DIALOGUE: What does the MSR deal mean for the EU ETS and its allowance prices?

Published 14:51 on May 6, 2015  /  Last updated at 00:30 on October 29, 2015  /  Conversations, Dialogue, EMEA, EU ETS  /  No Comments

EU lawmakers have reached a provisional agreement to start the MSR in 2019. We asked some of Europe's leading carbon analysts to weigh in on it and consider the deal's effect on the market and EUA prices.

Carbon Pulse Dialogues are discussions about carbon markets and climate policy by a selection of leading experts.

EU lawmakers reached a provisional agreement on the MSR late on Tuesday, and analysts say it could triple EUA prices by the end of the decade while bringing much-needed clarity and investor confidence back to the market.

The deal increases the ambition of the European Commission’s original MSR proposal, calling for a 2019 start rather than 2021 and for hundreds of millions of backloaded and unallocated allowances to be put in the reserve instead of entering the market.

It also prevents the MSR from touching, between 2021 and 2025, any allowances in a ‘solidarity fund’ for poorer countries, and invites the EC in its upcoming ETS Directive review to consider if up to 50 million EUAs should be put in an ‘innovation fund’ to help industry.

The deal still needs final approval by EU lawmakers in the coming weeks, but we asked some of Europe’s leading carbon analysts to weigh in on it and consider its effect on the market and EUA prices.

**Click here for an rundown of how the MSR will work**

Philipp Ruf, Lead Analyst - EU Carbon Markets, Tschach-ICIS. @ICIS_energy

Philipp Ruf, Lead Analyst – EU Carbon Markets, Tschach-ICIS. @ICIS_energy

Marcus Ferdinand, Head of EU carbon analysis, Thomson Reuters Point Carbon. @MFoslo

Marcus Ferdinand, Head of EU carbon analysis, Thomson Reuters Point Carbon. @MFoslo

Matteo Mazzoni, Market Analyst at NE Nomisma Energia. @MatteoMazzoni

Matteo Mazzoni, Market Analyst at NE Nomisma Energia. @MatteoMazzoni

Trevor Sikorski, Head of natural gas, coal and carbon, Energy Aspects. @EnergyAspects

Trevor Sikorski, Head of natural gas, coal and carbon, Energy Aspects. @EnergyAspects

Paolo Coghe, European power, coal and carbon analyst, Societe Generale.

Paolo Coghe, European power, coal and carbon analyst, Societe Generale.

 

Philipp Ruf, Lead Analyst - EU Carbon Markets, Tschach-ICIS. @ICIS_energyPhilipp Ruf – 0658 GMT: The deal constitutes a strong outcome. The MSR, with the design decided on yesterday, will effectively reduce the EUA surplus at end of Phase 3 (2013-2020) by taking over 1.5 billion allowances out of the market and transfering them directly to the reserve. This will, to a large extent, solve the supply-demand imbalance piled up in Phase 2 (2008-2012).

Post-2020, the MSR will make the EU ETS more resilient against external demand changes that could emerge from several sources, such as faster technological development and lower than expected economic growth.

One key feature that determines the ambition of the deal is the direct transfer of unallocated allowances (approximately 610 million) to the reserve, as this provision shields the EU ETS from being flooded with credits in 2020.

The early start date secured by (western EU governments) and parliament smoothens the transition to Phase 4 (2021-2030), but the exemption of the solidarity allowances until 2025 has no implication on the market as it simply re-distributes revenues between member states in a different way.

For now, our mid-term EUA price forecast is unchanged as it already includes speculative trading on the back of an agreement on the MSR by summer 2015. On the compliance side, we expect market participants to only gradually align their CO2 trading strategies to the new post-2019 regulatory setting.

Regarding the long-term forecast, we are currently modelling the nitty-gritty of the new deal. Towards the end of Phase 3, we expect prices to increase above €20, then evolve above €30 in the beginning of the next decade. For 2030, we see prices at around €40, meaning that the rate of increase flattens in 2021-2030, achieving one of the MSR’s objectives: a more stable carbon price.

 

Marcus Ferdinand, Head of EU carbon analysis, Thomson Reuters Point Carbon. @MFosloMarcus Ferdinand – 0728 GMT: The deal is very balanced. With a 2019 start date, it starts soon enough to prevent backloading from just being an ineffective quick-fix. Market participants have clarity now that the oversupply will continue to be reduced during Phase 3. Moving unallocated and backloaded allowances into the reserve prevents a huge supply overhang towards the end of this phase and will lead to a more steady price trajectory.

