Is there anything that could stop the carbon rally?

2020-07-01 15:00

The technical analysis suggests that there should be a correction as the price is overbought based on several indicators. The market however seems not to take into consideration the technical signals. Are there any fundamental reasons then that could reverse the current price trend or at least halt the rally?

The European carbon market surprised with a quick recovery from the levels where the price of emission allowances fell in March, when the coronavirus hit the continent. The increasing trend is unbroken since then and the price reached a new ten-month high at 28.33 euro on 1 July. 

The technical analysis suggests that there should be a correction as the price is overbought based on several indicators. The market however seems not to take into consideration the technical signals.

Are there any fundamental reasons then that could reverse the current price trend or at least halt the rally?

Below we list some factors that could push down the carbon price. 

1.    The API2 coal contract, a benchmark for the European coal prices witnessed numerous fluctuations in 2020. We observed a consistent bearish trend since the beginning of 2020 thanks to the declining demand for the fuel. The low interest for coal can be just partially explained by the negative effects of the Covid-19 pandemic. More importantly, the European power sector goes through a transformation process where coal is being replaced by renewables and gas. The increasing share of wind and solar power production is the consequence of national policies as most of the European member states have a coal exit deadline. The increase of gas use in Europe is the consequence of the cheap gas. In the past, Europe had only one supplier, Russia, but being exposed to just one supplier bears a significant risk of supply security. Member states therefore diversified their supply chains and receive gas from Arabic countries and even from the US. In addition, the last winter was mild and storages remained almost full. Declining margins for European coal compared to gas burn should limit the upside and keep coal unattractive for utilities, which should embolden bearish carbon market sentiment. As a result of the growing gap between the dark and spark spreads, which estimates the profitability of fuel switch in power generation, gas usage proves to consistently be more efficient and a cheaper option for installations since Q4-19. Therefore, coal usage is becoming less and less favorable in the EEA, which would in the medium and long term depress the rise of emissions price.

2.    A report recently published by Carbon Tracker Initiative assessed that it is cheaper to build new renewable energy projects than to continue operating 39% of the world’s existing coal capacity. The report found that the share of uncompetitive coal plants worldwide would increase rapidly to 60% in 2022 and 73% in 2025. 

3.    The ghost of Covid-19 is still casting its shadow on the global economy and putting a cap on growth expectations. The gloomy macroeconomic outlook of a projected 4.9% contraction by the International Monetary Fund (IMF), and a larger contraction of 10.2% in the EEA region, would push emission prices down and bring about future market corrections. Companies’ quarterly earnings data are expected to depress the market and place pressure on the carbon prices as many businesses suffer from losses as a direct result of Covid-19 lockdowns. 

4.    Brexit talks taking place in July and August are suggesting two potential scenarios for the EU ETS. Scenario a) in which the UK departs from the European Union 31 December 2020 and the EU ETS after the April 2021 compliance. In that case, businesses in the UK are expected to sell their remaining surplus of EUAs. Especially utilities covering emissions ahead could “dehedge”. This would result in an EUA glut by Q2 2021, which would abate price increase on the EU ETS. Scenario b) in case of extending the transition period, companies will remain within the EU ETS for the compliance year 2021. Although the extension seems logical after the pandemic delayed UK-EU negotiations (even PM Johnson was hospitalized with the virus), Britain rejects the possibility of asking for an extension. All in all, it seems that scenario a) has a higher probability.

At the moment, all the above seems just a theory as the price does not show any signs of a trend reversal. Compliance entities are afraid of a tightening market from 2021 when the next trading period starts and speculators just seem to ride the wave of the fear.
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