European carbon allowance prices have tumbled by more than 40% since reaching a record high of €101.25 almost a year ago. Dramatic reductions in the use of coal and gas in power generation as well as declining industrial output amid the macroeconomic downturn have reduced demand for EU Allowances (EUAs) as the region accelerates its energy transition.
EUAs climbed to more than €100 in February 2023 as natural gas prices remained high in the wake of Russia’s invasion of Ukraine, a trend which pushed the fuel out of the money for power generation and triggered a widespread recovery in coal use. With coal emitting twice as much carbon dioxide as gas this ramped up demand for EUAs.
However, by the spring of 2023 gas prices had begun to decline as the European Union implemented plans to speed up its transition away from fossil fuels and Russian gas in particular.
Front-month TTF gas contract dropped from €66/MWh at the end of January 2023 to €24.88/MWh today.
The roll-out of the REPowerEU initiative saw, among other elements, the addition of in excess of 250 million EUAs in new supply to raise €20 billion between 2023 and 2026. Shortly after this plan was approved, carbon prices began a year-long decline which brought them to a low of €55.41 in early February this year.
Gas’ decline has been underpinned by Europe’s success in both sourcing alternative sources of natural gas to replace pipeline supplies from Russia – mostly in the form of liquefied natural gas cargoes – as well as building stockpiles ahead of the winter of 2023-24.
Gas storages reached more than 95% full at the start of November, and a mild winter meant that demand was relatively muted, leaving the region’s reserves more than 65% full in mid-February.
The result has been that since last summer gas prices have been around two-year lows, making the fuel more economical to use in power generation and kicking coal back out of the generation merit order.
On top of the improved gas supply and lower prices, Europe has used less electricity than at any stage in the last six years. Data from the region’s transmission grid agency show that total EU public power generation in 2023 totaled 2,408 TWh, a drop of 3.6% year-on-year and the lowest total since at least 2018.
Of the 2023 total, gas-fired generation fell more than 17% from the year before, hard coal output dropped by 26.5% and lignite generation was down 24%.
The balance also tilted towards renewables generation, with power production from wind, solar, biomass and other non-fossil sources growing by nearly 10% in 2023, the largest annual increase since 2018.
The upshot of these developments is that demand for carbon allowances fell dramatically in 2023. Data show that power generation from both gas and coal for base-load consumption one month ahead was unprofitable for most of the year.
The negative margins led many utilities to unwind hedges that they had built up for their forward generation, which meant selling back fuels and carbon allowances.
Carbon’s drop was heavily accentuated by speculative traders amassing significant short positions in the futures market as they too saw the diminishing demand.
Data from the two main European derivatives exchanges showed investment funds held a total short position of more than 72 million EUAs in the week ending February 9, 2024 and a total long position of 23 million EUAs.
The net short position of 38 million is the largest net bearish bet since data was first published in 2018.
With carbon now trading at around a two-year low, the market is speculating over its direction for the rest of the year. With the European economy still depressed, there is little short-term prospect of an uptick in demand, experts say, though anticipated cuts in interest rates later in the year may prompt renewed investment and a pick-up in activity.
The rapid growth in renewable energy capacity surprised many last year, and January’s record output of more than 100 TWh could set a benchmark for the rest of the year, restricting the room for a revival in fossil output.
But analysts are at pains to point out that the EU ETS as a whole will become gradually tighter in terms of supply as the decade progresses.
The ongoing REPowerEU programme’s target of raising €20 billion from the sale of additional allowances may mean that the European Commission sells more than the originally estimated 250 million EUAs, further tipping the market balance towards oversupply, but the programme is set to end in 2026.
Furthermore, analysts add, the additional EUAs are not a net addition to supply over the 2021-2030 period, but instead represent supply that would have been sold into the market during 2027-2030. As a result the last three years of the current phase will be even tighter than previously planned.
The extension of the EU ETS to cover maritime transport emissions also adds to potential demand. Shippers will be required to surrender EUAs covering 40% of their total EU emissions for 2024, rising to 70% next year and 100% from 2026.
While the overall supply has been increased to take account of the new sector, the fact that shipping will not get any free allocation of EUAs – unlike many industrial sectors – will add to the weight of demand in the traded market, sources say.
While 2023 is likely to have seen a decrease in overall emissions, and indeed a net annual surplus as a result, the market stability reserve will remove its usual 24% of the calculated surplus starting from August, and this could cut auction supply for the following year by as much as the REPowerEU programme has added to it.
Analysts at Macquarie Bank recently forecast EUA prices to average €69 this year, rising to €93 in 2025 on their way to €146 by 2030. Other analysts have predicted prices of around €70-€75 this year, suggesting that the second half of 2024 may see a recovery.
