Carbon price surge delivers jolt to industry
Emissions contracts hit seven-year high in sign of significant upheaval for Europe’s energy landscape
LOVE them or hate them, carbon contracts are the City’s hottest trade this year. Those hedge funds and eagleeyed amateurs who track the European Union’s regulatory flow have made windfall profits.
Permits for EU carbon emissions spiked to a seven-year high of €20.84 on Friday. They have risen fivefold since spring last year, the best performing “commodity” in the world. The contracts have decoupled completely from energy prices and global raw materials.
Most commodities have been sliding jerkily for four months. Copper has fallen 17pc since mid-june and is flirting with a bear market. So are zinc and lead. Lumber and sugar have both dropped a third over recent months.
This is a clue to the underlying health of the world economy. Trade volumes stalled even before Donald Trump launched his tariff wars. It is the result of two shocks: a fall in Chinese fixed investment growth to levels unseen since the Nineties amid the crackdown on China’s shadow banking; and stress in emerging markets as the US Federal Reserve drains global dollar liquidity.
Oil has held up better. But that is a supply story mostly linked to politics. Venezuela’s output is in freefall. Fresh sanctions against Iran will take at least a million barrels a day off the global market by November. A lack of pipelines in the US will hold back shale output from the Permian Basin until 2019.
Yet carbon permits are flying. The EU contract is the price 11,000 power plants, steel foundries and factories – 45pc of Europe’s greenhouse emissions – must pay per ton of carbon emitted under the “polluter pays principle”. Airlines pay for intra-eu flights.
What has changed is that Brussels is finally sorting out its cap-and-trade system, a byword for bureaucratic incompetence and market illiteracy. It issued too many carbon permits, with no way of adjusting when industrial output collapsed in 2008 and again during the eurozone’s double-dip recession.
The new regime approved by the European Parliament this year empowers a Market Stability Reserve (MSR) to soak up the 1.7bn ton glut of contracts. “It is like a central bank doing quantitative tightening,” said Mark Lewis, former head of utilities at Barclays and now at Carbon Tracker. “The accumulated surplus is going to come down dramatically over the next five years.”
The MSR will remove 24pc of the market surplus each year between 2019 and 2023, with powers to cancel permits. In parallel, the overall carbon cap will be lowered by 1.74pc a year from 2019 and 2.2pc from 2021.
The price surge has become self-fulfilling. Industries with a stash of unused credits are hoarding them for gain rather than putting them up for auction. “Financial players have been all over this,” said Mr Lewis. He predicts
the price will double to €40 by 2020, with surges hitting €50 that winter due to gas shortages in Europe. If so, this will vindicate the UK’S huge investment in North Sea wind power.
The German bank Berenberg says the carbon price could reach €100 by 2020, warning that companies cannot adapt in time. “There will be no natural carbon price that will clear the market,” it said.
Sceptics may ask whether the EU authorities would allow a shock of this scale. “We think there are political limits on how high prices can go,” said Mr Lewis.
Energy Aspects sees a more gradual rise to €38 by 2030 with hiccups along the way. Tougher air pollution rules in the mid-2020s will shut down some coal lignite plants and reduce demand for permits, ceteris paribus.
All of a sudden, the EU emissions price has caught up with the UK’S carbon price floor of £18 a ton. This has major implications. While Britain’s surcharge over the last five years has largely driven coal out of the market – and is a model studied around the world – it has also left the UK’S chemical, steel and heavy industries struggling to compete with some European rivals.
Now the playing field is level. Furthermore, the pound is no longer overvalued. This could have an impact on the political economy of industrial northern England as Brexit unfolds.
The Government’s White Paper said the UK aims to remain in the EU trading scheme after Brexit. If Britain is forced out in a no-deal bust-up it could cause havoc for the EU. Permits held by British companies might flood the market. Vertis Environmental Finance said carbon prices could dive again.
The currency markets are clearly pricing in a high risk of no deal – too high in the view of the shrewdest EU veterans, who dismiss much of the brinkmanship at the Berlaymont and Westminster as political theatre.
Yet the carbon market is insouciant about Brexit. There must be lucrative arbitrage opportunity in this for “quant” funds. Nor is it the only glaring anomaly in the relative market pricing of Brexit risks.
The carbon trading scheme is the spearhead of EU efforts to cut emissions by 40pc by 2030, compared to 1990 levels. The consensus is that it will take prices well above €30 to force a major shift from coal to gas – which emits half as much CO2 – or from coal to renewables.
Higher carbon prices are already eating into the profit margins of coal users. Mr Lewis said some have hedge protection but this decays over time. “It will really start biting in a year. Still, it will take at least €35 to get lignite (the dirtiest fuel) off the market since it is open-cast and cheap to mine.”
It may take a worldwide carbon price of €50 to comply with the Paris Agreement and to have any chance of preserving a “two degree world” – keeping global warming down to just two degrees Celsius higher than pre-industrial levels by 2100 – though advances in renewable technology are shifting the cost arithmetic every year.
China is the world’s biggest emitter. It will flesh out its trading scheme for power plants in 2020, yet details are vague. The National Development and Reform Commission expects prices to reach a range of €25 to €38 a ton in the next decade, bringing about peak emissions in China before 2030.
The US is a tug-of-war. New England, the West Coast and Virginia are pressing ahead with trading schemes regardless of Donald Trump’s withdrawal from the Paris Agreement.
Overall, worldwide coverage has been patchy. Prices have been too low to matter. But that is changing. Climate-linked hurricanes and droughts are sharpening the political mood.
Europe’s carbon price is due for a healthy pause after the great surge. Daily Telegraph readers should not chase an asset in the midst of a parabolic blow-off.
At the end of the day, the emissions contracts are an odd hybrid. They are not a pure speculative play like Bitcoin, but nor are they a hard commodity either.
Fast-moving technology in solar, wind, electric engines, energy storage and perhaps carbon capture could render them superfluous. They may peak and then slide for years until the trading scheme is dismantled.
But that lies far ahead. The next correction in carbon prices offers a tempting entry-point for pension funds, life insurers and private savers looking to spread their portfolio. Green investments are no longer for the altruistic only.