EU emissions trading
Phase 4 of the EU emissions trading reform starts - check your purchase strategy!
Prices for EU emissions allowances have increased significantly over recent years, rising from around €5 per tonne in mid-2017 to a current level of approx. €25 per tonne (February 2020). The root cause for this is the reform of the EU emissions trading scheme (ETS): the rules for phase 4 of the EU ETS (covering the period from 2021 to 2030) have been determined, and the Market Stability Reserve (MSR) was introduced in 2019. This may cause considerable financial burdens for companies with higher CO2 emissions.
What will change in EU emissions trading
The EU Emissions Trading System (ETS) has evolved into the largest of its kind worldwide, with more than 12,000 energy production and industrial plants participating in the EU member states plus Norway, Iceland and Liechtenstein. With the end of the transition phase end of 2020, the United Kingdom will leave the EU ETS unless a linking agreement is signed. Such a linking agreement entered into force with Switzerland in 2020.
Participants will be facing extensive changes with the start of phase 4 of EU ETS.
Overview of the four key legislative changes in the EU ETS*:
- The number of EU emissions allowances auctioned off or issued free will be cut by 2.2% each year from 2021 onwards – a considerable acceleration on the 1.74% reduction envisaged by the ETS to date. These reductions are in line with the overarching goal of reducing CO2 emissions by 556 million metric tonnes between 2021 and 2030.
- Between 2019 and 2030, the set-aside rate provided by the Market Stability Reserve (MSR) will double from 12% to 24% of the previous year’s cumulative surplus.
- From 2023onwards, it will be possible to eliminate certificates from the MSR in order to cut the surplus of emissions rights.
- Certificates may also be subject to voluntary elimination. For example, certificates could be removed upon decommissioning a coal-fired power station.
The impact of these changes is already evident today, with EU ETS prices having risen from €5 per tonne in 2017 to around €25 at present. In fact, they might rise even further, considering ongoing discussions on the Green Deal, carbon neutrality by 2050, and further restrictions to CO2 targets for 2030. It is therefore crucial that affected companies fully understand the reforms, and how best to address them.
"Companies will have to change their purchasing strategy"
Ingo Ramming, Head of Corporate & Investor Solutions at Commerzbank explains the effects businesses can expect.
Mr Ramming, what do the changes in the EU ETS rules mean for business?
I would believe that two factors are important for companies. The introduction of the Market Stability Reserve leads to a significant reduction in auction supply in the coming years. This was the main driver of the significant increase in carbon prices in 2017 and 2018. The new rules for phase 4 of the EU ETS and increase of the Linear Reduction Factor will not only reduce auction supply but as well free allocation to industry.
What does this mean, specifically?
Reduced free allocation will increase the risk that companies face a deficit, i.e. need to purchase additional allowances in the market. Companies are facing significantly higher carbon costs after the jump in EUA prices and the widening EU ETS deficit. In this environment, risk management and an active procurement strategy becomes a success factor.
How do affected businesses respond to higher prices?
Behaviour of many companies has changed and we see indeed a more active approach when it comes to purchases and hedging. We work with clients, provide support when it comes to risk analysis, calculating expected exposures and explain possibilities to cover this exposure.
We expect that hedging will increase. Companies will increasingly focus on phase 4 and the implications of a carbon-constrained world following the discussions on the “Green Deal”, a net zero-pledge by 2050 and more ambitious 2030 target.
Switzerland will join the EU ETS this year. What impact will this have?
It is a good development and the link with Switzerland has a positive impact on the public perception of the EU ETS. CO2 emissions in Switzerland are low compared to the EU, as is the number of plants. Hence, the impact on supply and demand is likely to be limited.
How will the price of emissions rights develop going forward?
Our colleagues in Commodities Research expect the price per metric tonne of CO2 to remain high; they forecast the price to rise to €30 per tonne by the end of 2020, and to €33 per tonne by the end of 2021. Especially discussions in Europe concerning a ‘Green Deal’ and the potential tightening of European CO2 targets hold the risks of significant price rises. Most analysts expect price levels in the EU Emissions Trading Scheme to increase further.
