Coal Energy 18 June, 2021 3:00 pm   
COMMENTS: Robert Jeszke

Jeszke: Fluctuating prices of CO2 allowances make investments in reduction harder (INTERVIEW)

Robert Jeszke. Grafika: Gabriela Cydejko. Robert Jeszke. Graphics: Gabriela Cydejko.

The recent statements made by the European Commission suggest that the current EUA prices are still too low, so for the EU to meet its ambitious reduction targets, they need to be higher. While it is common knowledge that the allowances prices will continue to climb, the pace of the increase should raise certain concerns about the risk of too much price fluidity on the market. It is difficult to plan investments in emission reduction when EUA prices are unstable. This begs the question whether the EU ETS has the right protections in place – said Robert Jeszke, Head of Strategy, Analysis and Auction Unit at the Center for Climate and Energy Analyses (CAKE) at the National Centre for Emissions Management (KOBiZE), which is part of the Institute of Environmental Protection – a National Research Institute. Last year the CO2 emission prices soared by a hundred percent from about EUR 25 to 50 per ton. Should such a surge during the pandemic raise justified concerns about speculations on the market?

Robert Jeszke: It needs to be stressed that speculation as such is an inseparable part of this market. However, it is very difficult to determine who the speculators are. Can investment funds such as retirement funds that make long-term investments, often lasting about 10 years, be called this way? Or maybe this term should be applied to entities that act in the short-term, e.g. by using financial leverage by buying forward contracts for the allowances? Both of those groups contribute to the prices going up – funds in the long term (in line with the trend), whereas speculators in the short term, causing a very substantial price fluctuation (i.e. the so-called “price noise”). Unfortunately, this is typical of this market. For instance, between February and May this year the allowances price fluctuated within a month even between EUR 6 and 8. These changes are close to those from March 2020, when due to the COVID-19 pandemic the price fluctuations hoovered around EUR 9. This shows that the allowance market is becoming the perfect place for short-term speculation, because the wider the fluctuations, the bigger the profit for profiteers. And the fact that this market is very attractive for financial actors has been recently revealed by Refinitiv. In comparison to February 2020 the participation of financial entities in the secondary market grew from 21 to 27 percent (including hedge funds from 4 to 9 percent).

What encourages investments in the allowances the most is the certainty that the price will continue to climb. This is because the European Commission is adamant at consistently lowering the supply of allowances in the EU ETS, which is to contribute to reaching increasingly more ambitious reduction targets in the EU (e.g. the “Fir for 55” package that is to launch in July). The data from the ICE Futures Europe exchange show that in April 2021 investment funds increased their purchases of allowances three fold (from about 19 million to about 63 million) in comparison to October 2020 (as part of the so-called allowances net positions). Interestingly, according to Bloomberg, recently the funds have decreased their positions by as much as 38 million to rake in. This to a large degree might have caused the recent adjustment, which caused the allowances price to go below EUR 50 per EUA. However, one should expect that when the price becomes more attractive for the investment funds, they will start buying the allowances again, treating them as a good fuel for investments.

In the context of the recent price increase, the optimism on other markets was equally important for investors, especially on the recently correlated stock markets in the US and energy resources markets in Europe. The assets on those markets, similarly to the emission allowances markets, were growing exponentially during the pandemic. The installations that operate in the EU ETS system are also joining this “race”, as they probably buy out allowances for later (or are not eager to sell them), aware of the fact that in the future they may not have enough allowances to settle their emissions.

How to view the EU ETS? Some want to treat it as a mechanism that works the same as a regular market, other view it not as a market tool, but a political instrument…

Emission trade systems are instruments for climate and environment policy that bring us closer to reaching two targets: an environmental one (reduction), and an economic one (limiting the total cost of achieving the political goal, i.e. improving the economic efficiency). The reduction target is achieved by designating a total limit of emissions for all entities in the system, which is then lowered as time goes by and in line with the political target. The economic goal is reached thanks to properly allocating the allowances, depending on the final costs of emission reduction by individual polluters, which happens through the market mechanism, i.e. trading the emission allowances.

Emission allowances trading systems are perceived as an alternative to emission taxes.
In both cases the point is to impose a cost on the emissions. The rate should act as an economic incentive to reduce the emissions. In case of a tax the situation is simple (the lawmaker determines the rate), but the differences in the marginal costs are lost, which means the total cost for the economy is higher. It is possible to lower this cost by introducing a market mechanism, such as the ETS. However, when it comes to this solution, we lose control over the cost for an individual polluter and in result over the level of the incentive to reduce the emissions.

