London — EU carbon allowance prices rallied July 13 to their highest since 2008, with bullish sentiment continuing to dominate as participants look ahead to upcoming market reforms and focusing on the need for non-power sector emissions reductions.
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EU Allowance futures contracts for December 2020 delivery on the ICE Futures Europe exchange surged as high as Eur30.80/mt ($34.45/mt) July 13 -- the highest price for the front-December contract since 2008, and up from Eur29.02/mt at the close July 10.
"The market is re-pricing to industrial abatement now that power is priced in," a London-based senior carbon trader said July 13.
With significant fuel switching from coal to gas and coal to renewables for electricity generation seen in Europe over the last two years, expected tighter supply of allowances in future was shifting the market's focus to the non-power industrial sectors for future emissions abatement, the trader said.
"On this basis and longer timeframe, the market is still way too cheap," he said, although he noted the possibility of a short-term downward price correction.
Switching away from coal in the power sector has been the most widespread form of readily available CO2 emissions abatement under the EU Emissions Trading System, with power representing about 65% of total CO2 output.
However, several factors are likely to tighten supply when the fourth trading phase starts in January 2021, including a steeper reduction to the annual carbon cap (Linear Reduction Factor), declining free allocation for industrial sectors and the possible expansion to include new sectors such as shipping.
This expected tighter supply environment may be forcing participants to consider where the next round of CO2 reductions can be achieved in Europe. With decarbonization costs seen as higher among the industrial sectors compared with power generation, this acts as a bullish driver for carbon prices, the trader said.
Price surge likely due to financial players
However, some market observers see downside risk for carbon prices, especially if part of the recent price surge is linked to technical factors.
"Fundamentally, it is very difficult to justify the rally in the carbon market," said carbon analyst Bernadett Papp at trading house Vertis Environmental Finance.
"The approaching Phase 4 (fewer allowances due to higher LRF, lower free allocation, no borrowing, no linking capacity) with all of its reforms is a logical explanation [for the price surge], but market participants know about the reforms for quite a long time. It is not a novelty," she said July 13.
"All in all, I do not think compliance entities are behind this rally," said Papp.
"I think with all the money pumped into the economy by central banks and governments, there are plenty of financial entities/speculators that are looking for investment opportunities, and a small market with thousands of companies that have to buy the allowances seems a good opportunity," she said.
Moreover, options delta hedging could also be a factor in the price rally, which has seen prices jump more than Eur10.00/mt from around Eur19.00/mt in mid-May.
"Open interest in call options with a strike price at Eur30/mt and Eur35/mt amount to 50 million," said Papp.
Once the EUA futures price rose close to those strike prices, sellers of those call options would have to increase their buying of the futures contract in order to meet demand if the options buyer exercised those calls, prompting a scramble for December 2020 EUAs, she said.
"If somebody sold these call options thinking it would be easy money, now when the price was 1-2 euros from the strike price, they started buying the allowances because there is a risk the buyers of the options will exercise them at expiry," she said.
These factors may raise the possibility of a downward retracement in carbon prices, depending on the extent of buying that may be unrelated to underlying compliance obligations.
This factor was observed in June and July 2019, with prices pushing up to Eur30/mt ahead of tight auction supplies in August, before easing back to around Eur23.00/mt by early October.