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the Homing Bird #9

The EU Emissions Trading System (ETS) is here to stay. It will remain in place until it has achieved its goal of bringing carbon neutrality to Europe.

the Homing Bird #9
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June 2024

In this edition :

🔥 The Story - What's the future of the EU ETS ?

🎙️ Expert Insights - How does carbon pricing decarbonize indutries globally ?

🤪A new subscription period is opening tomorrow - Invest in a financial asset built for price appreciation, while directly contributing to the European fight against global warming.

The Story - What's the future of the EU ETS ?

"This is the most significant reform in the history of our organization." 1

In 2023, we “received the most monumental reform of the EU ETS system since its creation”, according to Dr. Joanna Sikora-Alicka’s academic paper on carbon markets fundamentals.

With the Fit-for-55 reform new rules, there will be no more EUA auctions from 2039 on. EUA Auctions are the default system for bringing new EUAs to the market. Their disappearance is therefore a profound change in market dynamics.

Yet this is far from spelling the end of the Emissions Trading Scheme. Carbon pricing in Europe will outlive the auction system.

While there will be no new supply (flow), there is a historical surplus of EUAs wandering in the economy (stock). As long as there are EUAs in stock, the carbon market will live on. For how long? It will depend on the demand volumes and dynamics.

"What's the plan?" 2

The EU sets climate targets to limit global warming, then computes the corresponding emissions reductions to achieve them, and finally engineers policies so that companies and industries deliver this decarbonization. In 2019, regulators brought forward the European Green Deal: the bloc will be carbon neutral by 2050.

It’s always convenient for politicians to set long term targets. Their voters cast their ballots today, not in 31 years. And politicians want their voters to be content and relaxed at the time of their ballot. The net-zero 2050 target, as seen by 2019 politicians, is a political and social abstraction for their long-term successors to deal with it.

Yet climate change also requires urgent effort - hence in 2021, we heard more concrete and shorter-term EU climate targets. The path to carbon 2050 neutrality goes through a 2030 milestone. Enters the Fit-for-55 “monumental reform”.

This intermediary target of a 55% reduction in emissions by 2030 compared to 1990, is much closer to us. That's why it's considered such a massive reform. It doesn't push back commitments, but pulls them forward.

And the subset of emissions covered by the EU ETS had their own, more ambitious treatment - for them the target was set at 62% reduction compared to the 2005 benchmark.

"How do we get from here to there?" 3

Regulators cannot stay behind every EU chimney’s shoulder and count every tonne of CO2 to reach the 62% goal. But what regulators can do is change the supply dynamics in the bloc’s carbon market.

Before the Fit-for-55, EU industries and power producers had to reduce their carbon emissions at a slow and steady rate of 2.2% per year. After the reform, they have to hit the gas (figuratively!) and decarbonize faster - at a 4.3% yearly rate from 2024 on, and then 4.4% between 2028 and 2030.

Faster reduction of EUA issuance means a more rapid end to EUA issuance.

Screenshot 2024-06-12 142111

"Is this the end?" 4

But the end of new issue of EUAS does not mean an end for the EUA market. In the past, the EU has consistently been issuing more allowances than the amounts that were needed to match emissions. So, every year less EUAs were surrendered back to the emissions than the supply volumes. There is a structural oversupply of EU carbon allowances that is transferred from one period to another - the total number of allowances in circulation (TNAC).

Imagine if the Central Bank stopped printing money. Money wouldn't disappear altogether: there is still a lot of it in circulation. Same goes for EUAs.

The EU ETS will come to an end once it has accomplished its mission. This will come when there will be no more allowances issued in the market, and when the TNAC goes to zero. And, above all, when Europe will have reached a complete and sustained carbon neutrality.

Screenshot 2024-06-12 120619

"How long can this go on?" 5

For how long will the market keep going once there is no more new supply after 2039? Well, it depends.

It depends on how fast the EU industry will decarbonize. And this in turn depends on the price of decarbonizing their activities: the trade off between price of EUAs and the marginal abatement cost. This changes over time. The cost of making operational technologies greener depends on the future prices of energy, labor, primary materials, interest rates… The carbon intensity of industry determines the level of compliance demand for EUAs.

It also depends on you. It depends on who you have voted for at the EU parliament elections. It depends on how your elected officials opt to shape the upcoming phases of European carbon pricing.

Voters' opinion determines climate policies, just as we saw during the green wave during the 2019 EU parliamentary elections. It led to an increase in the number of MEPs with a green agenda, which resulted in visible, actual, strengthened EU climate targets:
- The wind 2030 capacity target rose from 384 GW to 592 GW.
- The solar 2030 capacity target increased from 430 GWac to 510 GWac.
- The emissions reduction target elevated from -40% to -55%.
- The renewable energy target for 2030 escalated from 32% to 42.5%.

The EU ETS was also enhanced, with a faster pace of supply reduction (from 2.2% to 4.3% per year) and the inclusion of additional sectors such as the maritime sector in 2024.

This is good news - the already set climate ambitions are almost impossible to erase or fundamentally reformed by political successors.

While the long-term trajectory for the EU ETS is already set, potential future political decisions could still further strengthen it, it can still be expanded into new sectors, for instance.

A possible linkage with other ETS worldwide can impact demand for EUAs. Currently, 19% of global emissions are covered by such a mechanism and this figure is likely to grow to 60-70% by 2030 according to the president and CEO of the International Emissions Trading Association  (IETA) in the future. As the international interference between carbon markets increases (notably with the CBAM that the EU instituted in 2023), there is room for regulators to affect demand for allowances should they open up the regional borders of the EU ETS.

