Carbon prices have tumbled by more than a third since the beginning of the year and have reached fresh lows in recent days. Meanwhile a significant buildup is reported in short positions in the European carbon emissions market. Although fundamentals remain weak, market participants said a fresh round of global tensions could drive up natural gas prices and potentially trigger a short squeeze in the carbon market.
The European carbon market trades EU Allowances, or EUA, as part of the EU’s Emission Trading System. For a few weeks, this market has been buzzing with talk of a potential ‘short squeeze’ that could force hedge funds to close their positions in EUAs. A short squeeze happens when an asset which many investors have bet against, expecting its price to drop, suddenly starts increasing in value as investors decide to cut losses and exit their positions.
“If Iranian territory was hit, the likelihood of a short squeeze in EUAs would be quite high,” said Stefan Feuchtinger, head of market research and analysis at Vertis Environmental Finance in Brussels. The International Commodity Exchange, ICE, reported 32.5 million EUAs in net short positions last Friday, against 30.3 million a week earlier. For reference, about three million EUAs get auctioned off every day.
Fundamentals point against short squeeze
“Of course with big short positions you could always have short squeezes. But the fundamentals need to be aligned as well. I think right now, they aren’t yet,” he said. ”I think rather now we have fundamental support because the profitability of coal-fired power plants in Germany and most of Europe is really very bad.”
The carbon market in recent years has emerged as a novel and potentially lucrative investment arena. Major polluters like power companies and industrials were the primary participants in this market. Initially they were given free allowances to match their existing emissions; increasingly they have to buy their rights to emit CO2 in the market.
At the same time, the market is seeing increasing activity of hedge funds and financial investors, often via Exchange Traded Commodity, or ETC, funds. Morningstar has identified about 20 such funds. Some asset managers in recent years also actively recommend clients take short positions in EUAs in order to green their investment portfolios, although the rationale behind such trades could also be inspired by speculation.
Fundamentals in today’s carbon market are such that coal fired power plants in Europe are trying to switch off as often as possible because they are losing money when they keep on running. The winter, often an influential factor for energy prices, looks like it’s going to be over soon without any significant energy shortages. When fossil power plants step up production, they need to secure more EUAs. When they’re offline, that demand evaporates and they need less.
EUA prices tumbled 25% in January
Against this backdrop, EUA futures prices - for December delivery - during January declined to around 58 euro after peaking at 80 euro at the end of December. On Monday, they declined further, to 53.81 euro, down 33% from the peak set in December and about half the level prices were at in March last year.
In 2022, Feuchtinger explained, carbon prices spiked above 100 euro per EUA as a result of the massive droughts in France, which reduced hydro power capabilities and gave French nuclear production its worst year in three decades. Under such circumstances, power prices go up, as do the margins for coal plants. Fossil plants had to step up production, and buy additional EUAs to match that output.
A further escalation in the Middle East could be the other thing that moves the needle, Feuchtinger said. “Almost counter intuitively this could bring the profit margin of coal back into the money, and actually increase the demand for EUAs as coal requires more emissions.”
Cold spell unlikely to have impact
Another cold spell this winter, he said, would have to be extraordinary if it were to affect the EUA market. “It would have to be really hard. The one that hit us a few weeks ago would not do the job.”
A change in the carbon market rules, known as the Market Stability Reserve, or MSR, is seen as a major game changer in 2019, removing a lot of the oversupply that has historically burdened the European carbon market. The MSR is regarded as a critical tool for maintaining the integrity and effectiveness of the EU Emissions Trading System.
Implemented in 2019, the MSR works by adjusting the supply of allowances in the market based on predefined rules. Based on certain thresholds, the MSR either absorbs excess allowances into the reserve or releases them into the market. This helps stabilise the price of allowances by reducing volatility caused by an imbalance between supply and demand.
Fund positions in the EU carbon market
Further reading on Investment Officer:
- Carbon emission funds ‘look comfortable’ for next decade
- ‘Switch to low carbon era may disrupt financial system’
- ECB: disorderly climate transition will hit finance