An auction of EU carbon dioxide allowances on Tuesday morning cleared at a six-year high of Eur9.53/mt -- the highest carbon auction price since November 16, 2011.
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The carbon auction, hosted by Germany's European Energy Exchange on behalf of 25 EU member state governments, also attracted enough bids to cover the volume almost four times over, compared with the 12-month average of 2.6 times covered.
EU Allowance prices under the EU Emissions Trading System have reached successive multi-year highs since December on signs market participants have increasingly factored in a future shortage of allowances due to tougher regulation in Brussels.
EUA futures contracts for delivery in December 2018 on the ICE Futures Europe exchange rose as high as Eur9.77/mt on Tuesday morning, up 29 euro cent or 3% from Monday's close.
While underlying demand side factors remain rather bearish -- including milder than average temperatures in Europe and strong availability of renewable energy -- the overriding direction for prices has been higher since December.
And prices have more than doubled from a low of Eur4.40/mt in May 2017.
More recently, the strength in carbon prices has been further aided by falling coal prices, which make the emissions-intensive fuel relatively more attractive for power generation.
API 2 coal prices for delivery into Northwest Europe on a year-ahead basis have fallen from around $90/mt in December to as low as $76/mt on February 9.
Many carbon analysts have forecast a return to euro double digit carbon prices in the short-to-medium term as the Market Stability Reserve will cut into a long running oversupply that has kept prices low for years.
The MSR is set to become operational in January 2019 -- less than 12 months away.
The MSR will curb the cumulative oversupply -- which was 1.694 billion mt in 2016 -- by 24% each year until it falls below 833 million mt.
That implies a cut of about 40% to the volume provided at auctions in 2019, and further cuts in subsequent years.
Even if new bearish demand side factors emerge, such as new policies by EU member states to phase out coal or lignite from power generation, or to increase renewable energy capacity on the grid -- the MSR will continue to remove surplus allowances from auctions automatically on an ongoing basis, tightening the supply balance.
That has prompted some analysts to note that the tightening supply side part of the equation is overriding any demand-side weakness.
Arguably, the MSR flips the nature of the EU ETS by bringing in a greater balance between supply and demand, prompting more of the financial side of the market to bet on prices rising rather than falling.
This means that if market participants believe the price is going to rise in future, they are incentivized to buy allowances now or avoid selling surplus volume.
In the short-term, there are still potentially bearish factors, including the annual free allocation of EUAs by all EU member state governments, which normally takes place by the end of February.
This influx of fresh EUAs into the market, estimated at up to 750 million mt this year, has in the past weighed on prices as the non-energy industrial sectors such as metals, cement and chemicals producers sold off surplus volume.
But the upside risk for prices this year is a scenario in which the industrials avoid selling free EUAs and prefer to keep hold of surplus volume to mitigate the risk of future shortages.