks likely), along with the continued presence of the MSR, keeping the market tight in response to increased EUA supply in the short term through frontloading of auctions should result in higher EUA prices.

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