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London — EU carbon dioxide allowance prices are likely to hit Eur30/mt ($34.85/mt) before the end of 2019, according to a forecast Monday by Bank of America Merrill Lynch.

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If borne out, this would likely mean the power sector fails to deliver CO2 emissions cuts through coal-to gas fuel switching in the short-term, meaning carbon emissions abatement would need to be achieved through other means including growth in renewable energy generation.

The bank said it is bullish on European natural gas prices for 2019 on higher oil prices and a tight LNG market in Asia.

This, coupled with a bearish outlook for thermal coal prices in 2019 and carbon allowance supply cuts starting in 2019, is expected to drive carbon prices higher next year, Bank of America said in a research note.

Cheaper coal and higher natural gas prices are a bullish driver for carbon prices, as they encourage electricity generators to burn coal, which is roughly twice as CO2 emissions-intensive as gas.

"European natural gas prices rallied in 2018 on a cold end to winter and a hot summer. Combined with a strong LNG pull from Asia, weather has led to a drop in European gas inventories," it said.

"Looking forward, we see rising oil prices further lifting Asia's JKM and European gas prices alike," it said.

By contrast, the bank forecast Newcastle thermal coal prices at $92/mt in Q4 2018 and falling to $80/mt in 2019, both about $15/mt below the forward price, the bank said.

These trends are likely to provide further support for carbon prices in 2019, it said.

"European CO2 has rallied from Eur5/mt a year ago to Eur22/mt today, which makes it the best performing 'commodity' in 2018. The lift came mostly from the introduction of the Market Stability Reserve (MSR), a supply-reducing policy to support carbon prices," it said.

"We estimate that if API2 coal prices fall by $15/mt and TTF gas prices rise by Eur5/MWh, this adds Eur5/mt to CO2 prices," BofAML said.

"On top of the margin effect, a lot of utilities are still under hedged for 2019 and beyond. As they start to buy credits, CO2 prices will benefit," the bank said.

"As they come in to hedge through the remainder of the year (including buying CO2 credits), this will likely also contribute to higher CO2 prices," it said.

"Given the recent momentum and these structurally bullish factors ahead, we expect CO2 prices to hit Eur30/mt before the end of 2019," it said.

EU Allowance futures contracts for December 2018 delivery on the ICE Futures Europe exchange closed at Eur21.09/mt Friday, just off a 10-year high of Eur21.79/mt seen August 27.

The supply of allowances to be auctioned will be reduced by 24% of the 1.655 billion mt cumulative surplus each year starting in January under the Market Stability Reserve, which entered into legal force this year.

The MSR is a key reason why carbon prices rallied from Eur4.00/mt in mid-2017 to almost Eur22.00/mt in August 2018, BofAML said.

"Because carbon credits can be stored for the future at almost zero cost (since it is not a physical 'commodity', the only cost of carry is financing costs), anticipation of deficits years down the road affect prices today, even though we still have yearly surpluses in the present," it said.

With the short-term economics of power, coal and gas prices still favoring coal for power generation, longer-term CO2 emissions reductions may require direct regulation such as Germany's planned coal and lignite phase-down, and UK and Dutch carbon price floors, which contribute to make the most emissions-intensive fuels less competitive for power generation.

BoAML noted this as a downside risk for carbon prices.

"As our colleagues in European utilities equity research have pointed out, early coal plant closures are a downside risk to CO2 credit demand and thus to CO2 prices," it said.

"Any announcement of changes to future plans affects CO2 prices in the present. At the moment, most of the German coal plant retirements are scheduled for beyond 2023, but several government reports have suggested that closures could be brought forward if there is the political desire for it -- any such announcement would be bearish CO2 prices," it said.

"Germany produces the most CO2 emissions in the EU, and coal-fired power generation is a major component of those emissions. Germany has indeed increased wind and solar generation over the past decade, but so far that zero carbon emissions generation has mainly replaced low-carbon nuclear and gas generation," it said.

Longer-term, carbon prices will only fall as and when new sources of CO2 reductions can be found, the bank said.

"Prices are ultimately capped to the upside by emissions abatement projects, which become increasingly attractive at higher EUA prices," it said.

"Ultimately, the ceiling on CO2 prices is set by the cost of abatement. Wind continues to get cheaper to build as technology and costs improve," it said.

Newbuild wind in the range of Eur30-50/MWh is competitive with long-term power prices at Eur45-50/MWh in Germany, and as carbon prices rise, renewable projects become more attractive, it said.

"At current EUA prices of over Eur20/mt we expect to see permanent abatement projects worth nearly 100 million mt of CO2. These projects do take time to get completed, but as EUA prices increase, the more emission-reducing projects we expect to see," it said.

Furthermore, the risk of a sharp UK exit from the EU ETS under a "no-deal" scenario with the EU in March 2019 is a further bullish factor for the carbon price, according to BofAML, since the UK has reduced CO2 emissions faster than other countries and is a net supplier of allowances to the rest of Europe.

"If the UK leaves the EU ETS in a disorderly manner, then the decline in emissions credits (supply) in the remaining bloc will be much larger than the decline in actual emissions (demand). This would likely require higher EUA prices to make up the difference," it said.

"Starting in January 2018, EUAs issued in the UK are branded as such, and these EUAs are invalidated if the UK leaves the ETS before compliance [April 30]. This measure is intended to prevent UK-issued EUAs from flooding the market," it said.

Alternatively, a compromise EU-UK exit deal could see the UK continue to participate in the EU ETS for another two years until the current third trading phase ends on December 31, 2020.

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

--Edited by Maurice Geller, maurice.geller@spglobal.com