How Commerzbank supports companies with risk management and emissions trading
Reforms to EU emissions trading have been adopted – prices for corresponding certificates have already risen and, according to experts, are set to rise even further. Companies can benefit from the products on offer by locking in current emissions certificate prices, thus allowing them to hedge some of the pricing risk. Commerzbank is your reliable partner, thanks to our long-standing experience in this market. In 2001, we were part of the pilot project which launched the first CO2 certificate auction in Germany. In 2004, Commerzbank concluded the first ever ISDA-documented transaction for EU emissions allowances. Benefit from our extensive and proven experience in risk management, and from our know-how as a leading player in emissions trading.
Active management of commodity price risk is increasingly important
We can always adapt our comprehensive range of services to match our clients’ specific needs. We keep our clients informed about relevant developments in the area of emissions trading, as well as legal changes and new trends. Any cooperation always starts with a precise analysis of the specific risks involved.
Whilst the active management of commodity price risk is increasingly important to companies, we will also show you opportunities pertaining to the next phase of the ETS. We support our corporate clients from start to finish in the emissions trading process – starting from the assignment of free certificates in February of each year right through to settlement in April of the following year. Based on information provided, we calculate a potential surplus or deficit of emissions allowances, presenting potential action strategies. For example, we will look at how EU emissions allowances allocated for free can be used to optimise financing costs.
Active risk management enhances planning certainty
Together with each corporate client, Commerzbank will help to develop a bespoke risk management strategy, setting out the resulting strategies. As a benefit, active risk management enhances planning certainty.
Frequently used strategy concepts include:
- Passive strategies: CO2 certificates are acquired shortly before the compliance reporting date. Sales are made at either the end of the year or quarter.
- Tactical/active trading approach: Company uses market opportunities to buy or sell emissions allowances as soon as a predefined price target has been reached.
- Hedging/purchasing strategies: With this approach, enterprises regularly define a strategy as to how certificates will be acquired or disposed of.
- Integrated risk management approach: Commodity, exchange rate, and interest rate risks are managed simultaneously.
Stronger exposure to commodity price risks compared to interest rate and exchange rate risks
Commerzbank has a broad range of instruments to help enterprises manage commodity price risks, with a specialised range available specifically for emissions trading. Given that companies have a much stronger direct exposure to commodity price risks – compared to interest rate and foreign exchange risks – there is a strong case for using these instruments.
An enterprise buys or sells EU emissions allowances for immediate delivery, and pays or receives the corresponding price. This instrument can be used for annual settlement in April, or to generate a profit through sales.
Spot purchase or sales:
A company acquires or disposes of EU emissions rights with immediate delivery and pays or receives the corresponding price. This instrument can be used for annual settlement in April, or generate profit through sales.
Forward purchase or sale:
The company sets a price today at which their CO2 certificates will be bought or sold in the future, allowing the customer to hedge against rising or falling prices.
Commerzbank buys or sells emissions rights at a target spot or forward price on behalf of the customer. This strategy can enable companies to be highly flexible.
Purchase at average price:
Emissions rights are acquired or sold at a previously defined average price. In this way, companies avoid having to settle transactions priced at historically high or low levels.
Using options, or the right to be able to buy and sell CO2 certificates, customer’s hedge against extreme price developments. These can also serve as the basis for generating premiums.
In order to manage their compliance positions, companies can exchange a set quantity of certified emissions reductions (CERs) for EU emissions rights (EUA).
By simultaneously selling EU emissions allowances on the spot market and repurchasing these on the forward market, companies can receive funds and finance themselves.
This publication is treated as customer information within the meaning of the Securities Trading Act.
This information provides information only and does not constitute individual investment advice, nor does it represent an other to buy or sell any securities or other financial instruments. This document alone does not replace individual investor and/or investment-oriented advice.
Please read Commerzbank's full important notice / disclaimer here.