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EU carbon market faces changing hedging strategies, says analyst

Brussels — Europe's carbon market faces a paradigm shift as utilities may be adjusting their hedging strategies, according to an analyst.

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A 37 million mt drop in open interest in the December 2017 futures contract between January 1 and May 1 this year suggests that utilities may be acquiring carbon through the daily auctions of EU emissions allowances rather than in the secondary market, Marcus Ferdinand, an analyst at ICIS, told an industry conference in Brussels Tuesday.

This decline compares with an increases of less than 20 million mt over the same period in 2014 and 2016, and a drop of less than 5 million mt in 2015, he said.

Ferdinand told an industry conference in Brussels Tuesday that demand in the daily auctions has increased, even as the number of permits has increased by around 200 million mt this year due to the end of the backloading programme.



"If the market doesn't need the supply, you'd expect the cover ratio to decline if the volume being sold increases," he said. "It seems market participants are using auctions as an important part of their supply, and they might not be so active on the secondary market.

"The other explanation could be that there is less trading that is going on via exchange clearing and more is being done outside the exchanges, which could have an impact on the data."

Data from permit auctions in the first four months of the year also suggests a greater interest in auctions, he noted. The average cover ratio --the volume of bids compared with the number of permits on offer -- has increased, even though the auctions are larger than they were in 2015, he said.


SHIFT IN RWE'S HEDGING POLICY


Ferdinand highlighted RWE's recently-announced shift in its hedging strategy. The German utility recently announced it had shifted to modelling its activity on a so-called "negative virtual power plant," in which the company sells forward power to itself and hedges the generation.

This allows it to minimise the risk of power prices falling and instead focuses the risk on the profit margin these plants generate, Ferdinand said.

"RWE can do this because of its high lignite generation," he said. "Not many others can, excluding possibly EON."

The analyst estimated that RWE's strategy shift may reduce EUA demand by around 6 million mt/quarter.

There has also been a gradual shift in the profitability of power plants over the past 18 months, Ferdinand said.

"There's been a slow but very steady decline in the profitability of [hard] coal-fired plants since January 2014," he said. "They've been suffering for quite some time from high coal prices."

The so-called clean dark spread for power generated the following year has fallen from a profit of EUR4/MWh in 2014 to a loss of EUR 2/MWh at present, he said, while the clean spark spread, the profit from burning gas to generate power, has narrowed from a loss of EUR 20/MWh to a loss of EUR 6/MWh over the same period.

The clean brown spread, the margin for lignite-burning plants -- which are particularly important in Germany -- has fallen from EUR 17/MWh to around EUR 12/Mwh, he said.

"I see this as an incentive for power operators to be quite interested in hedging to lock in their profit margins and increase demand for carbon, as the spreads for gas and lignite look relatively healthy in historical terms," he said. "But as we've seen, the price of carbon isn't really lifting off."

Looking at the market in general, Ferdinand said the market was currently near its year-to-date lows and a "break-out" was looking increasingly likely.

Ferdinand forecast that emissions from the cement & lime and chemicals sectors would increase by 3.9% and 2.7% respectively this year, while emissions from metals and oil & gas would fall by 2% and 2.3% respectively.

"Chemicals and oil and gas are facing increasingly short fundamental positions," he said.

--Alessandro Vitelli, newsdesk@spglobal.com
--Edited by Wendy Wells, wendy.wells@spglobal.com