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London — EU carbon dioxide allowance prices tested the downside below Eur21.50/mt ($24.29/mt) for the third time this year in Week 7, coming under strong pressure from natural gas market weakness and heightened risk as the March 29 Brexit deadline nears.

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EU Allowance futures contracts for December 2019 delivery on the ICE Futures Europe exchange fell as low as Eur20.84/mt Tuesday afternoon, compared with Monday's Eur22.40/mt close.

The high so far this year of Eur25.73/mt was posted January 2 and the first month of 2019 saw an average closing price of Eur23.43/mt.

The renewed weakness in Week 7 reflects a combination of factors, including lower gas prices and uncertainty over Brexit.

Ongoing milder-than-normal temperatures across much of Europe have taken the edge off domestic heating demand during what is normally one of the coldest months. That has contributed to already healthy gas storage levels and LNG supplies coming into Europe weighing on gas prices.

Looking further ahead, the relatively cheaper gas prices for summer 2019 show that coal-to-gas fuel switching is likely to occur as clean spark spreads compete again clean dark spreads, with more efficient gas-fired generation expected to push marginal coal units out of the merit order for power generation in continental Europe, reducing CO2 emissions.

Carbon prices have moved in a range of roughly Eur21.50/mt to Eur25.50/mt so far in 2019, maintaining the gains seen in 2018 on the back of coming supply cuts in the 2019-2023 period that are expected to leave the market much more balanced after years of severe oversupply.

However, with cheaper gas prices and other risks, including Brexit, on the horizon, some sources have questioned whether that bullish narrative will hold.

Recent and upcoming price drivers could risk a downside price breakout from the current year-to-date range, according to analyst Trevor Sikorski at consulting company Energy Aspects.

"The EU natural gas market has continued to be weak, as storage levels remain high and supply continues to be complimented by incremental LNG washing in from a well-supplied global market," Sikorski said in a note Tuesday.

Tighter EU carbon market set to prompt more power fuel switching in Europe

2019 is set to be the year that coal-to-gas switching in power generation takes off in continental Europe. Carbon prices supported by the new market stability reserve cutting supplies, coupled with potentially lower gas prices, could prompt unprecedented C2G switching volumes.

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"The TTF [Dutch gas market] has been trading, particularly for delivery in summer 2019, at a much lower fuel switch trigger than seen in previous years," he said.

The gas market is now trading at a level that is expected to deliver much of the available coal-to-gas switch for summer 2019, reducing utility demand for EUAs to hedge forward power sales, he said.

A drop in coal prices below $77/mt this week reflects this increasing switch from coal-to-gas for power generation, meaning coal "broke away from its oil price anchor and started to compete for market share," Sikorski said.

"This looks like a potential race to the bottom between the two fuels, raising the question of whether the market will retain its consensus that the only way is up for EUAs," he said.

"With the fuel switch coming into the market regardless of the EUA price, will the 'buy and holds' retain their conviction that this is a market with gains still to come?" he said.

The risk of a no-deal Brexit continues to hang over the carbon market, and although the EU has taken steps to protect the integrity of the EU Emissions Trading System from a no-deal scenario, this could still prompt UK plant operators and non-compliance financial players to sell off positions if and when a no-deal outcome materializes. Conversely, any agreement on a withdrawal deal would be expected to see the UK stay in the EU ETS until December 31, 2020, which would maintain demand from UK companies.

"With Brexit risk likely to rule out an upwards break from EUAs, market focus should turn to a downside break given the increasingly bearish outlook for the fuels complex," Sikorski said.

"With much speculative capital taking its consensus view from the fuel switch price, and lower gas prices having now put paid to fuel switching providing any upside to carbon, now could be the time to take profit on long outright EUA positions. If the drop in the fuels complex shatters that bullish EUA consensus, this could be the trigger for a selloff," he said.

-- Frank Watson, frank.watson@spglobal.com

-- Edited by Keiron Greenhalgh, newsdesk@spglobal.com