Carbon prices in the European Union had been too low to really change behavior, but a new mechanism announced earlier this year is meant to fix that. It’s called the market stability reserve and it will begin to operate at the start of 2019. But prices have already begun to rise in anticipation. It costs over twice as much to emit a ton of carbon dioxide in the European Union today as it did at this time last year.
Mark Lewis, the head of research at Carbon Tracker, has authored several reports on what the European Union’s carbon market might look like over the next 10 years. He breaks down how the market stability reserve will work, who will feel its effects, and where financial speculation and politics fit into all this.
Una Jefferson: Can we begin with just some context on what the problem with the EU carbon market was that the market stability reserve is intended to address and how is this new central bank intended to change this problem?
Mark Lewis: We’ve had a Cap & Trade scheme in Europe since 2005. Since 2008, the allowances in the scheme have been bankable in perpetuity, which means they are usable until this game comes to an end.
The problem is that there has been a structural oversupply of allowances since 2009 as an aftermath of the global financial crisis when the demand across a number of industrial sectors in Europe collapsed.
This led to a large buildup of a surplus allowances which has depressed the price. This is because of a peculiar feature of the European carbon trading scheme in that it’s the only market in the world where supply is fixed for years in advance. When I say years in advance, I mean actually for decades in advance because we know with near certainty what the level of a supply will be in any given year, all the way out to the 20 sixties. But the demand as usual varies in real time as it does with any other commodity market. So, until the introduction of the market stability reserve, there has not been a way to modify supply in response to lower demand. And that’s really what the market stability reserve does. It will give the authorities in Europe the opportunity to modulate supply, reduce supply and get rid of this massive surplus that has accrued since 2009, and bring the market back into a greater degree of equilibrium.
Una Jefferson: How big a supply squeeze are we talking?
Mark Lewis: Well, let’s put this into context.
In the oil market for example, the amount of inventory or supply that is held in a readily available form would equate to 15% – 20 % of annual global demand. Compare this to the oil market in the EU, where the inventory is about 90 % of annual demand. That just gives you an idea of the oversupply problem we are facing now.
From 2019 onwards, the European Commission will start reducing the volume of allowances that are sold to the market by a number equivalent to 24 % per year of the outstanding oversupply.
The current oversupply is 1.7 billion tons. If you take 24 % of that, it is around about 400 million tons. It means that 400 million tons of the normal volume that would come to market next year will be taken out of the supply.
Annual demand for allowances in Europe is about 1.8 billion, that splits roughly $900 million for industry and 900 million for the power sector. The power sector, unlike industry, has to buy its allowances on the market through auctions. So, the industrial sectors like iron and steel, cement oil refiners, paper manufacturers, and other energy intensive companies receive their allowances for free.
So, by taking 400 million tons of allowances out from next year’s primary supply means that the level of auctioning is going to drop very dramatically, from about $950 million to $550 million the following year. Then there will be a further 24 % reduction in the supply every year for the next five years so that we squeeze the oversupply out of the market such that the level of by 2023 (on my estimates) will be about 1.4 billion tons lower than it is today. In other words, it will be down at about 300 million instead of 1.7 billion tons today.
In terms of the price impact, we think that this will force the power companies, who are missing allowances, to bid up prices to the level at which they are incentivized to switch from using coal for power generation to using gas.
At the moment coal is considerably cheaper than gas as a fuel for power generation in Europe. You would need a carbon price between 30 and 40 euros a ton to switch from coal to gas.
So, in all, next year and for the following two to three years, we think carbon prices in Europe will have to rise from the current level of about 16 euros as a ton to a range between 30 and 40 euros.
Una Jefferson: What about industries who are getting most of their allocations for free? Will this change their experience at all? And do you expect a significant knock on effect on electricity prices as utilities are having to pay more at auction for carbon allowances?
Mark Lewis: They all are protected until the end of the current trading period, until 2020, as they’re getting those allowances for free and the price in the market doesn’t really impact them from a C02 points of view. What it does mean is that the value of the allowances they are receiving is going up and therefore they are able to become more efficient in the way they produce steel or cement or the way they refine their oil, etc. So, it increases the incentive to be more carbon efficient.
The more negative side of the equation is that because all of those industries are energy intensive industries, they tend to use a lot of electricity, the hydrocarbon prices will push up power prices across Europe. The short answer is that all of those industries will find themselves paying higher electricity prices.