"This is not the end of me. This is the beginning." 6

Long story-short “The vast range of developments that appear possible at this time suggests that the ETS may as well not be in an endgame, implying that ambiguity about the long-term nature of the market further exacerbates long-term price uncertainty.”

Or in a less academic complex way - seize the opportunity and invest in carbon today. There is plenty of time for your investment to grow.

1) The Godfather Part II
2)  Han Solo, Star Wars: Episode VII - The Force Awakens
3)  Jack Sparrow, Pirates of the Caribbean: Dead Man's Chest
4) Frodo Baggins, The Lord of the Rings: The Return of the King
5) Neo, The Matrix Revolutions
6) Nemo Nobody, Mr. Nobody

Expert Insights -  How does carbon pricing decarbonize indutries globally ?

We are truly grateful to Vladimir Golubyatnikov, an expert in industry decarbonization and renewable energy, for his time during our exclusive interview with Homaio. He provided valuable insights on the industrial response to carbon pricing, particularly regarding the implementation of the CBAM.

H: What is your experience in the industrial decarbonization and clean energy sectors?

For the last 15 years, my professional focus has been heavy industry, natural resources, and clean energy sectors, specializing in investment valuation, investment management, and financial analysis. Initially, I dedicated 4-6 years to management consulting designing strategies and transformation programs, manufacturing conglomerates and metals and mining companies. Following that, I spent over 9 years at Eurasian Resources Group, concentrating on evaluating capital projects and developing renewable energy solutions aimed at decarbonizing industrial electricity supply.

H: You are periodically mentioning the EU Emissions Trading System (EU ETS) in your newsletter - when was your first encounter with the scheme?

I began closely monitoring the ETS when the company I was working for started to evaluate the impact of the Carbon Border Adjustment Mechanism (CBAM) on its business. As a reminder, this is a policy tool implemented by the EU to prevent carbon leakage by imposing carbon-related costs on imported goods based on carbon emissions embedded in their production process.

H: What was the initial reaction from the industry to the introduction of carbon pricing for them through the CBAM?

The CBAM is undeniably a game changing policy. Back in 2020, the scope of the policy was not clear yet and it was not known if indirect emissions would have to be accounted for or not. So, the affected industries had to model different scope and carbon pricing scenarios to know how their imports to Europe would be impacted. In some cases, the numbers were showing that it may not make sense anymore for them to keep selling in Europe. The carbon price from the CBAM would make it too expensive for EU importers to keep buying the goods with high embedded emissions.

H: How costly is the CBAM for extra-European industries?

Let’s take the case of aluminum producers. For selected aluminium producers working with coal-based electricity generation (e.g., in China or other Asian countries), up to 10-14 tonnes of CO2 equivalent are released per tonne of aluminum produced (including emissions from electricity consumed in smelting) - with the current EUA prices, this would mean a cost of carbon of €700 to €980 per tonne of aluminum. Currently, the price of a tonne of aluminum is around €2 500, so a cost of carbon of 30-40% of the total end price is just too high. Those companies would opt for putting an end to their exports to the EU and reallocate their production to other regions like Asia or the Americas.

H: You say that the CBAM can make it challenging for international traders to keep selling to Europe. How will this supply be compensated for, within the bloc ?

I believe that the affected industries will see some form of market segmentation: in the European market, carbon will become a differentiating factor, and the commodities with higher embedded emissions will be replaced by the “greener” ones, e.g. from other markets or producers. In turn, goods with higher carbon footprint that used to go to the EU will flow to markets with less strict environmental regulation.

H: So will the rest of the world keep their current CO2 levels and simply change their trade patterns?

The EU ETS has already served as a model for other countries to adopt similar pricing policies - China for instance. Pricing carbon there is starting to introduce a financial incentive to companies to decarbonize – for now, in the power generation sector. Until other sectors are added to China’s ETS, there are other non-price mechanisms in place. For example, aluminium producers are relocating activities to Southeast Asian countries to evade Chinese capacity limits introduced largely on environmental grounds, and this a perfect example of what carbon leakage is. I would not be surprised if China introduces its own version of Carbon Border Adjustment Mechanism (CBAM) to address such scenarios.

H: Globally and in the long run, what will be the result from this universal adoption of carbon pricing schemes and border adjustment mechanisms?

I believe that this global trend will lead to universal decarbonization in heavy industry sectors. Other regions are already actively pursuing decarbonization in aluminum production; for instance, in the UAE, they are testing aluminum manufacturing capacity using solar power. Once such operations can be stabilized and scaled, I anticipate they will become the new, lower carbon industry standard globally.

H: What is your general view on the dynamics in carbon markets that we can expect in the years to come?

The EU ETS is a very powerful mechanism. Decarbonization would not have gone as fast without carbon pricing. Other jurisdictions will have to (and for some of them, are already) scale up their carbon pricing schemes. In fact, CBAM regulation (which works in conjunction with the EU ETS) creates explicit incentives to do so: it allows to reduce the CBAM payment proportionate to the carbon price paid in the country of origin. It means that countries exporting CBAM-affected goods to the EU are better off charging carbon price domestically, and use the collected funds to decarbonize their economies, rather than letting this money go into the EU budget.

In terms of price dynamics, I believe that an important factor will be the industrial activity recovery. In Europe, and Germany in particular, we have recently seen fears of deindustrialization, especially with the energy price shocks after the war in Ukraine started. The production comeback will be key for EUA prices.

I do not think that the EU parliament election results will impact EUA prices to the downside. There could be a risk when it comes to the adoption of new climate-change related policies, but the existing ones will remain as they are - there is still a central political group in the majority.

H: Would you personally invest in EUAs?

I have never heard of the opportunity for individual investors to buy carbon allowances - it is definitely an interesting investment idea. I could see EUA prices going up to €100 - €150 by 2030.

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