In the face of the worst economic hit since Europe started trading emissions 15 years ago, carbon allowances have surprised many doubters to become the best performing energy commodity since the pandemic prompted lockdowns around the world.
Despite the IMF now expecting EU GDP to contract by 8 per cent this year, with emissions expected to fall sharply as industrial output slows, European carbon allowances (EUAs) have instead shrugged off a brief wobble to soar back above pre-lockdown levels, reaching a nine-month high above €27 a tonne on Tuesday.
Such outperformance in the face of seemingly bearish fundamentals has understandably led to questions. Are we due for a hefty correction or is the rally sustainable? The answer depends on the timeframe under consideration.
In the short term, the fundamentals are unambiguously terrible. But longer term, the pandemic and the EU’s economic and environmental response may have created the space for carbon to soar.
Analysts expect demand for EUAs from fixed installations to drop about 13 per cent this year, which would represent the biggest annual fall in emissions covered by the scheme in its history (beating even an 11 per cent fall in 2009 in the wake of the global financial crisis).
And in addition to the impact on power plants and other industrial facilities there is also the hit to the aviation sector to consider. After the power sector, aviation was until now the second-largest source of demand for carbon allowances. European flights in mid-June were down nearly 80 per cent on the same period in 2019, according to Eurocontrol.
Before the pandemic, aviation was projected to be the fastest growing source of EUA demand to 2030. Things might change, but from today’s vantage point it is hard to see how that ever happens now.
In the short term, then, it is hard to see how the market avoids a correction.
But what about the medium to long term?
The outlook here is more interesting, with a clue to the longer-term pricing dynamics in the European emissions trading system (EU-ETS) potentially provided by the breach in the past two weeks of a key pricing level keenly watched by carbon-market observers.
Although at the current levels the benchmark EUA contract is still below its all-time high of €30, in another sense EUAs have in the past two weeks traded higher than ever before.
This is because for the first time in their 15-year history, EUAs are now trading above the upper end of the so-called fuel-switching range — the range in which EUA prices incentivise less carbon-intensive gas plants to displace more carbon-intensive coal plants.
The upper end of this range is the point at which even the least thermally efficient gas plants displace even the most thermally efficient coal plants.
At the moment, looking at fourth-quarter European gas prices at the TTF hub of €10.30 a megawatt hour and coal prices for delivery to Europe of $52 a tonne, then even a gas plant with a thermal efficiency of only 45 per cent (the efficiency level typical of the earliest combined-cycle gas plants built in the early 1990s) would displace the most efficient coal plant in Europe.
The reason why this is significant is that for most of their 15-year history, EUAs have traded either somewhere in the middle of the fuel-switching range or — at times of excessive oversupply — well below this range. For prices to trade above the top end of this range therefore opens the door to new interpretations of what the market is signalling.
One interpretation is that the market now thinks that even the maximum level of fuel switching will no longer cut CO2 emissions enough for the EU’s longer-term targets to be met, and that prices will therefore have to go higher to incentivise reductions in the other sectors covered by the EU-ETS.
Indeed, with the EU set to raise its 2030 emissions-reduction target by the end of this year to either 50 per cent or 55 per cent versus 1990 (compared with the current 40 per cent target), and with the scope of the scheme to be expanded over the next few years to include shipping, buildings and transport, there are good reasons to be bullish about further market tightening.
So, while a short-term correction looks inevitable, the longer-term outlook gives grounds for hope that the EU-ETS is entering a new phase.
At a time when the Arctic Circle has just recorded its highest-ever temperature of 38°C, it is a stark reminder that climate change has not disappeared while the world has been focused on the pandemic, and that policymakers need effective carbon-pricing tools to help achieve net-zero emissions by 2050.
Mark Lewis is global head of sustainability research at BNP Paribas Asset Management
The Commodities Note is an online commentary on the industry from the Financial Times