OPINION/ANALYSIS
By Mathew Carr
Aug. 17, 2021 — (LONDON): The plan published July 14 by the European Commission to further tighten the world’s largest carbon market is seen creating a squeeze that might cause emission allowances to rise too high, too fast. (See note 1)
Commodity markets are changing, and there are many investors who are looking for a way to hedge their bets that oil, natural gas and coal will continue to rise. Some are hedging by buying EU carbon allowances, so they don’t lose out too much if crude was to plunge, for instance.
Such purchases are sometimes part of a risk-management process.
In other words, they are not about environmentalism, they are about protecting profits, said Thierry Bros, a market analyst with 30 plus years of experience looking closely at energy markets.
“It’s a new asset class,” Bros said late Aug. 16 London time by phone. “This is an investment asset class, not a green asset class.”
The reason why European policymakers should be careful is the EU carbon market is the only highly-liquid hedge option in the world. Other carbon markets, including that started by China in the past few months and California’s, do not offer the same ability to enter and exit the market without pushing prices around.
It’s difficult to say how much of the outstanding, or spare, allowances in Europe’s market are held by speculators and how much is held by compliance buyers who may need to use them in the future for the purposes of complying with the region’s emissions cap, Bros said.
The lawmakers and their advisors appear to have a limited understanding of what the size of the hedge is, he said.
Even though they are not sure about how many of the spare allowances have been purchased for compliance and how many have been bought to protect against market risk, the policy makers have still proposed a further tightening of the market, where prices have more than tripled — almost quadrupled — since the beginning of the pandemic (see chart below).
“I don’t think they should do policy this way,” Bros said.
The European Commission plan is being considered by member states during the next few months, or potentially, years.
Traders are buying EU carbon allowances both to hedge a scenario where their fossil fuel investments may fall because of upcoming policy and some are probably buying because they want to help protect the climate, in which case they will hand in the allowances to governments for cancelation, rather than sell them.
Purchases of EU carbon allowances are only “green” where they are handed in and cancelled, otherwise it is a hedging transaction, Bros said.
“If you want to be green, you have to surrender the EU allowances. This is the only way, for me, to be green.”
If a trader wants to “make green” their purchase of a barrel of Brent crude oil at the Aug. 16 price of $69.37 per barrel by surrendering EU carbon allowances, he or she needs to buy the equivalent of about half a ton of carbon-dioxide, which is valued at the equivalent of about $34.24 per each barrel of Brent, according to ICE futures data and Bros’s estimates.
These trades, should they become even more popular, will probably fundamentally change the end value of both crude oil and EU allowances.
The EU will need to further consider the future rules of its market — to account for the inward flows of money for fossil-fuel hedging purposes, and also for carbon removal — negative emissions, Bros said. “There will be further tweaks needed going forward. This needs to be taken into account now.”
NOTES
2. EU carbon settled Aug. 16 at a record high 58.16 euros a ton, the first time it settled above 58 euros since the market started in 2005:
(More to come)