In case of the EU ETS, which according to declarations remains the main climate policy tool of the EU, the goal has been to maintain the benefits of the market mechanism, and at the same time to continue to “improve it” to make sure the allowances prices ensure that the mechanism does work as an incentive to lower the emissions. This is why the mechanisms for regulating the supply (backloading, MSR) have been and are being introduced, and why ideas for directly controlling the prices have appeared. So, the EU ETS can be perceived as a market that to a degree is regulated. Apart from that one should not forget that it is natural that it functions together with political tools, and their codependencies should also be taken into consideration.

KOBiZe has estimated that the CO2 allowances prices may reach EUR 70 by 2030. Today, it is said that this price will actually be reached this year. What are the current estimates and what are they based on?

It should be pointed out that the price of EUR 76 by 2030 we have estimated at the KOBiZE was an average price. Depending on the reduction targets and the arrangements in the EU ETS, and as part of the general 55 percent reduction target in the EU for 2030, one can expect that the reduction targets in 2030 may reach an even higher price, e.g. EU 100. One should also add that the CAKE calculations did not include such additional factors as the activities of financial entities whose role, as the emission market is growing, may in the future be bigger than today.

It is worth pointing out that despite the fact that the allowances prices have recently approached EUR 60, so far their average price in 2021 has been a lot lower – about EUR 40. It is very probable that the works on the „Fit for 55” package will drive the EUA prices to EUR 60-70 in July. However, later on it should be expected that the investors will make a profit, which will cause a deeper adjustment on the market. Especially that the industrial installations should soon receive their free allowances, but it is still unknown whether they will want to sell them in view of the fact that they might be scarce in the future. Another factor that may contribute to the adjustment may be British installations, which have to buy allowances in their own system – the UK ETS. They will need money for this, which they can acquire by selling their EUAs, which are now deposited in their accounts. All of this may lead to a situation where the average EUA price this year would hoover around EUR 45-50.

According to experts, the allowances prices may reach even EUR 150 per ton, which could help achieve the ultimate goal, which is to phase out fossil fuels. Is this price feasible?

We need to remember that by 2050 the EU should be climate neutral, which means zero net emissions in the EU in 2050 (including, the uptake by forests – LULUCF). This means the emissions in the EU ETS need to be significantly reduced, and to achieve that, the emission prices need to be high (one can confidently assume that the EC will continue to limit the supply of allowances in the system). So it seems that the price for allowances at the level of EUR 150 is feasible, the question is in which year will it happen. It seems that it is more probable that it will happen in the next EU ETS period, which is after 2030.

At this point a technology that could fully replace fossil fuels as a stabilizer of the power system does not exist. So irregardless of the CO2 emission reduction cost, it will be impossible to completely abandon fossil fuels in the coming 20-30 years. Due to the dominating role of coal in Poland’s energy mix, in the shortest perspective, the most rational solution seems to be to invest in gas units, which in the future could be retrofitted with CO2 capture installations, and at the same time to develop RES. Promoting both of those technologies at the same time is also beneficial due to the high flexibility of gas units, which will be important as the amount of unstable energy sources in the system will increase (wind and PV). In the long run, as the technology to store surplus power produced by RES – in the short term in batteries and pumped-storage hydroelectricity facilities, or in the long term in hydrogen – will continue to develop, it seems that it will be possible to almost completely do away with fossil fuels. In the end the most emission generating technologies that will remain in the system will be gas and CCS.

The Commission seems rather calm about the growing allowances prices, which does not suggest that an intervention on the market will happen, even though an increasing number of states are pointing to this fact. What instruments does the EC have to influence the market?

The recent statements made by the European Commission suggest that the current EUA prices are still too low, so for the EU to meet its ambitious reduction targets, they need to be higher. While it is common knowledge that the allowances prices will continue to climb, the pace of the increase should raise certain concerns about the risk of too much price fluidity on the market. It is difficult to plan investments in emission reduction when EUA prices are unstable. This begs the question whether the EU ETS has the proper protections in place.

Even if the Commission changed its current approach and wanted to somehow alleviate increases in prices, it does not have the right instruments to act. While the EU ETS does have two instruments, which could impact the stabilization of prices, it is impossible to launch them at this point. The first one is an instrument that is part of the Market Stability Reserve (MSR). It can be used to flood the market with a specific number of allowances (200 million EU allowances from the MSR would be added to the poll of allowances available on the auctions), provided that the surplus of allowances (TNAC – total number of allowances in circulation) dropped below a specific level (under 400 million allowances). Recently the European Commission has published calculations on the the surplus of allowances in May this year. According to the report, the surplus is at about 1.6 billion allowances (which is 4 times more than the threshold for releasing the allowances on the market), which means the mechanism cannot be initiated. Moreover, according to the estimates by the KOBiZE it is not very probable that in the current settlement period the surplus of allowance will go below 400 million, which means the mechanism will not be launched. It may happen only after 2030.

