A black sea of troubles is menacing Europe's economies, as the continent stares down the barrel of a harsh winter recession amid record-high electricity prices, but Russia's invasion of Ukraine and the consequent energy crunch briefly pushed the cost of emitting carbon for Europe's industrial installations to new highs earlier this month.
The benchmark ICE European Union emissions allowances (EUAs) December 2022 contract surged to 99.22 euros a metric ton (mt) on Aug. 19, above the previous record set Feb. 8. Despite a subsequent 20% sell-off and a host of economic indicators showing industrial output across Europe is faltering, carbon market analysts have told OPIS they remain bullish that carbon prices will be in triple digits early next year.
Record EUA Price Spurred by Natural Gas
This month's record EUA price was largely the result of stunning gains for natural gas contracts, which have forced European utilities to look to more polluting electricity fuel sources such as coal and fuel oil.
Russia's decision to slash the supply of natural gas by Gazprom through the Nord Stream 1 pipeline to Germany has put a rocket under winter prices, with the November 2022 contract of the Dutch Title Transfer Facility natural gas benchmark surging to an intraday high of 353 euros/MWh Friday, the oil equivalent of $603 a barrel and 22 times its price two years ago.
Natural gas prices had already surged in 2021 on the back of a 20% rise in annual Chinese natural gas imports, weakening the marginal attractiveness of running natural gas-fired electricity plants in Europe and boosting coal-fired electricity output across the continent. Coal consumption across the EU duly jumped 14% last year, according to the International Energy Agency (IEA).
That natural gas-to-coal switching dynamic is still playing out in 2022, and the IEA said in July that it expects a further 7% year-on-year increase in EU coal consumption to 476 million metric tons. As a result, coal-fired electricity plants are buying EUAs with gusto.
Reactivated fuel oil-burning plants have also been providing an unexpected source of summer demand for EUAs. Even Sweden, one of the European Union's most environmentally conscious member states, resorted to bringing back online an old fuel oil-burning plant on its south-east coast to the chagrin of some politicians and environmental campaigners. The move came in response to a 400% increase in annual electricity prices in the south of the country.
"It is total madness that Sweden needs to burn oil in the middle of summer," tweeted the main center-right opposition Moderate party about the burning of 70,000 liters of fuel oil every hour by the 662MW Uniper-operated plant in Karlshamn. "To a large extent, this is due to the fact that Sweden and other countries in Europe have shut down fully functioning nuclear power."
That last salvo points to another of several factors behind Europe's growing reliance on carbon-intensive energy this year -- the post-Fukushima transition away from nuclear energy in Germany and Sweden.
However, France, which is heavily reliant on such nuclear power for its electricity, is facing its own difficulties and also contributing to the greater call on fossil fuel-generated electricity. Problems with several of France's nuclear reactors have resulted in more than half of the fleet being offline, with some unexpected maintenance likely to drag on through the all-important winter.
France's electricity prices have consequently entered eye-popping territory, with year-ahead French power futures contracts hitting 880 euros/MWh earlier this month, a rise of 900% compared to where 2023 contracts were trading a year ago. Peak-load November contracts to provide electricity to French consumers in high demand evening hours have soared as high as 2,880 euros/MWh.
EUAs were also buoyed in mid-August by dips in renewables output due to low wind and hydro generation amid what the European Union's Joint Research Center says is Europe's worst drought in 500 years.
A cut in EUAs available for installations to buy on the primary market EEX exchange, which happens every summer, was also a key factor in driving carbon prices to a new record.
U.K. Paying the Price for Natural Gas Reliance
The U.K. created its own emissions trading system in the wake of leaving the European Union, and it has consequently foisted an even higher carbon price on its big industrial operators than the EU. The U.K. ETS has low liquidity and lacks the surplus of allowances that built up in the EU ETS during the 2008-09 financial crisis.
As a result, the benchmark December 2022 U.K. emissions allowance (UKAs) contract hit a record 99 pounds ($117) intra-day price on Aug. 19, slipping back to 92.63 pounds on Monday.
The U.K. is paying a heavy price for its reliance on once-plentiful and cheap natural gas, which has provided as much as 60% of the country's output in recent weeks.
The consequent rise in electricity prices could have existential consequences, with citizens being told that unless the government intervenes, they could be spending upwards of 5,300 pounds ($6,300) per annum by April 2023 once a cap on retail electricity prices is lifted by the energy regulator Ofgem to reflect movements in wholesale prices.
According to a study by the University of York, such prices would tip 45 million people in the U.K. into the technical definition of fuel poverty -- spending more than 10% of their after-tax incomes on energy -- but would prove impossible for millions at the sharp end to pay, especially at a time when rents in cities such as London and Manchester are increasing by 15%-25% year on year and Goldman Sachs is forecasting that U.K. inflation could rise from its current 10.1% levels to 22.4% by the start of next year.
The living standards of many British workers and pensioners will be slashed in short order if that scenario plays out, but more worrying are the potential effects on the estimated 12 million British citizens who have no savings to fall back on, according to several surveys conducted over the last few years.
It has become almost a cliché of U.K. media commentary that poorer citizens will have to decide between heating and eating, but no less true for that.
"This is a catastrophe," said Martin Lewis, the U.K.'s leading money saving expert, on Friday. "If we do not get further government intervention ... then lives will be lost this winter."
The ramifications of unprecedented natural gas prices for industrial output and future demand for UKAs this winter are also seismic, and dozens of big industrial operators and carbon emitters are already curtailing or ending their operations because of energy costs. Earlier this week U.S. fertilizer group CF Industries called a temporary halt to ammonia production at its Billingham plant in northeast England, which uses natural gas as a feedstock. That followed the mothballing and then closure of its Ince plant in northwest England for the same reason.
