There are three important industrial scenarios for Europe’s carbon allowance market – or EUA – investors across the spectrum should be aware of:
1) A rising industrial output scenario – good for the economy; not so much industrial players short of carbon credit. Nonetheless, the ideal framework for the programme.
2) A sharply falling industrial output scenario — better for industrial players; not necessarily the carbon market itself if it leads to an allowance oversupply that threatens to crash the market altogether. Worst case scenario for the carbon market.
3) A moderately falling industrial output scenario — great for cash-strapped industrial players who can monetise extra allowance length via the carbon futures market, especially so if expectations of a recovery further down the line are firmly in place. Moderately in the context of carbon credits is still a lot though.
It’s scenario three, by the way, that we’ve mostly been witnessing since the crisis took hold — something that led to a bit of a super-contango appearing in the term structure of the carbon futures market.
But as ever with a synthetic market like the carbon market, matters unexpected can get in the way to flip things the wrong way. A European Court of First Instance judgement on Poland’s and Estonian’s National Allocation Plans, for example, now threatens to pump extra length into the market just when it might be most vulnerable.
That’s because, as Barclays Capital’s commodities team explained in a recent report, the market is already looking pretty long:
…out to 2012, the market is long EUAs by some 225 Mt — an increase in length from our previous report (-195 Mt) — a 15% increase in the gap to cap estimate (although only a 1% decrease in estimated emissions).
2013 is a net short of 170 Mt; and although emissions begin to increase in 2010 due to moderate economic growth, the still-poor performance of industrial output should keep those emissions increases in check.
The net long position in the market increases in that year due to the increase assumed in the cap, with more NER being allocated to new power sector installations. In addition, the Court of First Instance judgements on the Poland and Estonian NAPs have opened the possibility that NAP and/or auction volumes will be increased later in the phase. While we argued above this could add another 100 Mt or so of EUA volume, this number remains largely speculative and therefore has not been included in our market balance numbers.
If we are correct, then the phase length will be more like 350 Mt. Counterintuitively the super-contango, an indicator of low immediate demand, has been weakening. But as Barcap note that’s more to do with the improvement in the credit markets than fundamentals in allowances.
As they also note, however, that shouldn’t stop tempting industrial players to monetise their upcoming length. As they explain:
As such, the market does appear set to fall if a more active level of industrial selling comes to market. Last month we stated that we expect some industrial selling in Q4 09 and Q1 10 because, despite the improvement in credit markets for industrial participants, industrial production is down 17% y/y through H1 09.
Even with the moderate recovery underway and the base effect on the data in H2 09, we are forecasting that industrial production will be down 15% over the entire year. This does open up plenty of spare allowances that, even if the credits markets are better, will be tempting to monetise to improve bottom line performance in this fiscal year.
Such selling is likely to be concentrated at the end of the year (Q4 and Q1) when many installations do quarterly allowance audits, so by a week or two into October, they will have three quarters of 2009 emissions data and a good idea of order books for the remainder of the year.
Accordingly Barcap concludes it seems inevitable that a good volume of industrial length will likely hit the market and weigh heavily on prices over the coming weeks and months. Not good for the carbon market and not good for encouraging use of cleaner fuels like natural gas — or for that matter propping up natgas prices either.
Related links:
Carbon indulgences – FT Alphaville