Energy Monitor: Doctoring the ETS mechanism

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  • First adjustment to European emission trading scheme should lead to scarcity and higher prices…
  • …but not enough to enforce further carbon reduction in the long run
  • US gas prices ballooned due to extreme cold

Immense oversupply of CO2 emission allowances…

To control the climate targets and the linked carbon emissions the European Committee (EC) created the Emissions Trading Scheme (ETS) in 2005. Since 2011, however, the original idea of raising the costs of carbon emissions by compelling companies to buy carbon emission allowances does not seem to work properly. More than 30,000 companies in 31 European countries received free emission allowances and were able to buy more on the market to compensate for any excess in carbon emissions, if needed. However, as demand for energy was under pressure as a result of the economic crisis, and due to the fact that prices of fossil energy sources (such as coal and gas) rapidly declined (see figure 1), demand for the carbon allowances was not as high as anticipated. Therefore, a large surplus of more than two billion emission allowances was accidentally created, which led to a huge drop in their prices (see figure 2). Last year, a first plan to adjust the ETS was rejected by the EC.

… but a price rally can still be seen

On 30 January the EC approved an adjusted plan to lower the offering of carbon allowances. The so-called ‘back-loading’ plan means that the huge oversupply of carbon allowances will be temporarily cut back by 900 million allowances in 2014016. These allowances will return to the market through auction in 2019-2020. The purpose of this measure is to create scarcity, which should trigger a rise of the carbon allowance prices. In addition, the EC will win time to create an appropriate solution for the longer term. In the first week of February, the EC voted on when to start these temporary back-loading measures. On 6 February, the EC approved the reduction of the outstanding carbon allowances by 400 million in 2014. Anticipating this decision, the market already pushed prices higher. Energy-consuming companies also used the low price to buy a large part of the surplus carbon allowances for future use. The total surplus of two billion was thus already ‘reduced’ by one billion. Knowing that during the next three years the remaining surplus will be further reduced, more upside potential for carbon allowance prices can be expected. While market expectations are mixed, a doubling of prices in 2014/2015 seems possible. That would bring the EU allowance price to above EUR 10. A big impact on consumer prices for electricity is not to be expected, though. Carbon-emission costs as a share of the price that consumers pay for their energy are less than 10%, the rest being made up of the commodity price (30%), taxes (40%) and grid maintenance (20%).

More radical measures can be expected in the next phase

Besides these temporary measures, the EC is busy changing its longer-term policy. Opinion among the member states is strongly divided, however, which is related to their dependency on fossil fuels – and thus the amount of carbon emissions – within the domestic energy mix. Germany – with its Energiewende – and the United Kingdom are in favour of changing the policy to reduce the effects of carbon emission on the atmosphere. Other countries, such as Poland (more than 90% dependent on coal) and the Czech Republic, are against such a change, as their economies strongly depend on fossil fuels. Here, too, geographical differences play an important role (please see the Energy Monitor January – Geographical Difference for more details).  Higher prices for carbon emissions are a disadvantage for European energy-intensive companies, having a negative impact on their competitive position, compared with companies that can benefit from cheaper energy, for example in the US.

One of the ideas to improve the ETS during the next phase (2021-2030) is to introduce a reserve mechanism. This would include withholding 12% of the carbon allowances, which will only come to the market if needed. In other words: if the market is short. This plan fits the new 2030 targets to create targets in order to reduce carbon emission by 40% compared with 1990. The EC will vote in March on these new targets. According to EC Chairman José Manuel Barroso, the new targets should be ambitious and affordable. However, to get the ETS system really working, the price of the carbon allowances should rally to levels above EUR 40. The temporary measures are not strong enough to accomplish this. Furthermore, it is not certain whether the EC is capable of adjusting the ETS policy in such a way that prices are substantially and structurally increased and enough support among all European member countries is found.

Extreme jump in US gas prices due to cold

The long period of extreme cold in the US led to a huge rally in US natural gas prices (Henry Hub). The combination of rising (seasonal) demand for natural gas and the linked decline of supply pushed natural gas prices to a four-year record high of more than USD 5.00/mmBtu (see figure 3). We do believe in a structural rise of US natural gas prices, but this appreciation went too fast. The strong rally was mainly driven by extreme temporary weather conditions. As soon as temperatures return to normal levels and demand for gas eases (and stocks rebuild), prices of natural gas will start to normalise and decline. In Europe, the situation is exactly the opposite. As the winter in many countries never really started, or came late, demand for European natural gas fell short of expectations and resulted in lower prices.

On 30 January, we released our new Quarterly Commodity Outlook. In this report, we updated our forecast of natural gas prices. For this quarter, we expect lower natural gas prices in the US. A decline to USD 4.25/mmBtu is possible, and this decline will continue in the second quarter to USD 4.00/mmBtu. We expect an average price for 2014 of USD 4.25/mmBtu. Nevertheless, we believe that economic growth in the US will eventually lead to a moderate rising trend. For 2015 and 2016, we expect higher gas prices compared to the 2014 average (respectively USD 4.75/mmBtu and USD 5.00/mmBtu). The large reserve capacity that may come to the market when production starts to be profitable again as soon as prices start to rise, and the possibility to switch to cheaper alternatives (such as coal), will create a cap on US natural gas prices. This cap is expected around USD 5.50-6.00/mmBtu. In Europe, due to efficiency, moderate economic growth and (re-)negotiations of long-term contracts with Russia, the declining trend will continue. For the first quarter, the price will hover around EUR 27/MWh (or USD 10.68/mmBtu). In the coming years, we expect the price to decline further towards EUR 24.50/MWh (USD 8.90/mmBtu, assuming the euro declines to 1.25 versus the US dollar).