Carbon prices on the EU Emissions Trading System are currently increasing too rapidly, making the market extremely volatile, but it appears that the European Commission does not have any effective stabilization tool to do so. remedy, write Robert Jeszke and Sebastian Lizak.
Robert Jeszke heads the strategy, analysis and auctions department and the Climate and Energy Analysis Center (CAKE) in the National Emissions Management Center (KOBiZE), part of the Institute for Environmental Protection – National Research Institute.
Sebastian Lizak is an expert in the strategy, analysis and auction department and the Climate and Energy Analysis Center (CAKE) in the National Emissions Management Center (KOBiZE), part of the Institute for Environmental Protection – National Research Institute
The European Union faces the challenges of implementing the Green Deal while initiating economic recovery from the COVID-19 crisis. While the financing of investments is often discussed, we need a transparent policy framework that makes investments in climate-friendly technologies economically viable.
Therefore, the EU ETS market itself requires special attention, especially in relation to increases in the EU carbon price, which has reached a new high per tonne.
From April 2013 to May 2021, the price of EU Allowance (EUA) increased on the secondary spot market from € 2.75 to € 54.34 (over 1,900%). 2.75 € is the lowest EUA price on the secondary market since 2008, when it became possible to bank allowances between periods.
How big are these increases and could this be the start of a price bubble? Comparison with a stock market bubble on the US NASDAQ that burst in 2000 before gaining 3,000% over 10 years (“dot-com bubble”) indicates that we are halfway there.
However, if we compare the current distance of EUA and NASDAQ prices in March 2000 with the 200-session moving average, we have exactly the same values: we are now 2.6 times higher than average.
So what affects such high EUA prices? EUA prices not only reflect the current fundamentals of the EU ETS, but also anticipate long-term future conditions, including the tightening of ceilings through 2030 and beyond (for example, through reduction targets higher or possible changes in the market stability reserve).
This is due to the specificity of the EU ETS itself, including 10-year compliance periods and the possibility of having bank allowances. It affects the entities of the EU ETS, which have had to modify their hedging strategies. This is a challenge for the industry sector, which prefers to keep allowances in accounts rather than sell them and even buy them to avoid future shortages.
Other market participants, including long-term investment hedge funds and short-term market speculators, are buying EUAs as a great opportunity to profit. For example, the market share of hedge funds has increased sharply from 4% to 9% since February 2020 (according to Refinitive data from April 2021).
It seems it is only a matter of time before products aimed at individual investors, for example investment funds or Exchange Traded Funds, start to appear in Europe. Such funds are already available in the United States, for example the KraneShares Global Carbon Exchange Traded Fund holds 77% of the EUA market and assets worth 300 million USD.
It doesn’t take a market visionary to predict that this will dramatically increase EUA demand and price gains. In discussing the growing role of stock speculation, we should consider whether the market is sufficiently protected against the risk of manipulation.
Few recent market incidents (e.g. anomalous Polish auctions exceeding the secondary market price by € 1.5 or articles from the Financial Times that clearly affected the EUA price the day after publication) can be found.
The first case could be seen as a potential use of the primary market to manipulate the price in the secondary market. The second case could be considered as a potential profit to express an opinion on a financial instrument.
There has been no interest in such cases, although the provisions of the Market Abuse Regulation call them a form of manipulation. These potential risks could be seen as an opportunity to introduce better market guarantees, in particular by amending the provisions of the Market Abuse Regulation and the Auction Regulation.
There is no doubt that EUA prices are currently increasing too rapidly, making the EU ETS market extremely volatile. On the one hand, this is unfavorable for EU ETS compliance entities, but on the other hand, it greatly benefits speculators, for whom extreme volatility means more money.
The question is whether we really want to feed speculators on volatile EUA prices or whether we should instead strive to stabilize them.
Participants in EU ETS compliance should be given some sort of guarantee that when an extreme situation occurs in the market, the European Commission (EC) has a transparent mechanism that can be triggered. Such a “safety valve” would be essential to stabilize the participants in the EU ETS, contributing to better planning of future investments.
It seems that the European Commission does not currently have such effective tools to stabilize prices. The mechanism of art. 29a of the EU ETS Directive – which makes it possible to release 100 million allowances from the market stability reserve and auction them in the event of a sudden increase in EUA prices – cannot be described as such a tool.
It is practically impossible to trigger, given the current structure and the interpretation problems of the provision.
According to the interpretation, the price of the EUA is expected to reach an average of 72 to 74 € before June 2021 (it is around 40 € since the beginning of 2021) or an average of 80 to 84 € over the next six months, based on a two-year moving average.
In addition, any triggering of the mechanism would be conditional on the observed price variation “not corresponding to the evolution of market fundamentals”. This concept can cover any change that affects the EU ETS, and because it is constantly changing, the question arises as to which changes do not “substantially” affect the market.
The triggering of the mechanism is also conditional on the meeting of the Climate Change Committee, which may take some time. All of this shows that the European Commission has a decisive voice in this matter, and its interpretations determine whether market intervention will take place.
The next revision of the market stability reserve could be an excellent opportunity to introduce a price stabilization mechanism. One of the things to consider is the possibility of opting out of the cancellation of EUAs in the Market Stability Reserve after 2023 (a “rollback mechanism”).
These allowances can become valuable assets in the future when market conditions change dramatically and intervention is required. An uncontrolled increase in volatility that destabilizes EUA prices would be extremely negative for the EU ETS.
Lowering participants’ confidence through lack of price stabilization and predictability in the context of planning future investments is the latest issue the European Commission wants to tackle just ahead of the “Fit for 55 Package” discussion scheduled for July.