Carbon bears join the picnic

While currently trading around EUR 25/t, European carbon prices look set to be hit by several bearish factors next year, including a potential flood of UK permits, an economic slowdown and reduced demand as Germany starts its coal exit. 

Listen to the in-depth analysis of current and future CO market drivers. 

Host:

• Richard Sverrisson, Editor-in-Chief Europe, Montel.

Guests:

• Tom Lord, Head of Trading and Risk Management, Redshaw Advisors,
• Alessandro Vitelli, Carbon Reporter. 

Transcript

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Richard Sverrisson, Editor-in-Chief Europe, Montel: 0:05

Hello listeners and welcome to the Montel Weekly podcast, bringing you the most topical energy matters in an informal setting. My name is Richard Sverrisson Today in a carbon market special. I'm joined by Tom Lord of Redshaw Advisors and my old pal, Alessandro Vitelli. Alessandra's been covering this market since about 1980. A warm welcome to you both. Anyway, I think we should start by discussing current market dynamics. We've seen prices come down after a volatile period after summer. I. What are the main drivers here, Tom?

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 0:34

It's a mixed bag at the moment. We have a few a few bullish influences and a lot of bearish influences as well at the same time. So we've seen prices stuck in a fairly tight range.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 0:45

Could you isolate the sort of those, both the bearish and the bullish factors?

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 0:49

I. Sure. I think on the bullish side we have the MSR, which has been going all year. Lack of UK auctions. So the Brexit uncertainty is is ensuring there's no auction on a Wednesday, every fortnight. We have the December auction shutdown on the horizon now. So midway through December, the auctions will cease until the new year. And obviously we're coming into winter. So winter is generally supportive. Obviously higher higher heating demand from across Europe. In terms of the bearish influences, you have European gas prices I think that's probably the main bearish driver at the moment. We also have the Brexit uncertainty isn't helping. And coupled with that, you have the potential return of UK auction. So depending on the outcome of the Brexit saga you potentially have those UK auction volumes returning to the market in. 2020. So UK auctions adding to that supply in 2020 perhaps in a short space of time makes Q1 look particularly vulnerable to lower prices perhaps

Richard Sverrisson, Editor-in-Chief Europe, Montel: 1:43

Alessandra, do you agree with these factors there? Anything you'd like to add to that?

Alessandro Vitelli, Carbon Reporter: 1:47

I agree with 'em all. I think they're all relevant factors and how the market is playing out at the moment. It's trapped in a fairly narrow. Relatively narrow technical band. There's no great dynamic that's pushing it one way or the other. And as we near the expiry of the 2019 contract in December, there's going to be. Less desire to move it away from where it is now because simply because of the option, open interest that is congregating around about the current strike price. So as the further we go, I think the less possibility of a breakout comes after expiry. There may be a change as people start to look into 2020 and start seeing maybe a more bearish outlook as Tom indicated for Q1. But, so this narrow range is what, between 24 and 26? 2024 and 26. I mean, we're currently hovering I think it was just above 25, late lately. The point there being that people see no reason to move it, the lack of any of any speculative interest in the market, to see it go higher, to see it go lower suggests that, hands are off. And, you know, we get towards the end of the rain of the year, traders start, you know, slowing down their activity. They're closing their books. They don't want to put their current bonuses at risk. So you've got this sort of hands off. Sentiment now people sort of go quiet.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 2:55

Would you agree with that? Someone, do you think sort of speculators are taking a bit of a break

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 2:59

or, yeah, I think so. We have seen prices obviously stuck in this range and very closely correlated with the wider energy complex. Which usually suggests that there's nothing in particular driving carbon alone. It's seeking direction from elsewhere. And there's bearish outlook on the UK gas prices and European gas prices have largely driven the kind of. Downside that we've seen over the past few months, I would say. But we've seen prices come away from the summer highs and then kind of find this range that it seems happy and it seems comfortable reverting towards 25 at the moment. The year to date average is 24 91, I think it is. Okay. So it's it's reverting to that.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 3:36

I mean, how do you see, you know, how do you see the market developing for the rest of the year? I mean, would you concur with, with Alessandro that. You know, after December you could see a different dynamic. I, I mean, after the expiry date to the December contract.

