Listen: Deconstructing the European carbon market's price slump

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Eklavya Gupte: Hello and welcome to the Platts Future Energy podcast from S&P Global Commodity Insights. In this episode, we turn our attention to the price of carbon in the European Union, which has fallen sharply since the start of 2024. We will explore what is causing this steep price slump and what this means for EU energy and climate policy.

I'm Eklavya Gupte. Joining me today are my colleagues Coralie Laurencin, a senior director from the power and climate policy team, Michael Testa, our lead analyst on compliance carbon markets, and Scott Chen, a senior pricing specialist focused on carbon. Welcome, all.

Putting a price on carbon dioxide emissions is emerging as one of the most effective and shortest ways to drive the energy transition. And the EU, through its emissions trading scheme, which is the largest compliance carbon market in the world, has been leading the way for almost two decades.

The EU's ETS cap and trade system places a limit on the amount of emissions covered by different sectors, and it currently includes around 45% of the blocks total greenhouse gas emissions. Companies can buy and sell these carbon permits, which are known as EU Allowances or EUAs, which can be traded for each metric ton of CO2 they emit. But EUA prices currently find themselves in a dramatic downward spiral after years of quite consistent upward momentum.

Now, this volatility and weakness has surprised many in the energy and industry sectors and has left many scratching their heads. But it does come amid a backdrop of economic headwinds in Europe, low industrial demand, and a high supply of emissions allowances. Many are also wondering what these low carbon prices mean for the clean energy transition, especially when climate and energy issues are becoming heavily politicized.

So welcome Michael, Coralie, and Scott. Thank you very much for joining us today. So Scott, I would like to start off with you. Can you paint us a picture of how carbon permits are fairing this year and the current drama it finds itself in?

Scott Chen: Yeah, absolutely. So let's do a quick recap on the recent performance of EUAs. So we assess EUA December 2024 futures contract at 59 euro in the latest assessment. And with this price, we are seeing a year-on-year decline of 44%, and year to date decline of 22%. And we hit a 31 months low on February. However, in the past two weeks, we have seen a 40% gain due to the increased volatility in the market. So to answer the question, overall the price of this year has came down quite substantially since the price hit 100 euro last year. And the real question around this is that why the bearishness in the carbon market?

So we have to take a step back and look at the picture in a more broader sense. So firstly, we, in terms of a power demand side, we are seeing a weaker power demand, including economic slowdown, weaker industrial and commercial demand, and as well as mild weather. In terms of the power supply side, we are seeing a very healthy power supply, including record high renewable generation capacity. And in terms of fossil fuels, we are seeing a healthy gas storage supply and LNG supply. And in terms of the price point, we have got to analyze the profitability of the big emitters, which namely, the gas and coal industry.

So in terms of price point, we are seeing a negative clean dark and spark spread in gas and coal. Quite frankly, there's really no strong incentives for generate to increase the production mode than they should. It's quite logical that the overall emission are expecting to be lower and consequently suppressing the EUA demand.

So in terms of why the price is going down, in a more technical perspective, EUA are highly correlated with gas, namely the Dutch Gas TTF future contract, and they have a positive correlation of 0.7 and we are seeing the Gas TTF year to date have declined 30%. So that really speak volume on why the EUA has come down quite substantially.

And then lastly, if you look at the commitment of trade reports, we are seeing funds are building quite substantially, historical high natural positions and this really shows how the participant are seeing the EUA and what are they expect the EUA prices to be.

Eklavya Gupte: Thank you, Scott, for giving us some of the bearish fundamentals at play. And Michael, I'd like to pull you in now and just get your perspective on, on one level, we can see that some of these fundamentals have been part of the market in the last few months, but we're seeing more of an impact from them now. So just wanted to get your views on that. And also a second question is what are your market expectations for EUAs this year? Are we expecting a similar downward trend?

Michael Testa: Absolutely. As Scott mentioned, we are in an economic situation where GDP growth is projected as 0.4% compared to 0.5% for 2024 versus 2023. And PMI levels for most of 2023 have been below 50, indicating a contractionary state in the overall economy in Europe. So we're in an area of decreased industrial activity, which normally means lower industrial emissions. So the fundamentals, as well as weaker demand we also have a slight oversupply in the market. Auction calendar in 2024 was 31% higher than the auction calendar in 2023, although we might see that adjustment come in in May.