The second instrument that is worth discussing is the mechanism from article 29a in the EU ETS directive, which in case of a sudden increase in allowance prices will make it possible to free 100 million EUAs from the MSR to sell them at an auction. To be more precise, the sale of the additional allowances from MSR can take place, only if for a period longer than six consecutive months, the allowance prices would be over three times higher than the average prices in the EU ETS in the previous two years. Issues with interpreting this regulation aside, it is a condition that in practice is very difficult to meet. For instance, the allowance prices as of tomorrow for another 6 months would have to stay on average at a price of over EUR 84, but it would have to be proven that the changes in allowance prices, as the regulation states, do not correspond with “essential changes on the market”. Additionally, the EC would have to quickly call a meeting of the Climate Change Committee, which would be difficult to do, and every delay would increase the risk of the prices changing.

Do the ongoing negotiations on the non-EU ETS, i.e. transport and building, impact the prices of CO2 emission allowances?

It is hard to tell whether investors capitalize on the proposal of expanding the EU ETS system by new sectors, because in reality we do not know the details of this plan. We don’t really know whether transport and construction will be included in the EU ETS system, or whether a separate trading system for those sectors will be established. At this point it is said that the latter option is the most probable – a separate system, but the details on this issue should be revealed as late as in July, when the „Fit for 55” package will be revealed.

Which of the decisions planned for this year by the Commission may contribute to new changes on the EU ETS market?

The „Fit for 55” package, which is to be published in July, will be definitely the most important one. In order to implement the European Green Deal, achieve emission reductions in the EU by a minimum of 55 percent in 2030 and ensure climate neutrality in the EU in 2050, the European Commission has to, among others, revise the EU ETS and the Effort Sharing regulation (for non-ETS), updates to the directive on energy efficiency and RES, and the introduction of the Carbon Border Adjustment Mechanism. All of the above elements will have an impact on emission allowances prices. Increasing the EU target by at least 55 percent will translate into a significant increase of EU ETS and non-ETS reduction targets. For instance in the EU ETS it is estimated that the 2030 target will be upped from the current 43 percent to about 62 percent. This requires changing the Linear Reduction Factor (LRF) from the current 2.2 percent to about 6 percent, if this change is introduced by 2026 (in line with the EC Impact Assessment). This means the supply of allowances on the market will be significantly curbed. Aditionally, as part of the „Fit for 55” package the MRS reform is to be reviewed. Everything points to the fact that the mechanism will be reformed in a way that will accelerate the reduction of the current surplus of allowances on the market. It is very probable that in the first place the intake rate will be increased after 2023 from the present 12 percent to 24. The so-called MSR threshold is also to be narrowed. It determines to what level an intervention on the market as part of this mechanism can take place. In result, a bigger amount of allowances from the pool of allowances that are to be sold at auctions will go to the MSR. This means that also in this case the number of allowances will be limited. And we need to remember about the invalidation mechanism, which will start working in 2023 to eliminate a substantial amount of the allowances out of the market. At the same time, the changes in the directives on RES and energy efficiency will directly impact the pace of emission reduction in the EU ETS, which should impact the demand and EUA prices. It seems that the introduction of the CBAM in relation to the probable increase in production in the EU, which will spike emissions, should encourage the prices to climb.

To recapitulate, only once the “Fit for 55” program is revealed, will its impact be reflected in the allowances prices. We cannot exclude a scenario where the allowance prices will climb right before the package is unveiled and for some time after that, but also where later on the investors will reap the profits and a bigger drop will take place.

Will CO2 emission prices only climb?

In the long run, until 2030, the allowance prices should grow exponentially. Our last year’s forecasts as part of CAKE/KOBiZE say that after the 2030 EU reduction target goes up to 55 percent, the allowance prices will increase from EUR 41 in 2025 to EUR 76 in 2030. All other important analytical institutions on the market (e.g Bloomber and Refinitiv), which similarly to CAKE base their prognoses on econometric models have come up with similar figures. It needs to be stressed again that analytical institutions come up with average prices. This means that, just like on any other market, there may be deviations from the main growth trend and higher or lower adjustments will happen. This means a situation where the price is over EUR 100 will indeed happen sooner or later. Of course the average market prices of allowances until 2030 may be even higher, because the models on which the current forecasts are based do not include, among others, the role of financial institutions, which will increase their activities in the coming years.