EU carbon market enters choppy waters as Russia-Ukraine war triggers financial tumult

The European carbon market has experienced wild price swings amid financial tumult and energy policy uncertainty since Russia invaded Ukraine last month.

The Platts December futures contract for EU allowances (EUA) was assessed at €95.04 ($104) per metric ton (mt) on 23 February, the day before the invasion, according to S&P Global Commodity Insights' data. The EUA price then collapsed to €58.19/mt on 7 March before recovering to €77.42/mt on 15 March.

Companies covered by the EU Emissions Trading System (ETA) can use one EUA to emit one mt of CO2 for compliance purposes. The ETS allows speculative trading by financial institutions and other types of investors not facing emissions caps.

The initial selloff came as non-compliance players went into a risk-averse mode, according to market experts, with the Russia-Ukraine conflict pushing up energy costs and down stock prices.

"Many investors were forced to offload allowances to cover losses elsewhere to avoid margin calls," said Yan Qin, lead analyst of carbon research at Refinitiv. "The market was in shock … investors were not really touching a falling knife."

Elvis Pellumbi, chief investment officer of HFCO Capital Management, said investors became risk averse as they had to take into consideration political risks, changes in fuel prices, and potential demand destruction amid inflation.

"And hedge funds have been long on EUAs in a crowded trade for some time, so that has led to unwinding of positions as well," Pellumbi added.

But the EUA contract has since recovered, in part due to some compliance players out for bargain hunting. Under the ETS, companies must hand over enough allowances to cover their emissions by 30 April.

Moreover, some experts said the supply-demand fundamentals for the EU carbon market remain strong. In the short run, European power plants might need to burn more coal and require additional EUAs as the EU seeks to reduce imports of natural gas from Russia.

"It should be fairly bullish for the price outlook just from the sheer fact that we are probably going to be relying on … coal plants for quite some time," Anders Porsborg-Smith, global lead for commodity trading at Boston Consulting Group, said in a recent forum.

According to S&P Global's Platts Analytics, the EU could need an extra 17 GW of coal power plant capacity to meet its electricity demand amid disruptions of gas flows from Russia.

In efforts to reduce energy dependence on Russia, the European Commission (EC) on 8 March unveiled plans to raise the rate of wind and solar deployment by 20% annually in the REPowerEU communication. The EC has a goal of installing 480 GW of wind and 420 GW of solar by 2030.

"The initial sell-off in EUAs was also partly driven by fears that the EU will put climate policy in the back seat … The REPowerEU communication shows the EU's determination to quit fossil fuels earlier and double down on renewables deployment," Qin said. "This, in fact, has restored quite some confidence in the EUA market."

But S&P Global Commodity Insights' Coralie Laurencin, ENR senior director for energy futures, believes the EU's efforts in accelerating renewable energy expansion in Europe are "deeply bearish for the ETS market" in the long term.

"There will be less demand for credits as Europe will work tirelessly to reduce its fuel import dependency," she said.

Debate on market functions

In recent months, most market players have been bullish over the long-term prospects for EUAs on expectations of rising demand and tightening supply due to the EU's climate policy.

As part of the Fit for 55 climate policy package unveiled in July, the EC proposed amendments of the ETS and a Carbon Border Adjustment Mechanism that are expected to result in more demand for emissions allowances from manufacturers, airlines, and shipping companies.

The EC also plans a 4.2% linear decrease in the number of EUAs auctioned annually. Separately, the allocation of free allowances for stationary installations is set to be conditional on their decarbonization progress from 2026 onwards.

Pushing against those indicators of a tighter market is the reality of high energy prices and rising inflation, which could trigger actions by the EU to temporarily relax some of the plans for allowances.

German lawmaker Peter Liese, who is drafting the European Parliament's position on market reforms, has proposed a rule amendment that can quickly trigger additional EUA auctions if prices rise excessively.

EUPowerEU also suggested the EU member states could subsidize vulnerable households, and a Temporary Crisis Framework that might offer financial aid to energy-intensive firms is under consultation.

The handouts are expected to be partially financed by the proceeds from EUA auctions, according to the EC. The revenues generated from those auctions reached around €30 billion between 1 January 2021 and 28 February 2022.

While recognizing the subsidies could come in handy during the energy crisis, some think-tankers urged European countries to carefully design the policy measures so they would not encourage more energy consumption.

"Financial support based on lump sums per capita or per household could be a sensible approach," NewClimate Institute's Founding Partner Carsten Warnecke. "Industry support could be made dependent to implementation of energy efficiency measures."

E3G's Policy Advisor Domien Vangenechten said ETS revenues can play an important role but cautioned that their importance should not be overstated.

"In the short term, these revenues could contribute to mitigating a part of the costs indeed," Vangenechten. "Ideally, this shouldn't be done through energy price rebates but through general dividends or tax cuts."

Posted 16 March 2022 by Max Tingyao Lin, Principal Journalist, Climate and Sustainability

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.