And the investment funds have identified this, as Scott has mentioned, they've been net short for the majority of last year. In the beginning of this year, they've identified this oversupply in the market. And looking forward, we expect some sort of resilience in prices as compliance entities start taking advantage of the lower prices and they start building up allowances. So along with the fact that EUAs are becoming one of the best investment stories of 2024 when it comes to returns, which will eventually prompt, I believe, investment funds to hold some long positions or become overall net long eventually towards maybe the end of this year.

Policy makers are also expected, as I mentioned, to announce the auction calendar or adjustment to the auction calendar from August to December after we have the publication of verified emissions data. This normally comes around the 1st of April, but a revised version will be made available on May as well, which includes most of the industrial emissions from stationary installations. And it would be an opportunity for the European Commission to trigger the MSR, the market stability reserve intake, which will eventually tighten the current oversupply in the market. As you might have noticed, they've already relaxed the annual cap by 78 million allowances to account for maritime emissions, but we haven't seen a lot of activity from maritime entities as they have until September, 2025, to comply. And I believe they have an incentive to wait until the EUAs hit their price floor, which I believe will be around 42 euros per ton by April, 2024.

Therefore, in the coming months to summarize EUA prices from December delivery contract 2024 are expected to decline further, again, due to economic slow down the Eurozone, lower gas prices, prolonged short positions and oversupply, a weak demand from lower emissions, and in additions, we've got conflicts in the Red Sea which will further exacerbate inflation, which can delay interest rate cuts that are expected in June and therefore, we expect prices to hit the high 40 market in March.

However, prices will rebound back to the mid 70 euros per ton mark for the following reason. So first of all, you have TTF day ahead prices recovering. They will recover about 72% to around 40 euros per megawatt hour in December, 2024, and gas demand will also increase by that period. Finally, the GDP in the Eurozone in Q4 according to our internal estimates, will be substantially higher compared to Q1, which will mean that there will be some sort of recovery in industrial demand for EUAs as the year progresses.

Eklavya Gupte: Thank you very much, Michael. Does show that we still have quite a few more months of bearishness to come. And Coralie, I'd like to loop you in here and in a way get your perspective. I know you look at it a bit more from a broader European power and renewable perspective. So I just wanted to check what are your thoughts on the current weakness that we're seeing in EUAs and why has it caught a few people off guard?

Coralie Laurenc...: Yes, it's interesting because to be fair, we haven't seen this in a very long time in the European carbon market. And I think the first reason for this, the obvious reason for this is the fundamentals are back in charge. We've had policy be in charge in the last few years ever since the EU beefed up the ETS with the Fit for 55 package. The net-zero ambition for 2050 policy has really been the driving force behind the carbon price. And because we expect the carbon market to become tighter and tighter and because the efforts that industry in particular is going to have to provide are going to be quite costly, the prices have risen and we're seeing something completely different now, which is that fundamentals are back in charge and the prices are extremely low by the standards that we've had in the last few years.

So I think it's good to remind ourselves that we've had very low power demand last year. So 2023 power demand was same as 2020, so the year of COVID. And what my colleagues in the short term power team tell me is that there's little sign of a pickup. So initially, the power folks were thinking we're going to jump right back in there, power demand will fully recover. We're now thinking, are we going more for a financial crisis type of situation where you reset power demand at a lower level.

And then of course you've got industrial activity, which is weak. My colleagues on the gas side are saying about 6 to 10% of industrial gas demand will never come back. It's gone forever in Europe, and that's high prices, that's demand destruction. So it's really the fundamentals are back in charge. But I think keep an eye on the fact that the policy remains quite strict. The MSR will kick in, will reduce whatever excess is in the market. So we could see a pickup in the price at some point. And the question is, when will that happen? How low will prices go in the interim?

Eklavya Gupte: Thank you, Coralie. And now moving back to you, Scott, what are you hearing from your sources in the trading in brokering community who you're speaking to every day? How are they responding or what are you seeing as their strategy to the current volatility or headwinds that we're seeing in the market?

Scott Chen: So long story short, the overall market sentiment now is quite bearish, and due to the fundamental, has not really changed, as Coralie and Michael has stated the power demand has been low and we are in sort of a recession arguably. And in terms of the price point, we are seeing a psychological support between 55 to 60 euro and we could expect some volatility between 50 to 60 euro.

