EUA prices above 50 €/t are the new norm
In mid-December 2020, EU leaders agreed on a more ambitious 2030 emissions reduction target equal to a 55% reduction compared with 1990 levels. Since then, the new year has seen a continuation of a significant bull-run for the European carbon price. 2021 started at levels slightly above 30 €/t with auctions pausing a bit longer than usual at the start of the year.
New net-long positions taken by speculators betting on a high-ambition long-term policy framework and supported by a bullish narrative in the mainstream media caused a continuation of the upwards trend during spring.
The trend increase in prices was reinforced by developments in the European gas market. Following winter, European gas prices rose. This was mainly due to low storage levels relative to seasonal averages, a cold winter and reduced Russian and Norwegian flows at the start of the year.
Clean Spread development (weekly aggregate) past twelve months in €/MWh
Power demand recovered strongly compared to 2020, but with a soaring energy complex hard coal and lignite were deep in the money again, while gas generation is finding it harder to compete. The generation margins for hard coal and lignite plants for the first time since December 2019 convincingly stood above the gas plant margin. This caused the more carbon-intensive coal and lignite generation to successively push some of the gas-fired stations out of the market, supporting the bullish carbon price environment.
In August, profit-taking in the gas market put downward pressure on EUAs, but that was only short-lived. A new rally, pushing the EU carbon price above 60 €/t reflects the current fundamentals and the bullish policy outlook.
The start of Nord Stream 2 operations could entail some bearish risk for gas and, indirectly, for carbon prices. However, while EU discussions on the Fit-for-55 package continue, we expect the EUA December-21 contract to stay around the €60/t level for now. Should a correction happen, we expect the area between 50–60 €/t to attract significant support from dip-buying. However, volatility will remain high in the near future.
The Fit-for-55 package – abatement pressure increases
With the publication of the Fit-for-55 package on 14 July 2021, the European Commission advanced the political process to revise and re-shape the EU ETS to reflect the 55% 2030 emission reduction target. All the elements described are part of an ongoing political process and will likely change during negotiation.
A new cap is needed – timeline for implementation is key
The Commission’s proposal suggests that EU ETS emissions, including the yet-to-be-added maritime sector, would be reduced by 61% in 2030 compared to 2005 levels. The draft document suggests increasing the linear reduction factor (LRF) to 4.2% (up from the current 2.2% annual rate) with effect from the year following the entry into force of the new Directive. This corresponds to an annual reduction of the emissions cap of 82.1 million allowances, compared to an annual reduction of 43 million currently. We assume that the LRF change is implemented in 2024.
We see the cap being reduced by a further 1.9 billion allowances during the entire fourth trading period relative to the current legislative regime. The change to the LRF is also combined with a one-off rebasing of the cap to make up for time lost during the political negotiation. We estimate this one-off reduction of the cap to amount to 117 million allowances and to occur in 2024, resulting in a relatively tight market during the mid-2020s and a high risk of a price squeeze.
Extending the scope, increasing pressure on imports and creating an ETS-based approach for transport & buildings
Carbon pricing will be extended under the proposals. The EU ETS will have a broader scope, with maritime shipping included in the cap as of 2023. A separate emissions trading system is expected for the transport and buildings sectors from 2026. Finally, a carbon border adjustment mechanism (CBAM) is expected to indirectly widen the EU ETS’ reach. The mechanism would require importers of certain goods to hand in allowances sufficient to cover emissions in the source country. At the same time, EU installations in the relevant sectors will gradually see their free allocation shrinking as of 2026. The CBAM proposal, as well as the transport and building ETS, are amongst the more controversial elements of the Fit-for-55 proposals and could jeopardize the timeline if not separated from the core proposal.
The Market Stability Reserve will loosen its grip on the market
The draft legislation foresees some modifications to the Market Stability Reserve (MSR). It proposes to maintain the intake rate for the MSR at 24% until at least 2030, avoiding a reduction in the rate planned under current regulation. In addition, aviation and maritime emissions and allowances will be included in the total number of allowances in circulation (TNAC), probably from 2024, finally accounting for the net EUA demand from these sectors.
The upper threshold, which acts as the trigger for applying the withdrawal rate of 24%, will continue to be 833 million allowances. One can argue that including the aviation and maritime sectors in the TNAC would justify an increased need for EUA hedging requirements. Therefore, keeping the 833 million upper threshold unchanged could be seen as a de facto tightening of the MSR parameters.
Nevertheless, this effect would be eaten up by reducing hedge requirements associated with the rapidly declining emissions in the power sector. We see the MSR to stop withdrawing allowances during the mid-2020s.
Overall, the proposal looks bullish on paper due to the 24% withdrawal rate. However, when the threshold levels are accounted for, these changes could have a limited price impact in practice, with the overall EU ETS cap, rather than the MSR, becoming the major price driver from the mid-2020s.
THEMA’s European carbon price forecast in €/tonne
If the Commission’s proposal is adopted, we see significant upside potential for EUA prices, especially around the mid-2020s. Then, the more ambitious 2030 emission reduction target is reflected in a significantly higher LRF, a one-off re-basing of the cap as well as the extension of the EU ETS to the maritime sector. The introduction of a CBAM, coupled with a gradual phase-out of free allocation for those sectors covered, could cause additional abatement pressure on industries. We will likely see more industrial hedging as the free allocation is being phased out and the CBAM is brought in.
We see EUA prices in our base case scenario reaching levels around €80/tonne in 2030. This is followed by a period of increased industrial abatement, which eases price pressure during the mid-2030s. However, carbon prices continue to rise over time to meet Europe’s carbon-neutrality pathway. Beyond 2030, abatement costs in industry and costs for negative emissions will be key. We expect carbon prices to approach triple digits in the mid-2040s.
The clock is ticking
The policy process to change the ETS Directive, as well as the other interrelated legislation, takes time. Along with the other Fit-for-55 legislative proposals, ETS reform will require a co-decision procedure with lawmakers in the European Parliament and the Council of EU member states agreeing on a final outcome. When negotiators of the European Parliament, Council and Commission were tasked to review the ETS Directive framework for the period 2021 to 2030, it took them two years from the Commission proposal until final adoption. Given the complexity of the upcoming reform and its integration within the much larger Fit-for-55 package, the process could take slightly longer this time.
Uncertainties are high and remain
The timeline of the legislative process is amongst the largest risks to the carbon price outlook. If the process stalls or gets dragged out, the cap change will be implemented later in time. The linear reduction factor would likely need to be even more aggressive in that case to avoid missing the 2030 target. However, delays would nevertheless increase the overall available carbon budget for the EU ETS fourth trading period, which ends in 2030. That said, the political process could result in a lower-ambition outcome compared to the Commission proposal, given that negotiators from Parliament and Council have their say in the process now.
A detailed EUA price forecast and a Fit-for-55 impact analysis are available as part of THEMA’s Green Value and power market reports. For more information, please contact Marcus Ferdinand. Marcus Ferdinand.