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Highlights

Highest front-December carbon price since 2008

Compliance buyers and financials continue to drive prices

London — EU carbon dioxide allowances under the EU Emissions Trading System powered up to Eur20.50/mt ($23.73/mt) Thursday for the first time since 2008, on power sector demand and bullish sentiment ahead of looming multi-year supply cuts.

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EU Allowance futures contracts for delivery in December 2018 on the ICE Futures Europe exchange rallied as high as Eur20.50/mt on Thursday, up 70 euro cent from Wednesday's close.

Carbon prices have seen extraordinary gains over the last 18 months as the market braces for sharp supply cuts starting in January, which are expected to leave the market short of allowances in the next few years.

This has led compliance entities like power plant operators in Europe to lock in carbon allowances in the forward market, and financial companies to buy up volume ahead of a likely supply squeeze.

A London-based carbon trader on Thursday said the carbon price continues to be pushed higher by long-term supply constraints and strong underlying demand from power generators and financials.

"The risk of a correction is very high but I think it gets bid because hedge fund guys don't have as much price sensitivity," the trader said.

"There are equity hedge funds with massive portfolios who are jumping onto this," he added.

Short-term traders are also likely to "just trade systematically so will ride this trend up and buy dips, if they ever come," he said.

Underlying compliance buyers are also driving the gains, with power generation fuel price dynamics still favoring emissions-intensive fuels, the trader said.

"As long as gas keeps rallying more than coal, then they will continue to feed off each other," he said.

Natural gas prices have rallied this year, while coal prices have been relatively stable, helping to maintain the profitability of coal-fired power generation in Europe.

European wholesale power prices have increased sharply in August, boosting the clean dark spread -- the profit margin on power after accounting for the cost of coal and carbon allowances.

With coal emitting roughly twice the CO2 emissions of gas per megawatt-hour, this props up utility hedging demand for carbon allowances on the forward curve.

A southern-Europe based carbon and energy analyst said carbon prices have confounded expectations.

"It's absolutely stunning. Carbon is beating everyone's expectations month after month," the analyst said.

"The whole energy complex is pretty strong and there seems to be margin to gain further ground. If you add to that, that liquidity is not at its highest levels, it's hard to rule out further upside," he said.

"Is it sustainable? We'll discover that. Anything that goes up quickly usually comes down as quickly. Carbon is not that different," he said.

"The fact that carbon has not dropped yet since the beginning of the year is of course reinforcing the idea that this is a bull market. The question still remains 'at what price are they [financial players] willing to sell?' We can guess that for utilities. I think it won't be that simple for hedge funds," he said.

The main driver of the carbon price gains over the last 18 months is the upcoming Market Stability Reserve -- a set-aside pool of allowances to keep surplus volume out of the market.

The MSR was agreed by the EU Parliament and Council in late 2015 and strengthened under amended legislation which came into force in 2018.

Starting in January, the MSR will curb the 1.655 billion mt oversupply of allowances by 24% of the net surplus each year from 2019 to 2023, returning the market to a more balanced state after several years of oversupply.

That will translate into an estimated cut to carbon auction supply of about 400 million mt in 2019, or 40% down from 2018 volumes.

The latest jump in carbon prices also came in a month when primary supply from auctions fell by almost 50% to 46.6 million mt as governments curbed sales during the summer vacation period.

That could leave prices vulnerable to a downward correction in September when auction volumes rebound to 82.4 million mt, and rise further to 97.3 million mt in October.

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

--Edited by James Leech, james.leech@spglobal.com