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 3:47

Yeah. Quite possibly. And the expiry date also coincides with the auction shutdown. So what we typically see in an auction shutdown is higher prices. Just because there's no supply coming into the market and there is still hedging demand. But this August certainly went against the grain. On that one, and a lot will depend on the uk UK election. And therefore the influence that we see with the Brexit agreement and the return of UK auctions in 2020. So, if the UK auctions start or start again in, in early 2020, there's certainly the chance that any gains in late December because of the auction shutdown are countered

Richard Sverrisson, Editor-in-Chief Europe, Montel: 4:24

by

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 4:24

happy sellers.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 4:25

We've had someone on this pod arguing that carbon prices could reach 45 by the end of the year. From what you are saying, Tom and Alessandro, I think you have quite a different opinion.

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 4:35

Yeah. It seems very unlikely, I would say. You can't rule it out in carbon. It's a very volatile market, but gas prices look like they'll keep a lid on the carbon price. For the foreseeable future, I would say.

Alessandro Vitelli, Carbon Reporter: 4:45

There's also some supply and demand dynamics that are gonna come into play. I mean, let's focus firstly on Brexit. The deadline for an agreement is the 31st of January. And history teaches us that we always use that up. Before we get to a, an extension or whatever. So we get to the end of January. There's, let's say there's a deal. The 2019 UK allocation and auction have to come to market. Now are they gonna come to market in a compressed period of time? That is until the compliance deadline at the end of April or they gonna be spread out over the whole year? What is the logistics of 2019 Compliance if we have a deal.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 5:22

Secondly. UK utility. So that would, sorry. That would mean a flood of these allowances on the market. Well, and in a very short space of time, which as Tom hinted earlier, that could drive prices very much down with,

Alessandro Vitelli, Carbon Reporter: 5:32

and if it, if we do only get this deal at the end of January, you then have February, March and April in which to sell, I guess 70, between 60 and 17 million EUAs perhaps into the auction market. And. Issue all the free allocation to industry. They then have to quickly balance their books and give it back to the EU at the end of April and, and give those uas back to the eu. That kind of volume coming into the market in that period of time can only be bearish. Now, you then have, assuming we have this deal, you then have the UK continuing to comply. Until the end of 2020. So while the 2019 EUAs are coming in, the UK is also starting to sell and issue the 2020 EUAs. So you've got two years of UK supply coming to the market at the same time. That's got to be bearish. Now go even further than that and ask and, and look abroad. Look across the channel, look at what the last week's decisions from Germany 2020. They're gonna start tendering for the first coal plant closures middle of the year. The plan has to close seven months after it's been awarded the tender. I believe that's right. Case. Yeah.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 6:32

Yeah. From the details we saw. But it's still only a draft program, still

Alessandro Vitelli, Carbon Reporter: 6:34

only a draft program. And then they've also delayed a decision on cancellation of eua isn't until 2022. So you then have this lack of demand coming along the way sometime at the end of 2020, probably. From German coal plants that have shut, plus the German government continuing to offer those EUAs at auction. Yeah. Anyway. So you're, we're building up more over supply on top of reduced demand from the power sector due to decarbonization and renewable energy. Due to the downturn in economic output, which is causing in industrial emissions to drop.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 7:07

So it's quite bearish out for me. 2020. 2020 is 20. Nothing but bear as far looks like red arrows. Yeah, it does. You, Tom, I mean, would you share this view of Brexit? I know that amongst all the uncertainty sort of this year, and certainly after the summer when it looked like there was a deal coming or the, when the certain actual past in Parliament prices went up but actually the impact of Brexit or a deal is fairly bearish as Alexandra has just just said.

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 7:30

Yeah, I think a lot depends on the timing of the UK auctions. We would expect those allowances to come to market in a. Fairly short space of time, but the UK government will also be conscious of the impact of those auctions on the market. And they'll also be conscious of the auction clearing price. Their auction revenue is directly correlated to that auction clearing price, so there's no clear, clear picture yet of how quickly those auction volumes will come to market. And I think the key with the auction volumes is who buys them. The largest buyers of allowances are the utilities. And it's our understanding that UK utilities have carried on to, carried on hedging regardless of this Brexit uncertainty. So if they've already bought. Who then buys the allowances that are coming to auction. And that's a big question mark, I think. There will be some compliance demand and UK industrials in general. And I'm splitting the industrials from the utilities UK industrials in general have have taken a step back from hedging. Obviously, I can't speak for every single one of them. But a lot of them have not carried on hedging their 2019 exposure, so they will have catch up. But it probably won't be of the size of the UK auctions. In fact, I'm certain it won't be. They could well be joined by speculative or long-term investors who are happy to come back into the carbon market based on the fact that they now have that all this Brexit downside risk has gone away. But there's a, certainly a lot of question marks around 2020 price development especially in the first quarter, maybe first half of the year, I would say.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 8:54

