The market impact of the new EU ETS compliance cycle explained by Gauthier Bily, CEO of Vertis Environmental Finance.
- In April 2023, the EU adopted the revision of the EU ETS, as part of the ‘Fit for 55’ package. This revision includes among many other elements, an adjustment of the compliance cycle. What does that mean?
The text clearly states that both free allocation and allowances surrender deadlines will be postponed from next year onwards. National authorities’ deadline to grant free allocation will be postponed from 28 February to 30 June, and the deadline to surrender allowances from 30 April to 30 September.
We understand that the deadline for submitting installations’ verified emissions remains end of March, while the publication of the Total Number of Allowances in Circulation (TNAC) shifts from 15 May to 1 June.
This change is aimed at alleviating the administrative burden of Member States by giving them more time to complete their free allocation calculations; a move that will provide additional time for compliant entities to meet their obligations in 2024 and is likely to change their current trading seasonality.
- What will happen to the contracts? Will the December contract still remain the benchmark?
We expect a shift in importance of some of the pre-compliance contracts, notably in June and/or August – Summer becoming peak season – while the March contract should in theory drop in importance. Yet, we do not expect the December contract to lose its benchmark status as it has been the benchmark for years even though compliance was due by end of April and having the most liquidity. Traders will likely continue to use it as the go-to source for their trading operations.
To confirm which contracts will gain in relative relevance, we will have to monitor the moves of some of the companies with the biggest positions – For instance, RWE’s traded volume was majorly impacted when it switched to the March contract for some of their hedging activities back in phase 3.
- Will the August auction remain the same?
Trading activity during Summer traditionally goes at a slower pace given the holiday period. That is why August has historically seen a drop in supply through a reduction in auctioned volumes, to bring the drop in demand somewhat in line with a drop of supply. This year for instance, auctions dropped from 48m in July to 27m in August.
The question now is whether this is still workable if compliance happens just after such a month. To date, we observe that some companies wait almost until the last minute to buy their compliance needs. Such behaviour however could lead to a greater volatility at a critical time – a scenario that could be avoided by simply maintaining regular auction volumes in August from next year onwards. The draft auctioning regulation that got published end of July makes a hint in that regard, but more clarity on this topic is expected this Autumn when the final auctioning regulation is due to be published.
- How is this affecting compliance buying behaviours?
In fact, we already see that some companies are feeling less compliance pressure as they consider they have more time to buy. The success of this strategy depends on how the price will develop from here. In a bull-market, any opportunity to buy below the 200-day moving average is a good opportunity for buyers. Some market participants expect a bear market for the rest of the year and going into 2024. Anything is possible of course, but what could happen is that we see some sort of backloading of compliance demand, which could add further downward pressure to the next weeks or even months, but a stronger uptick in compliance demand next year – leading to a relatively short time window for the bears to be successful.
In addition, we have seen a drop in utility hedging since the liquidity squeeze last year. The big question is if and when these actors will go back to “business as usual”. The possibility of a reversal of this downward trend may lead to a tightening of EUA demand. While perfect timing may be difficult to predict, we would advise compliant entities to not be the ones holding the bag if and when the tide turns.
We should also not forget the major overhaul of free allocation that the ETS reform has brought. We expect a 9.5% average drop of free allocation by 2026 compared to 2025 merely due to the benchmark reduction. In some sectors, that drop will be even much more extreme: Some companies can expect a 34% drop of free allocation between 2025 and 2026 due to the benchmarks alone. On top of that, companies which are not carbon leakage exposed will see their free allocation fully phased out by 2030.
In addition, the new conditionality rules can lead to a 20% drop of free allocation. Due to the reclassification of the scope of the Energy Efficiency Directive, we expect virtually all ETS covered firms to be required to implement and follow energy audits in order to not fall under the haircut. Add on top of that CBAM and it becomes evident that the “old days” of buying just before the compliance deadline will more and more be a thing of the past.
- You mentioned the change in participants’ trading behaviour due to the changes to the compliance cycle. How do you see hedging behaviour among industries?
We anticipate two potential behaviours: purchasing only when price drops and hedging for future emissions. The last one is expected to gain ground among industrial market participants, especially those that turn from winners to losers due to the phase-out of free allocation and phase in of the CBAM obligations. The best example for that is the metal sector.
At first you would think that the sector is protected against sharp drops in free allocation, which is kind of implied under the derogation from the minimum and maximum adjustments to the benchmark between 2026-2030 (the hot metal benchmark is the only one that retains a minimum 0.2% annual reduction). The reality is that the iron and steel industry will likely see around 55% less free allocation in 2030 than what it had received in 2021. This loss translates into 88 million EUAs or about €8 billion if we assume no further price rise to the H1 2023 average carbon price.
While navigating the hedging waters, industries might also accelerate their decarbonisation plans to avoid the fattening emissions bill.
Gauthier Bily is CEO of Vertis Environmental Finance – www.vertis.com
Any opinions published in this commentary reflect the views of the author and not of Carbon Pulse.
