Fundamentals point to higher carbon prices
In spite of the recent rally in the price of carbon traded in the European Emissions Trading scheme, analysts at New Carbon Finance believe that there remains considerable upside potential with prices expected to increase to €38/t between now and 2012. Our central price forecast has been revised upwards over the last month on the back of further delays in issuances of Certified Emissions Reductions (CERs) supply and continued increases in gas prices.
In March 2008, New Carbon Finance projected an average Phase II (2008 – 2012) price of €28/t, while the market languished near €20/t. Since then prices have continued to push higher with prices of contracts for delivery in December 2008 occasionally topping €25/t. This represents a rise of almost 25% in less than two months, registering the highest closing price since April 2006.
Our latest analysis shows that the price could now rise above €38/t at some point in Phase II. This is even higher than the price of contracts for delivery in 2014 (i.e. well into Phase III), which are trading around €30/t.
The basis for these projections is our fundamental analysis which models the marginal cost of reducing emissions within the EU ETS in order to comply with the emissions caps set by the Commission. The primary method for abating emissions is to switch from coal-burning to gas-burning electricity generation, since gas fired generation emits half as much CO2 as coal fired generation. Another option is increased use of more efficient, modern coal power stations, replacing generation from dirtier “brown coal” stations, which are common in several member states, most notably Germany. Industry also has options to reduce emissions but these tend to be more expensive.
A cheaper option still is to purchase emission reductions generated in developing countries within the framework of the Kyoto Protocol under the Clean Development Mechanism (CDM). These currently trade at €16/t, some €10/t below the EUA price. Although the supply of these cheaper credits will, in our opinion, exceed total demand in the EU ETS in the pre 2012 period, the price of EUAs will remain well above this level.
This is for two reasons. Firstly because many of these CERs will be banked into the second phase of the scheme, which runs from 2012 to 2020, thereby restricting supply in the pre 2012 period. Secondly, because the delays in issuing CERs in 2008 and 2009 will be sufficient to push companies with EU ETS compliance needs to undertake a critical level of domestic abatement in these years. This has coincided with dramatic movements in fuel prices, with gas prices gaining 15% since April, increasing the cost of abatement by fuel switching.
In principle, the market should be able to smooth short term imbalances in supply and demand through the banking and borrowing of credits, but our view is that there is not yet sufficient liquidity in this market to fully arbitrage price differentials between years, resulting in increased volatility.
By the time more CERs are available, from 2010, we expect that the market will be increasingly affected by the expected price post 2012 as pre-2012 credits can be banked into the post-2012 system. This could drive further price rises, especially in 2012, when continued high gas prices could push EUAs above €40.
The European carbon market could therefore be in for a shock unless CDM projects accelerate through the registration process or gas prices drop substantially.
“A year ago the main concern of the CDM market was that certain projects would deliver fewer credits than expected; market players now wonder if projects will deliver at all,” says Manon Dufour, Lead Kyoto Analyst at New Carbon Finance. “Increased scrutiny from the CDM Executive Board boosts the credibility of the Clean Development Mechanism, but it has also delayed the registration process and unleashed the ire of project developers and auditors. Many projects in the approval process will not be registered in time for their start of crediting period, and a significant number will never reach registration.”
Guy Turner, Director of New Carbon Finance, says: “Having analysed this market since its inception in 2005, it is clear that prices continue to be driven in large part by sentiment. The fundamentals, however, imply to higher carbon prices, and as in any market, reversion to the fundamentals will occur at some point.”
New Carbon Finance does not offer investment advice. Its analysis focuses on the fundamental drivers in carbon markets, and does not provide guidance on short-term movements.