Sure. I mean, a lot of the UK utilities are also, uh. Foreign owned as it were, you know, or not, you know, the headquarters are the, the company's based outside of the uk so obviously they have a big trading and hedging strategy, which is either in Dusseldorf or Paris or Brussels, wherever that may be. And one of the Indu UK industrials that was. You know, the famous example, Tatar, which was then obviously wasn't so hedged. That's quite a key example. Alessandra, did you share this view that the UK utilities, you know, you were sounding an imaginary bell there,

Alessandro Vitelli, Carbon Reporter: 9:25

because I think that's, that, that's the key point is that UK utilities responsible publicly quoted companies will not leave themselves open. To that kind of risk. So they will have hedged this year. And in fact, they have told us publicly in many cases that we are complying, whatever that, however you wanna interpret that statement, which tells me they're buying uas. So when that 2019 UK auction Pot comes to the market, who buys it? And Tom raised that very important point. Who's gonna buy it? Are the speculators still interested enough? To buy that volume. Will European entities come into the UK market to buy those volumes? We don't know where that demand comes from. Normally you would know it would be UK utilities, but they're covered for 2019 and 2020 now, so that's a downside. That's a big downside. There are bigger ones. Further down the line, but that's the big one. For the next, for next year.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 10:20

Tom, we're talking a little about the UK election. I mean, how, you know, what, what are the ramifications of that? I mean, at the moment it looks fairly uncertain. It looks like the, that the polls are putting Boris ahead, Boris Johnson ahead, and the conservatives ahead. But does that then, you know, amplify the chances of a deal? For example, I mean, could you play, could you explain some of the ways that you see how the results of the UK election on and the impact that could have on the carbon market?

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 10:46

Yeah, I think you're right. If the conservatives win, it looks like the deal that's on the table is taken. Provided they have a big enough majority to get that through Parliament, I think the risk is probably a hung parliament again. Or someone without a strong enough majority to actually pass a Brexit deal and therefore we have a general election and end, end up back in exactly the same situation we've been in for the last three years in effect. Yeah. So the polls at the moment suggest that the conservatives will have probably a healthy enough majority to get that Brexit deal passed. But obviously there's still a good month to go until we actually go to the polls. And a lot can change in that time.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 11:23

Absolutely. I think moving beyond Brexit now and to my other fundamental aspects of the market. I mean, Alessandra, you highlighted the potential of the, of an economic slowdown in Europe. Would you agree here, Tom, that could also have a large effect on the demand for EUAs and carbon? Yeah, certainly. And I think

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 11:40

I. I think fuel switching, coupled with that is the big bearish factor. At the moment. The falling gas prices across Europe are driving fuel switching. There's more fuel switching to come. We've already seen some and as Alessandro noted earlier, we have this uptake of renewable energy every single year that capacity grows and therefore power sector emissions are falling. And that's also being aided by the fuel switch as well now. So there is a significant. Decrease in power sector remissions expected for 2019 and probably 2020 as well. 2021 even after that. So the MSR is there to counter that. But the issue with the MSR is the time lag. Now, that will work both ways. The MSR is effectively looking at emissions totals from the previous year. So it's reacting to what's already happened. Now, that will work the same way when the market tightens and the MSR may still be withdrawing allowances, but for now, we have this situation where the MSR is almost swimming. Swimming upstream, I guess. Mm-hmm. Its effect is being negated by these opposing factors.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 12:37

Do you have a view on a gas price at all going forward? I mean, I think the key factor here is what happens in the Ukraine Gas Pro negotiations. If they come to a deal by the end of the year, early next year, then that could drive. So the forward curve,'cause there's a disconnect between the spot price and the forward curve. If the forward curve then comes down. Further or crashes down, then you'll see again this massive, this fuel switching will continue.

