EU carbon price volatility in January a sign of things to come

EU carbon market analysts in December 2018 predicted that sharp price volatility seen in the second half of the year would continue into 2019. As of early January, they've been proved right.

After surging close to 10-year highs of over Eur25.00/mt ($28.65/mt) in December, carbon prices crashed back below Eur22.00/mt in the first few days of January.

And that's likely a sign of things to come in the rest of 2019 as the market grapples with highly significant factors, both bullish and bearish, that are certain to shape price formation this year.

In short, a now more finely-balanced carbon market will lead to increased price volatility because a smaller cushion of surplus supply will leave prices more sensitive to demand-side changes.

Europe's flagship policy tool to reduce carbon dioxide emissions from power plants, factories and airlines got a major regulatory overhaul in 2016-2018, after the EU passed key measures into law. Those included the Market Stability Reserve, which reduces a long-term surplus of carbon allowances by 24% per year from 2019-2023, helping to re-balance the market and propelling prices to 10-year highs in 2018.

Mild weather restrains prices

At prices of Eur4.00/mt to Eur8.00/mt in 2017, carbon made little difference to the economics of fuels for power generation. That all changed in late 2018, with carbon prices of above Eur20/mt beginning to help cleaner natural gas-fired plants push older emissions-intensive coal units out of the merit order for power generation.

With the MSR's supply constraints arguably priced fully into the market by the end of 2018, prices fell back in early January amid a raft of bearish factors including a milder than normal start to winter in Europe – reducing heating demand against expectations – and lower gas prices for summer 2019 which indicate a lower implied carbon price required to prompt coal-to-gas fuel switching.

That's a big change from 2018, when coal-fired profits in continental Europe were comfortably higher than equivalent gas-fired margins, even for lower efficiency coal units, maintaining strong hedging demand for carbon among the utilities.

The lower carbon prices in the first few days of January gave the bulls reason to pause for thought: January is likely to be among the tightest months of the year on the supply side, with German auctions on hold until February and no UK auctions in Q1 due to Brexit.

If prices fail to move higher in the remainder of January, this could be taken as a bearish sign in the short-to-medium term, as auction supply will rise in February with the return of German volumes. This is likely to have kept bullish momentum in check at the start of the year.

Poland in early December said it plans to increase its planned auctioning volume in 2019, by adding a volume of 55.8 million mt left over from a pool set aside for free allocation to help modernise its power sector. Those volumes will be spread across 2019, starting with Poland's first auction set for January 16.

Seasonal factors are also in play: as of the second week of January, very cold winter temperatures had yet to arrive in Europe, but any repeat of 2018's "beast from the east" would be expected to drive demand for domestic heating, pushing power, coal, gas and carbon prices higher.

Global gas price influence

Brexit also remains a risk, with any hard UK exit from the EU in March posing a downside risk for carbon demand from UK plant operators, while agreement on a deal would maintain demand by keeping the UK in the EU ETS until the end of 2020. UK lawmakers are set to vote on the draft UK-EU withdrawal agreement on January 15.

Some analysts have taken a bearish tone on the price outlook, pointing to Brexit risks and weaker gas prices for the time being, which help to make the fuel more competitive against coal.

"The main barrier to further upside in the coming two weeks is the Brexit vote, although even if the parliament rejects the current deal, the full implications for the EU ETS are far from clear," said energy analyst Trevor Sikorski at research group Energy Aspects, in a note January 7.

"The long-awaited tip of the global gas market into oversupply is showing some evidence of happening now, which is helping drive gas prices down and is already pushing more gas into merit in continental European markets," he said.

"A real downside concern for EUA prices in the coming two years is if gas continues to soften relative to coal, as this will drop the implied carbon price needed to get all of the fuel switch done, providing more [CO2] abatement at a lower price," said Sikorski.

On the flip side, the market short driven by the MSR in 2019 could be bigger than the CO2 abatement achieved through coal-to-gas fuel switching, re-igniting the bullish price trend seen in 2018.

"Still, even exhausting the fuel switch is unlikely to balance the EUA market, requiring some net draw from the credit inventory in the market," he said.

So there you have it. For carbon prices, a lot will depend on European gas prices in 2019 and their relative value against hard coal.

But whether or not carbon prices will gravitate around the Eur20.00/mt level or move to a higher pricing environment in 2019, as many analysts expect, the days of single euro digit carbon prices are gone.

Stronger carbon prices are set to play a much more prominent role in a switch to cleaner power generation fuels this year, boosting the economics of gas-fired and renewable energy generation and denting power sector demand for hard coal.