After testing the upside above €100/t in February, and the downside below €80/t in early June, the European carbon front-year contract has traded sideways, close to €85/t, so far in Q3. The ongoing drop in fossil power emissions is reducing 

 is increasing due to the front-loading to help finance the REPowerEU programme.

The fact that carbon has managed to trade sideways amid these strong headwinds is largely explained by supportive anticipation of the supply-tightening adjustment of the ETS that will take effect in January 2024

We attribute the timid movements in August mainly to the addition of the first REPowerEU volumes to the daily auctions and to more clarity over the remaining volumes with the newly released 

. Furthermore, in August, we observed support from a technical level around the €85 level, and from the temporary holiday lull in auction volumes. See price movements in Figure 1.

EUA price through 2023

Emissions from Europe’s power sector are declining, after a rebound in 2022, when coal burn increased temporarily to cover for some of the gas that disappeared from the power mix. The first half of 2023 saw overall demand for electricity decrease by 4.7% compared to H1 last year.

We expect European power demand to pick up only very slowly, especially from industry, given the backdrop of persistent high inflation, and a generally gloomy economic outlook. This reduces utilities’ needs for EUAs and we expect this will weigh on carbon prices this quarter and into the next one.

Based on generation data for the first half of 2023, and our modelling of coal and gas burn for the rest of the year, we forecast power sector emissions to drop 21% from 2022. For a more detailed breakdown of generation trends by fuel type and country, see our recent analysis 

European power emissions set to drop 21% in 2023

The best gauge for predicting the fuel mix going forward is to look at the relative cost of coal- versus gas-based power generation. Figure 2 shows that the fuel switching curve for 39% efficient coal to 50% efficient gas favours less emission-intensive gas in the front and end of the forecast curve. Compared to May, we now see gas in the money also in Q4 of 2023.

The current fuel prices have priced the risk of tight gas supply during winter, suggesting more coal burn in 2024. However, if Europe is exiting winter with solid gas storage and supply, we could see a similar drop in prices bringing gas back in the money.

STPF23: CO2 Fuel Switching Price, Forward Curve

Industrial emissions stable from last year’s drop

Europe’s manufacturing industries scaled down production (and their appetite for EUAs) in 2022, in response to skyrocketing energy prices. Emissions from industries covered under the EU ETS were down 7%. Production data for the first months of 2023 largely shows no rebound from last year.

A recent estimate from Eurostat revised economic growth (all sectors) in Q2 down from 0.3% to 0.1%. Looking ahead, the European Commission recently published the summer economic outlook revising its forecast for 2023 from 1% to 0.8%. For 2024, it expects 1.4% growth (down from 1.7% in its previous forecast).

Stagnant growth means stagnant emissions. Even though energy prices have largely come down to pre-war levels, we do not expect industrial activity to pick up substantially in the near term, as the backdrop of inflation, elevated interest rates, and general economic uncertainty suggest weak growth.

Overall, we expect the manufacturing industries' needs for EUAs to remain limited, with 2023 emissions in line with last year’s level. For 2024 we expect a slow recovery for industrial activity.

MSR to absorb less, frontloading for REPowerEU, but also cap tightening

As for the supply side, we are now in September – the first month of the annual Market Stability Reserve (MSR) cycle. The intake to the MSR for the next twelve months – the volume that is kept away from the market – is determined by the TNAC number (total number of allowances in circulation) published by the European Commission in May on the back of 2022 verified emissions. This year’s number showed the largest drop in available volume since 2019, the year when the mechanism came into operation. From this month, the MSR soaks up fewer surplus allowances than over the past twelve months, meaning more will be offered at the daily auctions.

Also on the bearish side, REPowerEU volumes are added to the auctions: 35 million EUAs will be sold for this purpose in 2023 (16.1 million front-loaded member states auction volumes and 19.1 million repurposed from Innovation Fund) and 86.6 million EUAs are stipulated to be auctioned in 2024.

More clarity on the volume and timing of the REPowerEU sales is a new element compared to when we published our previous forecast in May. First, the EEX auction calendar for the second half of 2023 was updated on 21 June, then, in late July, the European Commission presented a draft revision of the Auction Regulation, to allow for the front-loading of EUA volumes originally foreseen for later years. We attribute carbon’s weak performance over the last couple of months mainly to this improved clarity.

Full clarity will only be achieved once the Auction Regulation revision is complete, probably in January 2024. Then, the EEX auction calendar can be updated to include the additional volumes. Then, some four weeks later, the actual sale can start.

Note that the 2024 REPowerEU volume might end up lower, as it is calculated based on actual auction prices. A higher price means a smaller volume needs to be sold to reach the target value. For more details, see 

Turn the volume up: REPowerEU supply set, but not in stone

So far, we have looked at elements that are set to 

 the supply of EUAs. We need to keep in mind that by far the most important adjustment in January is the implementation of the revised EU ETS parameters that will set the EU ETS sectors on the path to achieving a 62 per cent reduction of emissions in 2030 compared to 2005.

This translates into an increase of the Linear Reduction Factor (LRF) from 2.2 to 4.3% (from 2028 it will be 4.4%), plus an extra cut of 90 m EUAs in 2024 (and another 27 m in 2026).

While these supply cut adjustments have been known for more than a year – and have to a large extent been priced in – we expect they will exert an increasingly bullish effect on carbon as we approach the date of implementation. 