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 13:00

Yeah, sure. And I guess with the Ukraine deal I think it's in the Ukraine's interest to make sure there is a deal. They rely on the revenues from that gas pretty heavily and therefore. Common sense says you get a deal. That doesn't always pan out, obviously, but the outlook for gas prices is bearish for the next year, if not towards year and a half, two years. And therefore, there's this. Continued pressure on carbon prices. There is a limit to the amount of fuel switching that can take place. There's not an unlimited supply of gas capacity that can come online and push coal out the merit order, but that fuel switch is gonna work against the MSR. So although the MSR is tightening things, it is gonna be a factor that helps keep a lid on prices potentially.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 13:43

And Alessandra, what's, what your, what's your view here then? The, the gas glut, uh, you know, storage is a record high, uh, l and g ships swimming around trying to find a home because there's no, you know, I mean, what's your, how is this playing out for carbon in your view?

Alessandro Vitelli, Carbon Reporter: 13:56

Carbon is going to re continue reacting to gas in the short term, but we are coming up to a period when the gas market in Europe is gonna go through a structural change. You've got Nord Stream two, which is now progressing faster and has. Every chance of being online by next year, you then have rush to this considering and planning to close pipelines that run the southern route. About two and a half thousand kilometers worth of pipelines that goes through the southern route are gonna shut. And effectively, from what I read and study, Russian gas export capacity is going to fall because of the focus on Nord streams one and two, and then the lack of southern pipelines. So. We could end up in a situation where there's less Russian gas coming to Europe, prices structurally have to move up to compensate for that. And that's good to have an impact on carbon pushing prices back up. And it risks in some marginal moments of bringing coal back. That's some parts of the year, maybe even the short terms. We have to watch out for that. And it's gonna change the dynamic for a lots of places. A lot of parts of southern, central East eastern Europe are not gonna have as easy access to gas as they did before. And so all this talk and then consideration of, you know, the future is gas. The future is gas. It may be true for the northern part of Europe, but it's not necessarily for the southern part. And this comes at a time when more and more countries in Europe are coming out with plans to phase out coal. Greece, Hungary, et cetera.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 15:20

You, you know, you have to worry about that. On the other side, you could say that Russia has never pumped as much gas into, into Europe as has done over the last couple of years. But, uh, and Norway the same, quite right. Yeah, absolutely. But I think that's an interesting point. So perhaps this view of a gas supply glu lasting two, three years is overdone or overstated?

Alessandro Vitelli, Carbon Reporter: 15:37

Well, I'm not saying two or three years. We won't be healthily supplied. I'm just saying watch out for these plans to decommission pipelines in the south. Okay.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 15:44

So listeners, you have been warned. Tom, if I can. Uh, you know, we've had you've mentioned hedging earlier hedging by the utilities. We've had a space of Q3 reports coming out for utilities across Europe. How do you see utility hedging strategies are and are there big differences between them?

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 16:02

There's always differences between hedging strategies. It's very much a hedging is a company specific thing. So obviously plants around Europe have different efficiencies. They have different variable costs, and therefore it's very difficult to interpret exactly what the utilities are doing at any one time. I think the higher carbon prices are gonna be impacting those the dirtiest and the most inefficient plants across Europe. And they're probably the ones feeling the pinch with the price rises that we've seen now. It's been well documented that RWE have taken a financial hedge against that, some of them have been proactive in managing that risk. Exactly. What they've all done is impossible to know in all honesty. Of course. Yeah. Yeah. We can make assumptions based on their reports, but even those reports don't necessarily tell you the full picture.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 16:49

Exactly. And the full picture will come out when the full year report, because often these contracts, when they go to expiry in, in December and in the fourth quarter, then becomes much more clearer in in February. Exactly. Yeah. February, March. But how about the industrials? You mentioned UK industrials. Tom, how about. You know, uh, industrials across Europe,

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 17:06

there's a general shift from reactive to proactive. I would say it's gradual for sure. What we saw with carbon prices around five euros a ton is that it was very much something people thought about at the end of the year, unless you had a very big exposure that warranted kind of real risk management of it. A lot of people are happy to leave that till the end of the year. So they leave that carbon purchasing till the end of the year safe in the knowledge that price was gonna be between somewhere between four and six euros. Obviously, that, that has, has seen a huge shift over the last couple of years. And that is driving people to think about their carbon exposure a bit more. It's. Again, there's no kind of one shoe fits all, but there is certainly a push to actually take a more proactive approach. And people are also realizing that phase four allocations are falling now. So a lot of industries are still protected by the carbon leakage list and fairly generous free allocations, but. Nonetheless, over time people see that the higher prices and the lower free allocation are really combining to, to drive up compliance costs.

