After Topping Commodity Gains in 2018, Carbon Set to Surge Again

(Bloomberg) -- The cost of pollution in the European Union’s cap-and-trade system is likely to surge again next year, contributing to rising electricity costs that are already uncomfortable for industry.

Carbon futures, reflecting the price factories and utilities pay for their emissions, tripled in 2018, making it the best performing major commodity of the year. Those contracts may surge again in 2019, by 20 percent to near $29 a ton or more for the first time in more than a decade, according to the median forecast of 13 brokers, analysts and traders surveyed by Bloomberg.

The gains are already roiling energy markets, driving up power prices across the continent and giving utilities an incentive to burn more natural gas than coal. Another surge in 2019 will put under pressure the government officials and lawmakers who were architects of the increase this year as they sought to restore the credibility of carbon as a tool for reining in greenhouse gas emissions.

“There will be rumblings from east European countries and some big energy intensive companies if we hit 35 euros to 40 euros next year,” said Jahn Olsen, an analyst at Bloomberg NEF in London. “The EU might not react if it happens gradually and reaches that level in November or December. Intervention is more likely if we get there in February.”

Higher carbon costs have fed through to the cost of electricity, with German, French and British power prices trading well above their five-year average. It’s also kept gas prices stronger than usual for the time of year.

Those gains awakened concerns industry and consumer groups have voiced for years about energy costs in Europe, which in some markets are more than double U.S. levels. French President Emmanuel Macron this month backed down to protests over fuel taxes, and German Chancellor Angela Merkel is working to slow the pace at which coal plants are being closed after an increase in electricity costs. Large power-consuming industries have expressed their discomfort about recent gains in prices and attributed the shift largely to carbon.

“This pressure will only increase and may cause further competitiveness challenges,” Eurofer, the European industry group for metals, said in response to questions. “The allowance is becoming tighter and tighter, so there isn’t much room for selling them. Some producers will already be facing a shortage, and others will soon come up against it.”

In normal markets, higher prices encourage more supplies to find their way to market. Not so in carbon, where volumes are fixed by governments. Poland already has asked EU lawmakers to intervene. The European Commission declined to act. The east European nation will now sell 55.8 million tons of EU allowances next year, worth about 1.4 billion euros at current market prices, a move that may mute some of the strength in carbon prices next year.

After six years in the doldrums, carbon allowances on the EU Emissions Trading System came to life at the start of this year following a years-long effort by policy makers to mop up a surplus of the credits that built up since the last recession. Countries allocated too many carbon allowances and put in place renewables subsidies that helped curtail the need for power from plants that pollute.

The screws on the program are set to tighten again in the coming years, with governments auctioning 40 percent fewer allowances starting next year.

“Auction volume is looking pretty poor,” said Louis Redshaw, founder of Redshaw Advisors in London, which trades carbon. “I suspect that many speculators are already positioned long.”

There’s a wide range of views on how significant those measures will be for the market in 2019, with estimates ranging from 18 euros to a sky-high 55 euros. This year’s contract recently traded at more than 25 euros a ton on Monday, up from the 8.18 euros registered at the end of 2017.

Options traders are also largely bullish on carbon, with bets on call options far outnumbering puts. The call option with the second most open interest for the December 2019 future is for a strike at 50 euros a ton, with the most popular at 20 euros. There are even traders betting on options to buy at 100 euros in 2020.

Levies on carbon emissions aren’t well understood outside the energy industry and haven’t been earmarked to pay for other social programs, making them politically vulnerable, said Bob Ward, policy director at the climate-research unit of the London School of Economics.

“People are more likely to support the tax if they support what the government is doing with the revenue,” Ward said.

Tighter carbon markets tend to push utilities toward burning cleaner fuels -- like natural gas instead of coal -- and to look toward renewables as a way of generating electricity without emissions. About two thirds of Germany’s higher power price this year was due to the cost of carbon, with another 30 percent coming from more expensive coal, said Lawson Steele, an analyst at Berenberg Bank in London.

“Gas will matter next year when the carbon price rises sufficiently to make gas generation cheaper than coal,” Steele said. “Today, coal sets the price.”

--With assistance from Brian Parkin.

To contact the editor responsible for this story: Reed Landberg at landberg@bloomberg.net, Andrew Reierson

©2018 Bloomberg L.P.