The Billingham plant had previously gone offline because of high natural gas prices earlier this year, only for the operator to negotiate a temporary three-week government support package because it produces carbon dioxide as a byproduct and does so in sufficient quantities to provide 30% of all U.K. demand. The ripple effects could be huge for the food and brewing sectors, as carbon dioxide is required to stun and slaughter animals as well as make beer.
Unprecedented electricity prices and CO2 supply cuts could cause both a national beer shortage and the closure of pubs in the U.K.
Policy decision-making in the U.K. has ground to a halt because of the Conservative party leadership contest that will result in the election of a new prime minister at the start of next month to replace Boris Johnson. Foreign Secretary Liz Truss, who is almost certain to become prime minister, polls of Conservative party members suggest, hails from the low-tax, libertarian wing of the party and earlier this month decried potential "hand-outs" as a means of easing the burden of soaring energy costs, preferring tax cuts instead.
However, given the scale of the existential challenges facing citizens and businesses, it is now odds on that the U.K. will spend tens of billions of pounds or else risk the lives of its more vulnerable citizens and a chunk of its industrial base. The opposition Labour party has upped the pressure on the government by proposing a consumer energy prize freeze over the winter that it has estimated at 28 billion pounds ($32.64 billion), 8 billion pounds of which would come from a one-off tax on energy companies. The British government will have to act quickly, as many businesses negotiated two-year fixed electricity deals with their suppliers in October 2020 and now face a potentially ruinous fivefold increase this fall.
A multibillion-pound intervention that includes cutting electricity costs for big installations could stave off industrial demand destruction and offer support for UKA prices.
EUAs to Break 100 Euros/mt, Analysts Say
Despite all the worries about Europe's economies and the quick sell-off after this month's record high, top carbon market analysts there are forecasting even higher EUA prices over the next year.
Lawson Steele, a prominent carbon markets analyst, told OPIS in an interview last week that the most important factors affecting the price of EUAs will be the EU's upcoming negotiations to sharpen the downward trajectory of annual EUAs supply in the cap-and-trade system and its continued reduction in surplus allowances through the European Trading System's Market Stability Reserve (MSR).
In mid-May, the European Commission said it would remove over 347 million EUAs from trading between September and August 2023, leaving surplus allowances at 1.45 billion credits. According to the European Commission, 24% of the total allowances in circulation will be placed in the MSR from 2019 to 2023.
"We've got 350 million [allowances] being taken out of the market supply, that for me is the real driver," Steele said. "For me, [EUAs] go into the hundreds quite comfortably. By the end of the year? Difficult to tell. By April 30 of next year? Absolutely.... In the medium term, carbon keeps going up. In the short term, [allowances] will be overbought," said Steele, speaking midway through the 20 euros/mt slide from this month's record high.
Christoph Mueck, manager of the global carbon fund of London-based asset manager Altana Wealth, told OPIS in an interview last week that factors such as the annual summertime cut in EUAs auction supply, reduced nuclear output and low hydro power levels were responsible for the run-up in EUAs. Better nuclear or hydro power availability would ease upward pressure on carbon allowances, he said, but if European countries increase their reliance on coal ahead of winter due to lower natural gas supply, Mueck expects carbon prices to rise in the coming months.
"For the remainder of the year, carbon prices will find support in higher power sector emissions," Mueck said. "This, however, has an economic impact which can lead to potential industrial demand destruction as we have already seen with energy-intensive industries beginning to cut their operations.... In the short run, carbon prices may be affected by industrial output destruction, but the dirtier fuel burn will certainly raise prices in the long-run," Mueck said.
Ahead of the trilogues next month between the EU Parliament, the EU Commission and member states, Mueck expects "volatility to pick up over the coming months," with EUAs "at risk of sharp moves." The trilogue discussion includes proposed measures like the potential additional sale of 20 billion euros' worth of carbon allowances from the MSR that would be used to fund energy transition projects under the REPowerEU package that aims to reduce EU dependency on Russian energy.
"Should this proposal come into effect, this would exert heavy bearish pressure on EUA prices," Mueck said.
Steele sees no let-up in Russian President Vladimir Putin's central role in determining the European energy prices and no obvious end to his country's war against Ukraine. "I think Putin is extremely long term," Steele told OPIS. "If Russia backtracked or if there's an agreement [ending the war], that's great for gas [prices declining] and everything else, but I don't think that's going to happen."
Conclusion: From Energy Crunch to EUAs Supply Crunch
Ultimately, the future path of EU carbon prices is likely to depend most on the EU's willingness to sharpen the downward trajectory of annual EUAs supply in its bid to force decarbonization of the 10,000 top polluters subject to the EU ETS.
Supply of EUAs in the EU ETS currently falls by 2.2%, but the European Commission's "Fit for 55" proposals announced in July 2021 would cut annual supply by 4.2%. The European Parliament wants to go further, voting in June for annual supply cuts of 4.4% from 2024, 4.5% from 2026 and 4.6% from 2029. The trilogue negotiations between the EU commission, parliament and the council representing the EU's 27 member states will decide between those proposals, which aim to cut emissions by those installations by between 61-63% over 2005-2030.
Analysts have previously suggested that the halving of EUAs supply this decade envisaged by the EU could necessitate political intervention. Otherwise, the logic of such a drastic cut combined with limited carbon abatement by industrial installations will result in a "kaboom in the EUA price" Bjarne Schieldrop, an analyst at SEB bank, told OPIS last year.
Slashing EUAs supply over the 2020s represents the most radical attempt in history by a major economy to bend the arc of its future carbon emissions. If the EU is to succeed, it will have to do so in the teeth of war, an energy crunch and a looming recession.
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