Alessandro Vitelli, Carbon Reporter: 18:07

Alessandro what's your view here and one of the approaches that say small and medium sized industrials take is to try and beat the average price of the year. And given that we are so close. Current prices to the average price for the year. This is actually a time for them to look carefully at their balances and say, Ooh, maybe we can buy a few if the price dips below 24 91 or whatever it is. Yeah. Certainly they'll be looking to beat those targets, that average price for the year. That's sort of. A halfway stage between full risk management on a day-to-day basis and no risk management, which is what we used to see when the prices were 2, 3, 4. This is a halfway stop, and I think more industrials are moving to that kind of semi

Richard Sverrisson, Editor-in-Chief Europe, Montel: 18:45

proactive. Well, I mean, you can understand why the risk is that much greater. Of course. Than the exposure to those prices is huge. But Tom, I mean, do you think that. Some companies are not aware of the total cost of carbon. I mean, you have the carbon price, but you also have the knock on effect, the indirect costs. What's your view here?

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 19:01

Yeah, certainly, and I, I think total carbon costs will come more and more into focus. A lot of companies until now have looked at their direct carbon costs and as I've said, they were relatively low. They were protected by free allocation and prices were quite low. That is changing. People are generally aware of that and kind of can do the sums to understand some of their exposure, at least indirect carbon costs are growing with the carbon price. So the carbon price is becoming a bigger and bigger factor in the power price. And what a lot of companies don't understand is those indirect carbon costs that they face. And there's. There's a, probably a lack of understanding and analysis on, on, on how big an influence carbon is in that power price. And now all these guys in the UETS are electro intensive and therefore it has a huge impact on their overall cost. So whilst they're may be receiving a generous, free allocation for their direct carbon cost Many are receiving either no compensation or limited compensation for their indirect carbon costs. It is a, it is certainly a changing picture, and I think if you throw in into that mix the general movement towards carbon neutrality. There is a growing carbon cost overall. So we have you have the cost of reducing emissions, the cost of potentially voluntarily offsetting the rest of the emissions that you can't reduce. And then there's also things like the opportunity cost of not being green. You know. Consumer trends are changing, investor trends are changing, and therefore companies are really having to understand that total carbon cost now.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 20:31

So I mean, could you highlight any companies or sectors in particular that sort of are not, maybe not so totally aware of their complete I couldn't say,

Tom Lord, Head of Trading and Risk Management, Redshaw Advisors: 20:39

I couldn't say a sector in specific. I, I think. Some companies are certainly more proactive than others. We already see companies that have the carbon neutrality all over their websites, all over their brand, and you're very much aware of who they are. The risk I think for those not understanding or embracing this change is that they're, they will very quickly be left behind. And that could have a huge knock on effect for businesses all across Europe, not just those in the UETS businesses. Across the whole world, in fact,

Alessandro Vitelli, Carbon Reporter: 21:05

absolutely. Yeah. There, there are supply chain companies who don't necessarily have an interface with the public, with the consumers, the ones who serve the retailers, the ones who serve, the manufacturers, who are exposed to a cost of carbon and yet who don't have a compelling corporate social responsibility story to tell, who don't face the public, and therefore don't really get impacted by public concerns. Those guys who are stuck in the middle of the chain have no real incentive. To look at their carbon costs except in terms of what, you know, their power bills, et cetera, et cetera. And they maybe get some compensation for that. But these are the people who probably are the slowest to pick up on these trends, the public concerns and the idea, the benefits of showing yourself to be a properly carbon neutral company. Yeah.

Richard Sverrisson, Editor-in-Chief Europe, Montel: 21:47

Gentlemen, I mean, a fascinating discussion, but I'm afraid that's all we've got time for today. Tom, thank you very much for joining us. It was a pleasure to have you on board and I hope we can, we'll have you back on the pods to discuss the key carbon issues. Certainly. And thank you for having me. And Alessandro, thank you once again. And I, you are off to the cop very soon, aren't you? And in Madrid I think we're not as far as Chile this time, but you'll save on the on the, on your carbon emissions. That's correct. I'll be walking the hallways in Madrid. Perfect. Well, thank you once again Alessandro. Thank you. That's about all from the Monte Weekly podcast this week. Remember to keep up to date with all our stories on Monte News and follow us on Twitter and LinkedIn and subscribe on Apple Podcasts and Spotify. Goodbye.