Market behaviour: technicals suggest room to the downside

In addition to the basic supply and demand balance, prices tend to react to various non-fundamental elements, such as hedging, technical analysis, the disclosure of holding positions of different types of market participants, and others.

The long-term bullish trend which started in October 2022 supported EUA prices for the first half of this year, leading to relatively strong EUA price performance, given overall bearish fundamentals. However, the EUA Dec-23 contract reversed its direction in late June, dropping below the bullish trend support line and reaching almost the lows from the beginning of the year at €77/t. Despite a short-lived recovery in July, the front-year carbon contract fell off the bullish trend channel once again in August. The downward move was preceded by the “death cross” pattern (the 50-day moving average dropping below the 200-day moving average), which normally suggests a bearish shift in momentum. The lower highs from the end of June, July and August cemented the bearish picture. Since the end of August, the EUA Dec-23 contract has been trading in a clear bearish trend, dropping below all the major moving averages.

Currently, the front-year carbon contract is trading below the August low, which opens further room to the downside. The only thing that could stop the bearish trend is the support area between €77/t and €78/t. This level has provided a floor to EUA prices on many occasions, namely in January, April, and July 2022 as well as in January and June this year. Given the strong performance of this level, the probability of discontinuing the bearish trend is very high. However, if this level is broken, the EUA Dec-23 contract might revisit the lows from October last year, around €67/t. Overall, we expect EUA prices to find a floor at €77/t and halt the downside move. For any upside potential, the front-year carbon contract would need to recover above the 50-, 100- and 200-day moving averages.

Less hedging, drop in specs’ open interest positions

Commitment of Traders data indicate that hedging activity has been lower in 2023 than during the past two years. This is not entirely unexpected given the fall in power emissions. With a switch from gas to coal expected no earlier than January 2024, hedging needs for 2023 are simply lower. Hedging speed is picking up in comparison to 2022 as we approach the autumn and winter months.

The behaviour of financial entities in the EU ETS has been in the spotlight since 2021 as volatility in the market is often ascribed to speculative trading. In line with the decline in hedging activity, open interest in non-hedging activities has fallen gradually since 2021. As of 2 September, open interest from specs is at 81% of 2022 levels.

Overall, this paints a broader picture of falling open interest across groupings of actors. If the trend continues and we see interest in the carbon market wane, there is a risk that liquidity will suffer. However, we view this development as market recognition of the underlying bearish demand picture for carbon in 2023. With hedging speed picking up ahead of Q4 (particularly if the autumn/winter proves colder than expected), we may see OI close the gap between 2023 and 2022 levels.

The looming supply cut from the new ETS parameters is clearly the single most important bullish element now, and in the years to come. As we have already said, we believe much of the effect is already priced in, but we do expect it will continue to support the carbon price as we approach the date of implementation.

On the other hand, the prospect of additional EUA supply in 2023 and 2024 has been on the cards since May 2022, when the Commission first proposed monetising EUAs for part-financing REPowerEU. Yet, the renewed attention following the recent revision proposal has clearly weighed on the EUA price and is also the main reason we take down our Q3 and Q4 forecasts compared to what we predicted in May.

Overall, the supply side picture presents counter-acting impacts for 2024. Weighing cap tightening versus REpowerEU frontloading means assessing the effect on the near-term annual balance (one year ahead) versus the more long-term effect (three years ahead) on the annual and aggregate balances.

In Figure 3 we show various factors that are likely to affect the EUA price going forward. Most importantly we see the switch to a more aggressive linear reduction factor (LRF) that will cut supply by around 84 million annually (compared to 43 under the current regime), and a so-called ‘rebasing’ that will cut another 90 m.

On the other hand, we see the monetisation of some 87 m EUAs for REPowerEU that will add to the available supply and weigh on prices.

The average EUA price between 1 July and 15 September is €85/t. We expect that to be the average level throughout Q3. The looming implementation of the new ETS parameters should provide support, but this will likely be balanced out by dwindling demand from the power sector.

The above-mentioned drivers will remain relevant also in Q4, again with little prospect of coal-based electricity generation. The supply cut will be increasingly imminent though, and likely to provide more upward push. We also expect some additional support coming from the expiration of the December 2023 futures contract (roll-over to the 2024 contract), and the December option expiry. Furthermore, the absence of auctions in the last two weeks of the year normally adds an extra layer of support. In sum, we predict a Q4 average price of €88/t.

In 2024 the supply of EUAs will be significantly reduced as a result of the new LRF and rebasing. Also, in early 2024 we expect more coal burn, based on the current fuel-switching curve. How much depends on gas storage levels, which again depends on temperatures. Overall, we expect fuel switching will provide support for the EUA price in Q1. The bullish effect will probably be partly offset by the approximately 87 m EUAs that will be auctioned for REPowerEU. The exact timing of this will be known once the revised Auction Regulation enters into force and the EEX auction calendar is updated. 

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We lower our short-term carbon price forecast in response to a sharp drop in power emissions, an expectation of limited coal burn throughout the rest of this year, and the prospect of additional EUA volumes coming to market through the REPowerEU sales. We believe the EUA price is still bolstered by general anticipation of the supply cuts that will take effect from January 2024. We now expect the EUA price to average €85/t in Q3, down €5 from our previous forecast in May. For Q4 we predict an average price of €88/t, assuming additional support from the expiry of the Dec-23 contract and the lack of auctions in the second half of December. We expect the price will continue to inch up and average €90/t in Q1 of 2024, supported by the implementation of the fit for 55 legislation and a return to coal-based electricity generation.