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The most important factor that contributed to the EUA (EU allowance for CO2 emissions) reaching a price of EUR 40 per ton was the first Polish EUA auction in 2021, where the final price of the allowance was EUR 38, which is as much as EUR 1.48 over the price on the secondary market. Why did the buyers overpay for the EUAs if they could buy them for a lot cheaper? Robert Jeszke Head of Strategy, Analysis and Auction Unit at The National Centre for Emissions Management (KOBiZE) at the Institute of Environmental Protection answers the question.
BiznesAlert.pl: The growing prices of CO2 emission allowances have become one of the hottest energy topics in Poland at the beginning of the year. Some claim this poses a threat to Poland’s power industry, while others say Poland is profiting from the rising prices. How does the allowance trade work?
Robert Jeszke: The auctions on which Poland and the other 27 member states (and 3 EFTA countries) sell their allowances have been organized since 2013. Every state auctions a certain pool for a given year, which is split into weeks or months, depending on how many auctions will be held during the year. For instance this year Poland organizes weekly auctions on Wednesday via the EEX exchange.
At first glance the mechanism behind the trade may seem complicated, but it is fairly simple in practice. Every auction is organized in single rounds, which means the participants have two hours to offer their bids. All bids are confidential. After the round is over, the auction platform operator establishes and reveals the clearing price, which is determined on the basis of the below procedure:
• The participants inform the organizer how many allowances they want to buy (volume) and the price at which they want to buy them (one bidder can submit a few bids at different prices);
• The auction organizer ranks the offers according to price – from the highest to the lowest (descending cumulation) together with the requested volume;
• Once the volume available on the auction runs out, the clearing price is determined;
• All purchasing offers that are higher than the clearing price are accepted, the remaining ones are rejected.
The bidders that proposed a price that is equal to, or higher than the clearing price win the auction. The original price proposed by the bidder does not really matter (even if it was very high), because in the end they will pay the clearing price.
The price of every product offered on any exchange depends on legal, economic and sectoral factors. The same applies to CO2 emission allowances. Could you discuss the specific factors that impact their price?
Just like on every other market, the price depends on demand and supply. The demand depends on the amount of emissions in the EU ETS, which the participants (power sector and industry) need to surrender, and on the demand generated by the financial entities that buy speculative allowances. Many factors can impact the volume of emissions, including, reductions in emissions achieved by the EU ETS participants (e.g. when they change technologies, or start using fuels that produce less emissions), economic crises that limit production (e.g. the 2008 crisis and the coronavirus downturn), change in policy (e.g. on energy efficiency or renewable energy sources), or – in the short term – weather forecasts (e.g. cold spells, which cause increased energy consumption and drive up emissions).
Whereas the supply for allowances hinges on the availability of allowances in the system, which are issued to the participants of the EU ETS for free and sold on the primary market (auctions). The allowance supply is a very important element, which strongly impacts the price. In recent years the European Commission has been trying to limit it, e.g. by increasing the Linear Reduction Factor (which results from upping the reduction target), limiting the amount of free allowances (e.g. by upping the benchmarks), or through the Market Stability Reserve. In the future the EU also wants to implement a part of the European Green Deal strategy called the “Fit for 55 percent” package, which also includes another reform of the EU ETS system. Probably, investors are already partially capitalizing on this in the prices of allowances, even though they don’t know all the details yet, which should be revealed in June this year.
Another important element that is worth considering, and which is also an issue we often write about in the “Report on the CO2 market” published by KOBiZE is the strong correlation of allowances prices with other classes of assets, i.e. raw materials prices (gas, coal, power), or stock prices across the world (especially the U.S. market). We have noticed that when the prices of those assets go up, the probability that the EUA prices will increase is very high, and the opposite is also true. This gives a solid reason to claim that the EUA market is impacted as much by the fundamental factors (demand and supply) as by the attitudes of investors in other markets.