And just keep in mind that EUA Allowances is something that they have to buy. So in terms of long term, anything below 60 euro is quite desirable for them. So although the sentiment now is quite bearish, but we could see a price surge on catalyst, so it can including [inaudible 00:12:35] EU, so now the target budget is 20 billion, but if there's a unexpected adjustment on lowering that budget, there could be a positive influence to prices, and as well as the EU commission election is going to happen in June. If there's a switches party, there might be some drivers for the price as well. And thirdly, if there's a black swan, arguably if there is a geopolitical escalation, supply chain disruption on gas, coal or renewable energy generation, that could potentially drive the price up.

Eklavya Gupte: Thank you very much, Scott. Going back to you Michael, does the current price fall that we're seeing, does it change much for the expectations of very high prices from 2030 onwards? Because the ETS is sort of hinging on that very premise?

Michael Testa: Yes. Over the longer run, the current headwinds don't necessarily influence what will eventually happen. So before we talk about 2030, which is a landmark year, given the Fit for 55 targets, the 55% reduction in overall emissions in the EU so and compared to 1990 levels, we expect EU ETS prices at a nominal level to reach 107 euros per ton. So the primary driver up to that point is the market stability reserve we believe because... And the market stability reserve really was established to serve as a rule driven long-term mechanism to correct any imbalance in the supply for allowances. We've seen historically that, for example, in 2013, there was a surplus of 2.1 billion allowances. The MSR will effectively modulate the supply based on what's called a total number of allowance and circulation, short for TNAC. So depending on these TNAC levels, allowances are either moved from the auctions to the reserve or vice versa.

They've been operational since 2019 and they are there to maintain the market balance and resilience against any supply demand for fluctuations. So it's usually published as well annually by the commission. So in 2022, for example, say 1.13 billion, which led to the withdrawal of 272 million allowances, that's 24% from auctions from the period between September to August, 2024. We expect that this will continue to occur over the years leading up to 2030. And there's several developments between now and 2030. So the number of allowances circulation will be decreased by 2030. So we believe that there won't be any oversupply post that period. So really what would then be the factors affecting the post-2030 era would be, if you've noticed the European Scientific and Advisory Board recommended a 90 to 95% emissions reduction target by 2039, which would, in some cases, lead the carbon price to escalate even further.

Our projections suggest that those prices by 2040 will reach 243 nominal euros per ton. And there are other estimates that would put this at a slightly higher point. There are other estimates that would suggest that the prices might even reach 400, but the period between 2030 to 2040 would come along with other developments, which we believe will need to happen, that is the potential inclusion of negative emissions into the compliance markets. As you might see in the Canada or the Australia ETSs, they have negative emissions or carbon removals into the ETS. And that's going to effectively change the supply. It's going to change the obligation requirements from compliance entities. For example, if you're an energy from waste firm and if you attach a CCUS technology onto your plant, and if you capture biogenic emissions, you might even end up being net negative, which would mean that you'd be able to not just avoid your compliance requirements, but also be able to sell back credits to the ETS.

And that will be the driver from the periods of 2030 to 2040 along with investments in decarbonization technologies. And we expect marginal abatement cost curves from these technologies to be cheaper as the learning rates increases over time.

Eklavya Gupte: Thank you very much, Michael. And staying in the medium to long-term, Coralie, do you see the falling prices tell us anything about wider EU climate and energy policy?

Coralie Laurenc...: Yeah, so that's a good question. I think the EU is coming out of a policy cycle, a regulation cycle. In the last year, it approved almost all of the Fit for 55 regulations. So the EU now has a 2030 target, which is to reduce emissions by 55% by 2030. And it has the package of regulation to do that. And the ETS is one of those. The EU is really very long lead time. So that's not going to change. We now have the framework for 2030. And to be fair, the framework for 2030 does include the kind of flexibility that the carbon market needs to get itself back a little bit more on track. So I don't think by 2030 we're going to see something very different.

2040 is another question, another time horizon. The commission released its recommendation on the climate target for 2040, and you could see there it's absolutely not slowing down. It recommended minus 90% emissions reductions target for 2040. And very clearly in that text that was saying the carbon market is going to have to be net-zero by 2040 or thereabouts, and the carbon market is going to have to be adopted for negative emissions. So I don't think at the moment there is a link with what the policy sphere is thinking and the prices that we're seeing in the market.

