A Different Sort of Political Risk Will Make the U.K. Carbon Market Fun to Trade

OPINION

By Mathew Carr

April 30, 2021 — LONDON: Britain’s new post-Brexit carbon market will be fun to trade, and potentially financially dangerous, because of the multiple political risks on the table.

When the market officially kicks off in three week’s time, traders bidding in the first auction and buying and selling futures contracts on ICE Futures Europe will have plenty to think about.

Initially, prices won’t trade too low because there’s a 22 pound per ton reserve price at auctions. The country also has a separate floor support system with complicates comparisons between the EU and U.K. programs (see story linked below).

The British government intends to withdraw its reserve price as the market “matures,” according to guidance updated April 28 (see link below).  “The government will consult on its intent to withdraw the auction reserve price as part of the planned consultation to appropriately align the U.K. emissions trading system cap with a net zero trajectory which will be launched later this year.”

There’s plenty for traders and potential traders to think about in that sentence right there.

But there’s also plenty of potential market shifts, should prices surge, because that’s when “cost containment” measures will kick in.

The Cost Containment Mechanism (CCM) will provide “a process for the U.K. government and devolved administrations to address significant extended price spikes in the market. The UK CCM will have lower price and time triggers in the first 2 years of the U.K. ETS when compared to the equivalent EU ETS mechanism.

This will allow quicker intervention in the early years if appropriate. If the CCM is triggered, a meeting of the UK ETS Authority is called to consider what intervention, if any, to make. If there is no agreement on what action to take, the final decision will be taken by HM Treasury (HMT). This intervention can include:

  • redistributing allowances between the current year’s auctions
  • bringing forward auctioned allowances from future years to the current year
  • drawing allowances from the market stability mechanism account
  • auctioning up to 25% of the remaining allowances in the New Entrants Reserve

All of these decisions will require complicated analysis and traders seeking to second guess the authority and then potentially Treasury will probably need sophisticated models to predict the various potential outcomes.

I imagine the U.K. cost containment system will indeed be able to be nimble compared with the EU, should prices spike. That’s what the British government is aiming for and that may prove attractive to traders. EU rulemaking is notoriously laborious, yet even so has its own logic for traders with the stamina to get to know it.

So even after EU carbon prices surged this year, the first year of the Paris climate deal, there are going to be plenty of opportunities, and risks, going forward for traders. See this two-year chart:

ICE Futures Europe EUA price chart in euros/ton. Prices as of Thursday April 29. Traded down 0.4% at 47.82 euros a ton as of 11am April 30

The U.K. market may initially dent the EU market, as traders divide their time, potentially sell EU futures to finance purchases of U.K. contracts. On the other hand, increasing interest from the wider global investment community will probably more than make up for those short-term shifts.

ICE was appointed to host emissions auctions on behalf of the U.K. governments as the new market replaces the country’s participation in the EU ETS.

According to ICE:
Full details of the U.K. Allowance (UKA) auctions, including the auction calendar, can be found here. ICE plans to launch UKA Futures contracts on May 19, coinciding with the launch of the first auction, with UKA Daily Futures following on May 21, subject to regulatory approval. These will clear at ICE Clear Europe alongside ICE’s global environmental complex, including European Union Allowances (EUA), California Carbon Allowances (CCAs) and California Carbon Offsets (CCOs).

“We believe the UK ETS will be pivotal in supporting the climate ambitions of the U.K.,” said Gordon Bennett, Managing Director of Utility Markets at ICE, in an emailed statement. “Reliable and liquid carbon and energy benchmarks are critical for markets to deliver an efficient transition from high to low carbon energy generation and carbon cap and trade programs have proved to be an incredibly successful policy tool in abating emissions.”

ICE provides access to the largest and most liquid environmental markets in the world. More than 14 billion metric tons of carbon trades on ICE annually, which is equivalent to about 40% of the world’s total annual energy-related emissions footprint based on current estimates, it said.

Environmental markets have been offered for nearly two decades. A wide and increasing group of investors and emitters use the price signals from markets and indices to help assess and manage climate-action risk in their portfolios of stocks, bonds and commodities.

February UK carbon story: https://carrzee.org/2021/02/24/five-years-later-and-after-the-fact-brexits-still-set-to-roil-europes-carbon-market/

Updated U.K. guidance: https://www.gov.uk/government/publications/participating-in-the-uk-ets/participating-in-the-uk-ets#auctioning-and-market-operation

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