The threshold that triggers the EU’s MSR to stop absorbing surplus carbon allowances from the market may have been set too high, as annual EUA demand may drop further with the changing hedging patterns or possible closures of Germany’s lignite-fired power plants, analysts said on Wednesday.

Based on the rules for the bloc’s supply control mechanism that were agreed by EU lawmakers last year, from its launch in 2019 the MSR will withdraw 12% of the allowance oversupply in the ETS annually, provided the surplus is above 833 million tonnes.

When the oversupply level drops below 400 million, some 100 million EUAs are taken from the reserve and added to annual government auction volumes.

Turn to Germany’s lignite-based power sector, the largest emitting segment of any EU member state, which is currently deep in the red due to record-low electricity prices.  This is prompting the country’s largest utilities to reconsider their forward generation hedging strategies.

Analysts at ICIS Tschach Solutions estimate that those plants will be uneconomical as long as baseload power prices are below €26/MWh, a level some €3 above where the calendar-year contracts are currently trading on EEX.  German power prices are currently depressed due to muted demand and higher capacity from renewable sources.

Those installations may also be targeted for closure by the German government as it seeks to meet its upcoming emissions reduction goals and to potentially phase out coal-fired power in the EU’s largest economy over the next few decades.

According to the analysts, speaking during a webinar on Wednesday, the carbon component of German lignite plants’ current hedges may be as high as 330 million tonnes, representing roughly a quarter of what they see as the market’s excess length.

In theory, the elimination of this demand could mean the MSR will stop absorbing EUAs from the market at a time when it is still handling excess supply – creating a scenario where EUAs are subject to artificial downward pressure from the mechanism, which is aimed at supporting prices.

However, if that were to happen, it could be short-lived as any distortions can be addressed via rule changes made when the 28-nation bloc reviews the MSR, a process that will occur every three years starting in 2022.

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The ICIS-Tschach analysts also pointed to other factors that could be contributing to low EU carbon prices, which at €5.50 on the benchmark Dec-16 contract on ICE are down by a third since the end of 2015.  The drop has been attributed to unseasonably soft demand stemming in part from utilities’ changing hedging strategies.

The analysts noted that EUA open interest levels are low in relation to previous years, suggesting that “utilities don’t seem to hold a significant amount of EUAs anymore.”

They added that this could be because of lower overall demand from the sector, or because utilities have hedged a larger portion of the less CO2-intensive component of their generation portfolios.

Looking at Q1-2016 figures reported by RWE and Vattenfall, the analysts said the two companies appear to be overhedged this year, which is resulting in reduced carbon demand of 24 million tonnes compared to last year.

That figure, the analysts added, could rise to 44 million tonnes, especially if the utilities delay their forward hedging until power prices recover.

Vattenfall this week confirmed the sale of its German lignite assets to Czech firm EPH, a deal that did not include the former’s electricity or carbon hedges.

By Mike Szabo – mike@carbon-pulse.com