This year the price for CO2 emission allowances went over EUR 40 per ton, but after dropping below that threshold, it clearly found a new, higher minimum price. Why are the prices growing so dynamically this year?
The fact that the price permanently went over EUR 30 per EUA in December 2020 is, from a technical point of view, key to understanding the situation we are witnessing today. We should remember that previously, the buyers failed three times at surpassing this psychologically important level – first in August 2019, and then second and third time in July and September 2020. In those cases, each time the prices reached EUR 30 per EUA a deeper price adjustment occurred.
Only on the fourth occasion, in December 2020, did the price go over that level permanently. This coincided with the December EU Council summit, during which the heads of states supported the more ambitious EU reduction targets (a minimum 55 percent reduction by 2030 in comparison to 1990). Undoubtedly this was one of the key reasons why the price went up, as it promised to decrease the supply of allowances in the EU ETS in the 2021-2030 perspective. It was the long-term factor that the investors started to capitalize on, but “on the way” to high allowance prices there were short-term factors as well, those included: the delay in organizing auctions in 2021 (the first auctions took place 1.5 months after a break, so it was possible to buy the EUAs on the secondary market), the ban on using the emissions bought in 2021 to surrender emissions for 2020 (which means the installations had to buy EUAs on the market), the delay in issuing free allowances to EU ETS installations (were supposed to have been issued in February, but the EC announced a delay until the 2nd quarter of the year). All of these factors resulted in upping the price to EUR 32 this January.
What was the breakthrough about?
Actually, a watershed moment came in early February this year. After Bloomberg and Financial Times published articles on how a hedging fund announced it expected the allowances prices to go up to EUR 100, the prices went up to EUR 35 within a day. Interestingly, it has become a kind of a rule that whenever the Financial Times writes an article on the topic, the price of allowances goes up. Additionally, there has been a lot more talk on new hedging funds that want to profit from long-term investments in allowances. Recently, Carbon Reporter has informed that the number of investment funds that have emission allowances in their portfolios doubled between 2018 and 2020 (from about 100 to 200).
This is where we arrive at the heart of the matter as to why the price of the allowance reached EUR 40. Interestingly, in our publication “GO2’50”, which we created in October 2020, we predicted that the allowance prices after exceeding the EUR 35 threshold may reach EUR 40 within a few months, which happened last February. The most important factor that contributed to the price reaching EUR 40 was the first Polish EUA auction in 2021, which settled the price at EUR 38, which is EUR 1.48 above the price on the secondary market. This is an anomaly, which had never happened before.
So why did the buyers overpay for the EUA? They could have bought the same instrument a lot cheaper.
Probably, the intermediaries from the OTC market, which is outside of the exchange, were responsible for this. They had to conclude their forward contracts, which guaranteed their clients the price from the primary market (so-called trade at auction derivatives). This is the reason for the high maximum price proposed on the auction, which reached up to EUR 50 per EUA (the rule is that the winners pay the clearing price, regardless of the price they had initially proposed). Probably the purchasing offers had rather high volumes, because only 5 out of 21 participants managed to buy the allowances. Additionally, a so-called short-squeeze, recently popular on other markets as well, might have occurred. Many market participants (i.e. installations in the EU ETS, private investors, traders) hoped the prices would drop after the February auctions came back. Many traders who bet on a price drop started to repurchase EUAs in panic to limit their losses. The situation was similar to what recently happened to GameStop and AMC stocks in the U.S. The remaining factors that contributed to the price growth this year, include: cooler weather (more emissions increase the demand for allowances), rally on market exchanges across the world (especially on the American markets that are strongly correlated with the EUAs) and growing gas prices.
According to our analysis, which takes into consideration the entire technical infrastructure that determines how EUA prices are shaped, the prices should not go down in the nearest time below about EUR 30. That’s where a very strong, technical support behind the price, which earlier constituted a strong resistance to buyers, is located. Perhaps this minimum is even higher, i.e. at about EUR 35, which would go in line with the present, upwards trend.
