How ECB Policy Helps Squeeze This $48 Billion Energy Market

  • Carbon for this year and 2017 at smallest gap in 10 years
  • Reduced utility demand, record low interest rates cut premium

The $48 billion market in European pollution credits is sending some interesting signals about the state of the region’s energy industry.

QuickTake The Cost of Carbon

Carbon emission futures for this year are trading at the smallest discount to longer-dated contracts in more than a decade, with reasons ranging from European Central Bank negative interest rates to nuclear power plant outages. Next year’s premium has narrowed to near zero, signaling little price growth in a market where pollution costs are meant to rise over time to encourage emission cuts.

The last time forward spreads were this small was when the European Union was setting up the emissions trading system. Back then, traders were more concerned about whether carbon permits could even be allocated properly, much less about the workings of the market in two years’ time.

Here are four reasons why carbon prices are set to stay on hold:

A place to park cash

Companies, banks and investors, hurt by the ECB’s negative interest rate policy, use carbon markets to protect their cash. By buying permits and simultaneously selling them forward at a slightly higher price, a business can lock in a return with no currency risk, according to Commerzbank AG.

“Negative interest rates in the euro-zone have been creating demand from investors in the carbon market,” said Ingo Ramming, the London-based co-head of commodity solutions for Commerzbank, who has followed the market since it began in 2005. 

The trade’s popularity has helped narrow the difference between one- and two-year contracts by 90 percent this year to as little as 1 euro cent ($0.011) per metric ton. That compares with an average spread of 20 cents over the past five years. Benchmark December 2016 futures rose 1 percent to 5.79 euros a ton on ICE Futures Europe exchange in London.

Surge in fossil-fuel demand

Allowances surged 19 percent last month, the most since February 2014, as Electricite de France SA halted some nuclear reactors for safety inspections. That spurred additional demand for natural gas and coal-fired power.

Utilities had to snap up carbon allowances to cover the increased output of dirty power from fossil-fueled plants just as winter arrived. That caused near-term, or prompt, prices to rise faster than those for longer-dated contracts, further narrowing the price differential.

“The prompt has been so strong,” said Trevor Sikorski, an analyst at Energy Aspects in London. “The arbitrage is getting squeezed.”

A Decline in Hedging Needs

A glut of carbon permits is also stifling urgency to buy emissions permits in future years. After governments handed out more allowances than needed to factories and utilities just as economic growth weakened, a surplus equivalent to a year’s supply of pollution rights has built up since 2008.

Swedish utility Vattenfall AB has said it’s less inclined to buy carbon in advance to lock in profit on future power sales amid increasing levels of renewable power, which don’t require the permits. Such hedges are even less attractive as the profit from burning coal for power in Germany fell below zero for the first time this month. Enel SpA, Europe’s biggest utility, sold 60 percent of its power for delivery next year in Italy, compared with 80 percent at the same time in 2011.

“The way power markets are going, liquidity beyond 12 months is increasingly drying up,” said Mark Meyrick, the trading and origination director at Good Energy Group Plc in Chippenham, England. Volatile, short-term power markets influenced by renewables means “this is where companies are having to focus their risk management.”

Donald Trump’s election as U.S. president may also spur some nations to hold off on climate action, curbing ambition in Europe, according to Mark Lewis, an analyst in Paris with Barclays Plc.

Supply Will Surge Next Year

This year marks the end of a three-year attempt by the EU to reduce its carbon permit glut by withholding 900 million metric tons of allowances, or about half a year’s supply, from auctions held almost daily. Such sales will jump 28 percent next year, while actual emissions in the market will drop 2.9 percent, according to Sikorski at Energy Aspects.

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