2023 Outlook For EUA Futures

Brief Carbon Outlook For 2023

As we look towards 2023, the outlook for carbon markets remains promising. With policy clarification and tightening carbon allowance supplies, the price of carbon allowances may increase. This is particularly noteworthy as the global blended price of carbon is still well below universal estimates. Despite this, global markets continue to expand, with new initiatives being launched in Washington state and Pennsylvania and North Carolina moving towards joining the Regional Greenhouse Gas Initiative Program (RGGI). Both Australia and China are also making progress in building their own emissions trading systems (ETS).

One key advantage for carbon markets in 2023 is their continued low correlation with other asset classes, providing a level of diversification that can enhance portfolio performance. Additionally, carbon markets can see constructive tailwinds in risk-off markets, supported by strong policy, while in risk-on environments, they can be more aggressive, potentially leading to accelerating performance. This asymmetric upside potential makes carbon markets an attractive opportunity for investors who are looking for a way to diversify their portfolios and hedge against climate-related risks. However, as with any investment, careful analysis and monitoring of market trends will be essential to maximize returns and manage risks.

EU Allowance (EUA) Futures

Overview

EU Allowance (EUA) futures have displayed strong performance, increasing by over 20% in the last quarter of 2022, following positive policy developments and new emissions reduction targets. Despite experiencing fluctuations and starting below €70 levels, the year ended with EUAs at €83.97, with the majority of trading concentrated within the €75 to €85 range.

Supply

Looking forward to 2023, EUA supply will continue to decrease, with an accelerated cap reduction factor of 4% and the MSR's 24% intake rate remaining. The accelerated cap reduction factor of 4% refers to the annual decline in the total number of EU allowances in circulation, which is faster than the previously planned 2.2% decline.

This implies that the number of allowances available will decrease more quickly, reducing the supply in the market. This reduction in supply will lead to higher prices if demand remains constant, which is good news for holders of EUA futures. Meanwhile, the Market Stability Reserve (MSR) will continue to intake 24% of the surplus allowances, which aims to increase the flexibility of the supply side of the market, preventing sudden price shocks. By removing surplus allowances from the market, the MSR will decrease the overall supply, which is likely to further support prices in the long run. Together, the accelerated cap reduction factor and the MSR's 24% intake rate create a positive outlook for EUA futures in 2023 by decreasing the supply, ultimately increasing prices and creating a more stable market.

The strategic bullish frontloading of auction allowances to fund REPowerEU are critically supplying additional allowances now but also creates a steeper tightening in the future, implying further price appreciation on the horizon. The REPowerEU proposal, which aims to end Europe's dependence on Russian fossil fuels, includes an initiative to raise €20 billion through additional EUA sales. This increase in supply from borrowed volumes of the 2026-2030 period will create downward pressure on short-term prices, but will ultimately lead to tighter supply and higher prices in the future. The frontloading of auction sales will result in a 4.5% tighter supply in the 2026-2030 period, which will support future price appreciation on a steeper supply curve. By increasing the supply in earlier years, the REPowerEU proposal will also cause a greater net intake of excess allowances into the MSR, resulting in the removal of about 145 million allowances from the supply through the year 2030. This represents 1.7% of the total remaining supply from 2023 through 2030. While the increase in supply will be felt in the short term, the overall impact will lead to tighter supply and higher EUA prices in the long term, especially when supply constraints are realized.

Demand

Moreover, a new tariff, called the Cross Border Adjustment Mechanism (CBAM), has been introduced to account for carbon leakage across borders. This will require European importers to buy allowances in the secondary market, boosting demand and price discovery dynamics. Carbon leakage refers to the phenomenon of companies moving their carbon-intensive production outside of the EU to countries with less stringent climate policies or the replacement of EU products by more carbon-intensive imports. The CBAM aims to ensure that the carbon price of imported goods is equivalent to the carbon price of domestic production, creating a more level playing field for EU companies. The political agreement reached on 13 December 2022 will see the CBAM initially applied to imports of certain carbon-intensive goods such as cement, iron and steel, aluminium, fertilisers, electricity, and hydrogen. This will eventually capture more than 50% of the emissions in ETS covered sectors, which is a significant step towards combating carbon leakage. The CBAM is expected to enter into force in its transitional phase as of 1 October 2023. The introduction of the CBAM creates greater price discovery dynamics, as EU importers will now be required to purchase carbon allowances in the secondary market, leading to a more stable and predictable market for carbon allowances. This new tariff is an important step towards achieving the EU's goal of achieving net-zero emissions by 2050, and it is a positive development for the carbon market in 2023.

Additionally, the exchange rate between the euro and the dollar may affect the EUA futures performance in 2023. Despite the dollar's initial strength in 2021-22, a recent improvement in economic sentiment in the eurozone and the Fed's slowing interest rate hikes could potentially support the euro, making EUAs more attractive to non-EU investors.

“We expect USD strength to ultimately prove short-lived. Indeed, we believe a multi-year bearish trend in the USD is underway, with portfolio flows turning increasingly negative for the currency… Yields turning positive in Europe and Japan could spur repatriation by local investors” -BNP Paribas Research

Europe’s Challenges

Europe's increase in climate ambitions and the rebounding of coal-fired generation present a complex challenge for the continent's transition to a low-carbon economy. Europe's power sector has been working to transition away from coal towards gas, resulting in a 3-4% reduction in EU ETS stationary emissions annually from 2013-2019, primarily driven by the power sector fuel switching from coal to gas. However, the pandemic-induced recovery has caused a 6.8% increase in stationary emissions in 2021, and coal-fired generation has risen to multi-year highs in 2022 as natural gas prices have reached record-high levels. While gas prices have come down in recent weeks, the pace of power sector decarbonization has slowed down, and we expect power sector emissions to remain elevated in the near term. The EU's ambitions of meeting more stringent climate targets will require a more substantial reduction in emissions from the industrial sector. However, industrial emissions are heavily tied to production levels, and as the European economy rebounds, we expect these emissions to increase again. The lack of readily available solutions to reduce industrial emissions by 2030 substantially, coupled with the current low carbon prices, makes it challenging to implement new technologies like CCS or green hydrogen. Although current prices remain low, we expect significant near-term upside as the EU seeks to transition to a low-carbon economy, insulating carbon from the economic cycle.

Conclusion

In conclusion, the European Union Emissions Trading System (EU ETS) is entering a new era with ambitious climate targets for 2030 and beyond, and the implementation of various policies to drive the transition to a low-carbon economy. In 2023, we expect EUA prices to remain volatile, with downside risks related to macroeconomic developments and supply/demand imbalances in the EU ETS market. However, we also see upside potential for EUA prices, driven by the growing ambition of EU climate policy, the implementation of new policies such as the CBAM, and the supply restrictions imposed by the REPowerEU initiative. The combination of these factors is expected to create a steeper supply curve in the longer term, leading to higher EUA prices. The EUA market remains an attractive investment opportunity for those seeking exposure to the decarbonization of the EU economy, as the tightening of the EU ETS market is expected to continue over the coming years, and the need for low-carbon technologies and renewable energy sources is expected to increase. The year 2023 is likely to be a critical year for the EU ETS market, as it sets the tone for the upcoming decade of decarbonization and transition to a low-carbon economy.