Eklavya Gupte: Now, there is a school of thought that lower carbon prices means that the EU has less money to fund clean energy and renewable projects. So do you think this is a fair assumption and how are renewable energy developers viewing the current price all?

Coralie Laurenc...: Yeah, so that's a good question. I think the answer is a bit, yes and a bit, no, and I can go into that. So definitely, the EU finances clean projects with the sale of European allowances for carbon, very true, EUAs. So the fact that the prices of these allowances is lower has a direct consequence on how much money the European Union has to spend on projects.

And one example of this is the innovation fund, which is an auction system for a cutting edge project, maybe first of a kind demonstration project. And these projects are financed by the ETS. In the last few years, these auctions, this innovation fund has funded a large amount of projects that are looking at hydrogen, green hydrogen, looking at CCS, most of it for industry. So it's a really important project in the EU.

However, the EU doesn't do all of the climate funding. For example, renewables, which you mentioned earlier. Renewables are mostly funded by national budgets, so that's national money, the French state, the Spanish state, maybe the Polish state, the German state, but not the European Union. So I think developers or perhaps industrial companies are looking at this and maybe thinking on the one hand, it's great, I'm paying less for EUAs, which I think would be their first thought, first and happy thought. But on the other hand, yes, there might be a little bit less money for the projects that I'm looking to develop in the future.

Eklavya Gupte: As we know, 2024 is being touted as the year of several significant elections globally, and we are also approaching a new political cycle for the European Parliament with elections scheduled for June. So I wanted to ask you, will I likely swing to the right in Brussels have major implications for the EU's Green Deal and its energy and climate policy?

Coralie Laurenc...: Yes, thank you. I think that's a really key point. The EU is about to change, and as you say, I think the driver for this change will be the European Parliament elections that are scheduled for June. The expectation is that the parties of the right, whether the sort of classical right or the more extreme right are going to have more seats than they've had in the past, they will have more of a voice, they will have more influence on policy, and that, we believe, will change the balance of focus in Europe.

So the European Parliament has a say in who is in the European Commission. So a new commission will come in after these elections. And it's important to remember that the parliament has really been very much the engine of ambition for Europe's green agenda in Europe. And if it is less the engine of green ambition, I expect to see that there will be less ambition overall across the European Union.

But the council, which is member states, has always been a little bit more cautious with green ambition. It was the parliament driving it, the commission driving it. If we now have a less green parliament, a commission whose mandate it is to be less green, to be more focused on affordability, on the cost of addressing the changes that need to happen for climate change, then I think that will have an impact on the appetite for ambition in climate in Europe.

We're also seeing this change not just at the European Union level, we're also seeing at the member state level. So if you look back at 2023, countries like France and Germany had introduced laws or proposals for laws to decarbonize heat using mandates, sort of effectively forcing people who had to change their boilers to go for a renewable option. And most likely, that would've been a heat pump.

The reception of these proposals was not good. And in both countries, especially in Germany, there was a lot of pushback. And we saw government backtrack, change its proposals, make the law a lot less constraining. We do have evidence that the issues of affordability are really at the top of the agenda, and this is not just European Union only. We've seen the same thing in the UK. We're entering a different political cycle. There's more focus on the cost, on the affordability that is linked to the efforts that need to be made to achieve the climate change ambition.

Now, what does that mean for legislation? So as I've said before, the ship has sailed for 2030, that legislation is in place. We know where we're going. We could see member states dragging their feet a little bit on implementation, and member states do have significant leeway to implement and therefore, to do that. But the question is really for 2040. What will European Union, going into this new policy cycle, aim for if we've got a different political appetite or a lower political appetite for the green agenda? So that's what we'll be looking out for.

Eklavya Gupte: Really interesting. It does show the influence of politics on carbon and climate markets. Thank you Coralie, Scott, and Michael for your fascinating insight into the nitty-gritty of carbon pricing. We will be closely following the developments around the intersection of energy and climate in 2024 across our news, pricing, and analytics streams. For more details, please visit spglobal.com/commodityinsights. This podcast was produced by Felix Fernandez in London.