In some European countries, governments will take measures to protect an industry from higher power prices, but there is a limit stated in the EU rules, on the so-called state aid rules, as to how much a government can protect their industries from higher power prices. So, you will not get 100 % compensation for higher power prices caused by high prices, but you will be in most countries protected for the bulk of that increase.
But clearly, it will have a painful impact on some of those industries, particularly the most electricity intensive ones like aluminium smelting.
Una Jefferson: And what about the entry of speculative buyers? Since the announcement of the central banking mechanism, carbon has been doing really well as a commodity. How will that change the experience of compliance buyers?
Mark Lewis: Yeah, it’s a great question. By speculative buyers, we’re talking mainly about hedge funds and some commodity trading houses. They, as long ago as 12 months, had figured out that the political reform of the EU ETS was a very interesting opportunity because it’s not very often that you get such far reaching changes and structural reforms made to commodity markets by a governmental authority.
When European Commission says we’re going to reform the market and radically reduce the supply of carbon allowances for the next five years, that’s a much clearer signal to financial investors than if a similar statement comes from OPEC. OPEC only controls about 45 percent of global oil supply but European Commission is ultimately responsible for 100% of the supply of carbon allowances. Also, there’s always questions about, the extent to which OPEC respects its statement as different members of OPEC have different incentives at different times, whereas this is a matter of European law, which has been written into the law in Europe. So we have a very high degree of certainty and confidence that it will be followed through. Now, the law can always change and can be rewritten at some point if political pressure is brought to bear. And certainly, if prices do rise to the kind of levels, we’re thinking 30, 35, 40, you will see a lot of political pressure being applied, but for the time being and going back 12 months ago when it was clear that we were heading for a reform, forward looking investors said to themselves, well, actually, I’m here. You have a very rare opportunity to get ahead of the curve.
And that’s, I would say has really driven a lot of the price increase over the last 12 months. Financial speculators have come in and said, well, actually, it’s clear that the price has to rise because if supply is going to be restricted as severely as the commission is saying, then prices will have to rise.
Una Jefferson: Part of your job at Carbon Tracker and also in your previous position at Barclays, involved meeting a lot of financial actors and presenting research about the risk that comes about investment in fossil fuels. How is the behavior of investors changing in response to the idea of carbon risk?
What you were describing just now seems to be mostly in response to legislative measures, but do you think that there is a change in behavior beyond what is reactive to legislative measures?
Mark Lewis: I think the legislative measures obviously give you a degree of certainty and visibility. The investors really like to transact on the market with a very high degree of conviction. That being said, there is no doubt that for the last five years there’s been a growing momentum behind investor initiatives to screen their portfolios much more comprehensively for carbon asset risk.
There are a number of initiatives, the most famous one is the Action Force on climate related financial disclosures that was set up by the financial stability board. It meant to provide investors with frameworks for reporting and disclosure around climate change and getting investors the tools to ask probing questions of companies around how they are thinking about climate change, how they are reporting, the risks associated with climate change, and really establishing an ongoing dialogue in the market between investors and companies around how climate change is reflected in the reports and accounts and strategic decision making processes of large corporations.
So that’s one very obvious example, but I think many institutional investors globally are really improving their own internal processes to capture this risk and deal with it. And, and I think that that process will only intensify and accelerate over time.
Una Jefferson: In your report you also establish various price trajectories for the carbon market. You mentioned that if the price rises too fast it might bring political backlash. You establish a very specific kind of maximum rate of change where if prices were to exceed at 50 Euros a ton for more than a couple of months within the next two or three years, this would likely lead to countervailing measures. I was wondering how you came up with this number and also whether the rate at which carbon prices can rise would be different in different jurisdictions?
Mark Lewis: It’s a very good question. I think there is a quite a large degree of variation between different jurisdictions in terms of the levels of carbon prices that can be tolerated politically today.
We are well below the kind of levels that the intergovernmental panel on climate change says we need to be at in order to achieve the goals of the Paris Agreement.
Even within Europe, there are wide variations between different member states of the European Union. For example, Poland, the Czech Republic, and Romania have all already voiced concern about carbon prices being too high, even at 20 euros a ton, never mind 40 or 50 euros a ton.
So, we are entering a period where we’re going to see exactly what levels can be established. But there is no that we need higher carbon prices globally if we are going to get anywhere near to achieving the goals of the Paris Agreement and the sooner the policymakers globally wake up to that, the better.