The EUR 40 price was mentioned in forecasts for 2030, not 2021. The government’s analyses from two or three years ago said the same. So how to draft strategic documents, if forecasts from a dozen months ago are already invalid?
Considering the huge fluctuations in allowances prices in the recent years, forecasting their future value is very difficult. Let me remind you that only in early 2018, the prices were below EUR 8 per EUA. Today, as we all know, the price reached EUR 40 in mid February, so it’s a 400 percent increase within about 3 years. This is caused by the ongoing amendments to the regulations and legislation on the EU climate and energy policy, which most often manifest themselves as increasingly more ambitious climate targets. And this necessitates introducing changes to, among others, the EU ETS and non-ETS areas, which are to guarantee the implementation of those targets. Therefore, it is very difficult to function in an environment subject to never-ending systemic and legal changes, which are often political. This is why the price forecasts need to be constantly updated by various analytical institutions. Let me give you an example of such a systemic change. A few years ago a portion of EUAs were taken off the market as part of the so-called backloading. They did not go back to the market, but nobody expected that, because the original legislation had guaranteed they’d return. Also, a few years ago nobody expected that the Market Stability Reserve (MSR) would be established, which would successfully limit the supply of allowances available on auctions. Moreover, once the climate targets were increased, it became necessary to up the linear reduction factor (LRF), tighten benchmarks and limit the usage of the CER/ERU offset credits.
Also, today we do not know in the context of the new EU 55 percent target by 2030, e.g. by which year, at what value and in what way the LRF will be introduced (will it be in 2023, or 2025, will it include the so-called “rebasing”). We do not know how the MSR will change, and whether new sectors will be added to the EU ETS (transport, construction) . To add to that, other policies are also of great importance, e.g. the targets on energy efficiency or renewable energy sources, which additionally decrease emissions, which impacts the EU ETS and the prices of allowances. Another important factor in the short term is the border tax CBAM, which may impact the EUA prices to some degree. The uncertainty caused by the changing regulatory environment, and the COVID-19 pandemic, makes it significantly more difficult to prepare pricing forecasts. This impacts installations that function in the EU ETS and want to plan investments, as well as governments that need to prepare various strategic documents. The current situation will be solved to a large degree in June this year, after the European Commission publishes the “Fit for 55 percent” legislative package. The document will answer the questions on the future of the climate and energy policy, which will reduce the uncertainty surrounding the drafted forecasts.
Is it possible at this stage to predict the path and the prices that the allowances will reach by 2030 and 2040? If yes, what price level are we talking about?
At this point the forecasts that are being published pertain to 2030 rather than 2040. In the January issue of our “Report on the CO2 market” we published 2030 forecasts authored by various financial institutions. According to those, the EUA prices (on average) will revolve around about EUR 41 in 2025 and EUR 72 in 2030. These projections were made in December 2020. Let me remind you that already in March 2020 we at the National Centre for Emissions Management (KOBiZE) prepared an analysis for a 55 percent reduction target scenario by 2030 and we reached similar results – EUR 41 by 2025 and EUR 76 by 2030. At that point few people believed that the allowance prices could go up so much in the future. I guess that today nobody no longer doubts that such a scenario is very real.
In February Poland sold its allowances at a record-high price of EUR 38 per ton. What does this mechanism look like and where does the money go?
All the profits from the auction in Poland first go directly to the State Treasury’s bank account. Half of the money is spent on climate-related goals, which is required by the Act on the emission trading system. For instance, in 2019 the money earned on allowances bankrolled such programs as “Mój Prąd” (My Electricity) and “Czyste Powietrze” (Clean Air), as well as producers of energy from RES. To learn more about how the money from the auctions has been used in recent years, one can go to the EEA website, where Poland reports on how the profit is spent.
Interview by Bartłomiej Sawicki