As is with all negotiations, in the end it was a give-and-take and everyone had to deviate a bit from their initial positions. That said, Germany and UK did not get the 2017 start but still achieved a strengthening of the initial Commission proposal by moving, according to our estimates, around 1.3 billion backloaded and unallocated allowances into the MSR. Eastern European member states will be happy about the ringfencing of the solidarity fund until 2025. The 2019 start date was a natural compromise by taking the mid point between 2017 and 2021.

If someone would have told the market that this would be the outcome when the Commission’s intial proposal was put forward in Jan. 2014, it would have been considered as a very ambitious mechanism to tighten the market. This will provide market participants with greater confidence that the oversupply will decrease with a steady pace. It will, in our view, re-instil the faith of investors in the EU ETS’ price signal, allowing them to take more confident decisions when investing in abatement measures and technologies.

Regarding the price impact, we think this agreement will push EUAs gradually higher from where they are today, reaching (in real 2014 terms) €15 in 2018, €19 in 2020 and €32 in 2030 (not accounting for the sale of 50 million units via the innovation fund).

In the near-term, we expect the Dec-15 EUA contract to test the year-to-date high €7.90 amid lower volatility.

 

Matteo Mazzoni, Market Analyst at NE Nomisma Energia. @MatteoMazzoniMatteo Mazzoni – 0818 GMT: It’s indeed a strong and balanced compromise which sees basically just one loser: Poland.

 

The major breakthrough here is higher certainty. Operators now know that the market is going to change and that the huge surplus will not last forever. And even though the MSR does not create actual permit shortages, the idea that there’s a certain limit above which allowances will not flow into the market is something radical and may lead to perceived shortages in the mind of many operators.

That said, this does not change our short-term EUA price forecasts much, except that there’s going to be a larger portion of daily movements now connected with the market’s general enthusiasm (or lack of it). We don’t see any major upward movements in the coming weeks. The chances of prices getting anywhere near double-digits by the end of this year are infinitesimal.

However, starting from 2018, our forecasts will likely be more bullish. The market is now more certain that there will not be any major dumping of allowances at the end of the period, and that the MSR will be already operational by 2020. Even though the market will still remain oversupplied for a great part of Phase 4 (2021-2030), the surplus will fall year after year, adding upward pressure to EUA prices.

 

Trevor Sikorski, Head of natural gas, coal and carbon, Energy Aspects. @EnergyAspectsTrevor Sikorski – 1222 GMT: The MSR, with the inclusion of backloaded and unallocated volumes, sees the market go short of inventory by 2019, and that shortness continues to expand as the market goes through to 2025. Under our modelling, the MSR peaks with an inventory of almost 2.4 billion tonnes, with the implication it will take 24 years (2028 to 2052) to empty it, with a withdrawal rate of 100 million tonnes per year.

As a result of these market balances, our price forecasts remain the same with and without the MSR in the period out to 2018. This is based on the model framework that has the market looking out three years in terms of demand (the demand for hedges) and assumes all the hedges are backed up with physical carbon (the existing supply and inventory).

While the impact of the MSR will be likely to also eventually change the willingness of the market to supply hedges, necessitating higher prices, we mainly expect to see that once we get much closer to the start date.

From 2019, expected prices begin to diverge with changes in the market inventory levels falling given the start of the MSR, putting upward pressure on the EUA prices. This opens up a big difference in the market balance between the two cases and price paths (i.e. with or without the MSR), with 2020 forecast prices at €21 compared to €2, and 2025 forecasts up at €42 compared to €9.

Given the MSR, the EUA market goes through a period of strong trend volatility, due to the transitioning from a market balancing from inventory, to one balancing from short-term abatement (fuel switching).

The MSR package is highly supportive of prices at the end of this phase compared to the case without the package in place, but we expect that the initial impacts on price formation to be limited.

 

Paolo Coghe, European power, coal and carbon analyst, Societe Generale.Paolo Coghe – 1428 GMT: Yesterday’s provisional deal – the final details of which still need to be fully examined and verified – is a good compromise. We updated our change point analysis (CPA) just ahead of the MSR deal, finding that, over the past year or so, the market has seen EUA prices settle into a path of ‘comfortable’ growth of about 0.7% per week. If applied forward, this growth rate would yield Dec-15 prices of about €9.50. However, the current technical outlook confirms that EUA prices continue to be bound on the upside by strong resistance at €7.50-7.65. Against this backdrop, we reiterate our current forecasts and see Dec-15 EUA prices at expiry at €8.30. Thereafter, on account of regulatory measures slowly working against the surplus, we see Dec-16 EUA prices averaging €8.50. We anchor our forecasts for the rest of Phase 3 to this base.

Compiled by Mike Szabo – mike@carbon-pulse.com