What explains the correlation between gas prices and EUAs?
Gas prices and European Union Allowances (EUAs) have moved in tandem recently, but this hasn't always been the case. After months of almost perfect correlation, the markets are now decoupling as EU ETS participants focus on long-term fundamentals: the market is built for price appreciation.
The theory: the link between gas prices and EUA prices
The relationship between gas prices and EUAs is fundamentally tied to the concept of fuel switching. This refers to the practice of changing from one type of fuel to another, such as from coal to natural gas, based on cost or environmental considerations. Natural gas burns cleaner than coal, emitting significantly less CO2. Therefore, when gas prices drop, industries are incentivized to switch from coal to gas, reducing overall carbon emissions. This decreased emission level leads to a lower demand for EUAs, which are required by industries to offset their carbon output, thereby driving down EUA prices.
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A relatively low historical correlation in practice
EUA prices are influenced by a multitude of factors beyond just energy prices. Regulatory decisions, macroeconomic conditions, weather patterns, and trading behaviors all drive carbon market pricing. This is why historically, the correlation between gas prices and EUA prices has been relatively modest. For example, before the recent energy crises, the correlation was around 0.12. The European Union Emissions Trading Scheme (EU ETS) market participants consider many variables, with gas prices being just one factor.
High correlation in late 2023 and early 2024
However, in late 2023 and early 2024, the correlation between gas prices and EUAs surged to unprecedented levels for such extended periods. During this time, gas and EUA prices reached a “point of pivot”, becoming the main arbitrage variables for power producers' fuel switching decisions. For instance, in March 2024, a spike in gas prices due to LNG plant shortages led to an 18% increase in EU TTF natural gas prices and a corresponding 15% rise in EUA prices.
New factors at the EU ETS center stage
Other factors than gas markets are starting to influence EUA prices recently, and this will possibly lead to a longer term decoupling of the two markets. Regulatory and policy changes, such as the EU Commission’s climate targets and the RepowerEU program, are becoming more significant. Also, the inclusion of new sectors into the EU ETS, the phasing out of free allocations, and broader economic and political developments, such as upcoming elections, play increasingly important roles.
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The decoupling has started
As we move further into 2024, the correlation between gas prices and EUAs is weakening. Market participants are focusing more on long-term structural factors - they are reminded that EUAs are designed for long term price appreciation independently of energy market dynamics. For example, before the announcement of the 2040 climate targets, the correlation between gas prices and EUAs had already begun to decline, dropping to 0.47 in January 2024. In July 2024, just after the European and French elections, the correlation fell into negative territory for the first time since May 2023.
Long-term fundamentals are here to stay, while gas price swings are just temporary. EUAs and gas markets won't stay linked forever, as the EU ETS evolves into an increasingly effective decarbonization tool.
