FEATURE: Why the next recession won't break the world's largest carbon market

A decade after the financial crisis sent carbon prices under Europe's cap-and-trade emissions scheme cratering, reforms made in the interim will ensure the mechanism is not neutered by the coronavirus pandemic and its economic aftermath.

Set up in 2005, the EU's Emissions Trading System is the world's largest carbon market and covers around 45% of the EU's CO2 emissions from more than 11,000 installations, including power stations and heavy industrial plants, as well as flights between EU countries.

Companies receive a number of allowances for free and buy the rest in regular auctions, or from each other, to cover their needs for any given year.

Following the economic shock of the global financial crisis, prices under the scheme lingered at rock bottom for years, enabling heavy polluters to make less stringent emission cuts.

Now COVID-19 has had a similar impact, sending prices for emission allowances, so-called EUAs, about 40% lower mid-March. Although they have regained some ground since then, analysts said more downside could be on the horizon.

But carbon market watchers say the latest economic shock will not wreak havoc on the scheme as it did a decade ago, even though the International Monetary Fund now expects the coronavirus recession to be far worse than in 2009.

That comes down to both concrete measures taken to avoid a repeat of the ETS price crash, as well as the EU's longer-term climate ambitions.

"It is not going to ruin the market in the same way," said Coralie Laurencin, a senior director at IHS Markit, an information provider that closely tracks commodity markets. "The ETS is not going to go down a negative spiral like in 2009."

One big reason for Laurencin's optimism, shared by others, is the Market Stability Reserve, a mechanism introduced to reform the ETS at the start of 2019. By gradually removing the oversupply of carbon allowances that built up over the past decade, it already helped lift prices from around Eur15/mt ($16/mt) in mid-2018 to as high as Eur30/mt in 2019. Each EUA covers one metric ton of CO2-equivalent.

"It is designed to prevent that sort of slump reoccurring, with the relatively low prices over a long period. That is why it was introduced," said Peter Vis, who helped develop the ETS as an official in the European Commission and is now a senior adviser on climate and energy policy at Rud Pedersen Public Affairs, a consultancy.

Since 2019, the MSR keeps the market tight by reducing annual auction volumes by 24% so long as the surplus of allowances -- the amount above what all installations and airlines are allowed to emit –- remains above 833 million mt.

This percentage cut will equally apply to any surplus generated as a result of the coronavirus-induced slowdown. In addition, the overall cap of allowances under the ETS will also decline by 2.2% each year from 2021-2030 under current legislation, and may be increased under tougher 2030 targets.

Price plunge

The plunge in EUA prices in March was partly driven by lower economic activity and power demand, but analysts say so-called non-compliance investors, who trade in the market without an obligation, also sold off allowances in droves, amplifying the effect.

Aside from utilities, industrials and airline operators, participants in the carbon market range from investment banks all the way to individual retail investors. EUA futures contracts for December delivery, traditionally the most liquid contract, fell as low as Eur14.34/mt in March, down 45% from a February high of Eur25.86/mt.

Prices had already been declining since mid-2019 as speculators reversed their long positions, according to Louis Redshaw, founder of Redshaw Advisors, a carbon trading and risk management firm.

Prices have been rising again, which analysts attributed to growing confidence that lockdowns will soon start easing across Europe, as well as some last-minute compliance buying before the deadline for covering 2019 emissions ends at the end of April. Carbon has also been moving in line with stock markets and the oil price, as investors look for broader signals.

"It is a bit of a relief rally," said Tom Lord, Redshaw's head trader, adding that EUAs likely overshot both on the sell-off and subsequent recovery. With gas prices falling and some extra EUA auction supply coming to the market as a result of the UK's exit from the scheme, bearish factors still abound for now.

"I still think there is more downside to come," he said.

Prices could see another drop after the end-of-April deadline and market observers also said it was unclear how long national lockdowns will stay in place, a major uncertainty factor.

IHS Markit said EUA prices could drop as low as Eur5/mt in its worst-case scenario for the economic shutdown, before the MSR brings the market back into balance in 2021.

Lewis, global head of sustainability research at BNP Paribas Asset Management and the former managing director of the Carbon Tracker Initiative. "That being said, the sheer scale of the demand shock here is terrifying."

Vis said worries about the depths of a potential carbon plunge were somewhat misplaced, since lower prices simply reflect the economic reality. With airlines grounded and factories lying idle, companies need fewer allowances because they are simply polluting less.

If prices had stayed at Eur25/mt, companies would justly be complaining about the additional burden. "If it did not have [this] built-in relief provision, we would all be screaming," Vis said.

Long-term uplift

Longer term, market observers also take solace from the EU's push for net zero emissions, which could have a more significant structural effect than any short-term disruption, even on the scale of the coronavirus.

"That will entail, at some point...a significant further tightening of the cap. And it is coming," said Lewis.

The European Commission is preparing to present plans for a higher 2030 target to lower emissions later this year, which will increase its current 40% goal to 50%-55%. The expected drop in emissions as a result of lower economic activity during 2019 will make it easier to argue for a more stringent emissions cut, Lewis said.

"Given the scale of the demand destruction and the impact on GDP, we could see the biggest ever drop in ETS emissions this year."

In 2019, emissions covered by the scheme already declined by more than 8%, the sharpest annual drop since 2009, thanks in large part to lower coal-fired power generation in countries including Germany and Spain. Coal plants are usually the most polluting source of power generation, so they suffer most from higher carbon prices.

Wood Mackenzie, a consultancy, expected global emissions to drop 5%-15% in 2020 as a result of the coronavirus pandemic.

Vis, the former EU official, said the past success of the ETS stands for itself, pointing out that, even under the low prices seen until 2018, ETS emissions dropped by almost 30%.

With the EU on a trajectory to only increase its environmental ambitions, that should help hold off the scheme's critics. Countries including Estonia and Poland have recently argued for a suspension of their obligations to ease the economic shock, and some fear companies could also lobby to weaken the scheme.

"Tell me another sector that has done that? This is something that is proving to work," Vis said, referring to past emissions cuts under the ETS. "It is an instrument that, if we did not have it today, we would like to invent."

--Yannic Rack, S&P Global Market Intelligence