European Allowance (EUA) Futures Q1 2023 Performance and Forecast
Unveiling the Resilient Rise: Exploring the Surprising Surge of EU Allowance (EUA) Futures in Q1 2023
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EU Allowance (EUA) futures have witnessed an intriguing performance over the last quarter, showcasing a remarkable appreciation of 9.5%. The journey began with EUAs opening the year at €83.97, only to face a tumultuous start in the first week of January when they dropped approximately 8% to reach €77.39. This decline was influenced by the decrease in the price of the Dutch TTF natural gas proxy during the same period. Traders, perceiving a higher probability of coal to gas switching, factored in reduced demand and lower prices due to natural gas's lower emissions, which necessitate fewer allowances.
Nonetheless, this initial setback proved to be the lowest point for EUAs as optimism surrounding the rebounding EU economy took hold, bolstering expectations of higher emissions. As a result, EUAs rallied impressively by 19%, culminating in a quarter-end price of €91.93. Throughout the quarter, EUAs traded within the range of €85 to €94, even breaching the €100 mark in February.
The robust performance of EUAs in the first quarter unfolded against the backdrop of the gradual progression of the "Fit for 55" legislative process. Over nearly two years, policymakers diligently worked to reform the EU ETS through the Fit for 55 package, aiming to achieve a 55% reduction in emissions by 2030 compared to 1990 levels. The various elements impacting the market are now drawing closer to receiving the final sign-off from member states in the EU Council.
The new legislative measures tighten emission caps through several means. Firstly, the annual cap reduction factor, representing the percentage of allowances removed from the cap each year, will increase from 2.2% to 4.3% in 2024 and further to 4.4% in 2028. Additionally, the cap itself will be rebased downward by 90 million allowances in 2024 and an additional 27 million allowances in 2026. The market stability reserve (MSR), responsible for removing allowances from future auctions to prevent oversupply, will continue to absorb excess allowances at a 24% intake rate. The MSR acts as a mechanism to manage market imbalances by adjusting the supply of allowances based on the predetermined threshold for the total number of allowances in circulation (TNAC).
Another significant development is the approval of the Carbon Border Adjustment Mechanism (CBAM), which introduces a carbon border tax on selected imports into the EU. Under CBAM, foreign energy-intensive producers will be obliged to pay the EUA price on goods imported into the region, creating a more level playing field. This addition is expected to exert upward pressure on EUA prices, as more entities are likely to take positions in EUA futures. The anticipated sources of EUA demand include importers seeking to hedge their exposure to CBAM certificate prices and EU producers who will no longer receive free allowances, as these are being phased out in conjunction with the introduction of the new tariff.
Furthermore, the progression of these policy measures is set to support EUA prices by mitigating regulatory uncertainty that had loomed over the market in the previous year. The expectation of a rebound in industrial output has also played a role in bolstering EUA prices during the first quarter. As European energy prices experienced significant declines, with gas falling by 37% and coal by 24%, confidence in business activity picking up has grown. The relief in energy markets has contributed to a substantial reduction in price pressures and expectations of a faster decline in inflation, thereby alleviating the burden on businesses. In fact, the European Central Bank revised its 2023 gross domestic product (GDP) forecast in March, raising it to 1% from its previous estimate in December, while adjusting the inflation forecast for the year to 5.3%, down by 1% from the previous projection. These revised forecasts came as a result of February's Eurozone activity indicators published by S&P Global, which pleasantly surprised the market by indicating a rise in the European business activity index to an 8-month high. This positive signal suggests that eurozone firms remain in a hiring mode and points to further expansion in business activity.
The encouraging economic news served as an additional catalyst for EUAs during the quarter, shifting sentiment towards expectations of a return to growth. Moreover, Bloomberg New Energy Finance (BNEF) made adjustments to their 2030 price forecasts for EUAs, revising them to €165/ton following the approval of REPowerEU. This €20 billion initiative aims to accelerate Europe's transition away from Russian fossil fuels and towards low-carbon energy sources. The funding plan for REPowerEU involves frontloading 40% of allowances from auctions in the years 2023-2025, meaning that allowances originally earmarked for future auctions will be sold earlier.
While the injection of extra supply resulting from auction frontloading may have bearish implications in the near term, the market will witness tighter auction supply in the subsequent years. This tightening of supply is expected to support steeper future structural price appreciation. BNEF developed three different price forecasts based on various distribution scenarios for the allowance frontloading, as the full timeline has yet to be confirmed. The European Commission announced its plan to sell at least 16.5 million EUAs starting in July, with the possibility of additional allowances being added afterward. Additionally, they confirmed that no Innovation Fund auctions will take place this year, reducing the expected supply hitting the market in 2023.
Looking ahead, approximately 16.1 million EUAs of extra supply are expected each quarter from 2024 through Q3 2026. Despite this additional supply, the net impact is balanced out by a supply crunch in the years following 2026. In BNEF's base case, assuming equal frontloading across each year, a price forecast of €160 is projected for 2030. However, if more allowances are frontloaded earlier, the average EUA price in 2023 could drop to €80 compared to the base case estimate of €88. In such a scenario, a greater supply squeeze would occur later, resulting in EUA prices rising by €5 to reach €165 by 2030.
Regardless of the specific distribution scenarios, it is evident that REPowerEU's funding scheme will lead to greater supply in the short term while ultimately reducing supply in the later years. This dynamic is expected to drive EUA prices higher than previously forecasted.
