SEFE Marketing & Trading Insight: Is the emissions market blinded by COVID-19?

covid 19 emissions impact

Julia Elmgren, Carbon Trader at SEFE Marketing & Trading, shares her insights into what the future holds for the emissions market in the current pandemic.

julia elmgren

Julia Elmgren, Carbon Trader

Global emissions have taken a real beating this year. And expectedly so – with the spread of the novel coronavirus, many countries have implemented either lengthy complete lockdowns or at the very least closed schools and introduced new social distancing rules.

Recent reports suggest global emissions as a whole are down at levels last seen in 2006, or by 8.6% over the period from January-April, compared with 2019. This is good news for environmentalists, but also lends itself to another very sobering thought: we would need to maintain the same rate of annual reductions in emissions for a whole decade, to have a chance of limiting global warming to 1.5°C by 2050.

Limiting global warming to a scientifically acceptable level is, of course, the main aim of the Paris Agreement and the global talks that surround climate change. But will there be enough political will to maintain the momentum on the recent climate change ambitions in the face of one of the most severe recessions we have had to endure?

How is Europe responding?

In Europe, I think the answer is a resounding ‘yes’. Here, climate change has been at the forefront of political ambitions from the start, and despite the hard hit that economies will go through this year, the EU has in recent weeks made it clear that it will not let climate change drop to the back of the agenda.

The European Commission, with its heavily publicised Green Deal, is currently conducting an impact assessment for the proposed 50-55% emissions reduction target by 2030, and they’re sticking with the timetable they initially set. The impact assessment is due in September, with a Parliamentary vote on its tighter targets scheduled for October.

european union flags

If we look more closely at the flagship emissions scheme of the continent, the EU Emission Trading Scheme (ETS), this year, emissions are expected to be down by about 200-250Mt compared with 2019. This is a significant amount for a system that is set by relatively static annual allocation methods, and that struggled to cope with a similar sudden reduction in emissions back in 2009.

Even before COVID-19, 2020 was a year of relative slack with high auction volumes (mainly due to the 2019 auction volume from the UK coming to market in 2020) and low gas prices that were set to continue the ‘fuel switching’ trend of 2019. As the pandemic hit the continent, renewable power generation remained healthy, but with peak power consumption down by up to 25-30% during some weeks, lignite and coal burn was severely hit.
On the industrial side, steel and cement plants were mostly completely shut down, and the expected slow opening of the wider economy with regards to for example car sales, has led to a forecast drop in emissions of around 20% year on year.

So, with this big drop in emissions, why are EUAs currently trading at pre-COVID levels?
The answer lies in the future. Not only are tighter emissions targets imminent from next year when Phase IV of the EU ETS starts, which is likely to incentivise long position building by both compliance and speculative players, but most importantly one can also identify the continuation of a big shift in the behaviour of market participants that started in 2018 – particularly that of industrials.

In the industrial sector, the majority get their emissions allowances allocated for free, so they could easily sell any banked surplus in moments of distress. However, with the prospects of the new 2030 targets, and thus reduced allocations, more and more companies are reporting forecasts of higher prices in the future. Logic thus dictates that they are less likely to part ways with their allowances now.

Additionally, many companies, especially in the emissions-intensive cement and steel sectors, have announced their own internal targets to reduce emissions, and have started implementing pilot projects to that end. This is certainly part of the reason why prices for allowances in the EU ETS have retained their relative strength.

And to visualise the expected effect of the Paris targets on the EU ETS, I have shown in the chart below just how tight the EU ETS is set to get under the proposed 50-55% target (with a 1% annualised drop in emissions) until 2030.

Germany and France spearhead a move to lower emissions

On the political front, Germany, who will shortly take over the EU presidency for the second half of this year, are also taking the lead and recently unveiled a very green stimulus plan of some €130bn focusing on weaning the country off fossil power and petrol cars. In addition, not only have they announced an increase to the carbon price in both transport and heating sectors scheme starting next year (from €10/t to €25/t), but have also joined France in calling for a floor price for the EU ETS. Both of these issues point towards strong political support for a high carbon price, and crucially for more sectors to be covered by the EU ETS.

The continent should be confident that the EU ETS is a suitable tool for lowering emissions – one must only look as far as the power sector for assurance, where emissions are down by roughly 30% over the last decade. This is as a result of both the expansion of renewable generation and more recently by the improved economics of natural gas power generation, encouraged by the long-term targets set by the EU and which together have displaced a large part of Europe’s old coal and lignite generation fleet.

energy emissions

What the future holds for emissions reductions

So how do we make sure that we achieve the emissions reductions over the next decades as seen in the power sector, in the wider economy without the economic chaos of a pandemic?

Compelling cases are certainly being made to attach environmental conditions to the economic stimulus and state-provided loans. This would guide the continent on to a more sustainable emissions trajectory whilst ensuring jobs are maintained.

Encouraged by its success stories, Europe should feel confident in its chosen policy tools to combat climate change and should swiftly strengthen its climate targets, tighten the cap of the EU ETS, and roll out carbon pricing to further sectors.

And finally, by looking at the big divergence between current expected emissions and the proposed Paris targets in the EU ETS, it’s clear that the current situation is not tenable, and something has got to give – the EU ETS simply cannot be 1.5bn tonnes short of CO2 in 2030. The European recession will not last a decade, and when economies do begin to hum again, rest assured that, sooner or later, significantly tighter targets will give out strong signals for EU ETS installations to reduce emissions. This is, after all, the beginning of our only chance for Europe to do its part in limiting global warming to 1.5°C by 2050.

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