The EU decided long ago that if it was going to effectively cut pollution then it needed to put a price on carbon, and over time that price had to rise. Some of the world’s biggest oil traders and hedge fund managers now appear to believe it.
In the past four months, the price of European carbon allowances — tradable securities that dictate how much it costs power stations and industry in Europe to emit a tonne of carbon dioxide — have soared to a near record high above €30. In turn they have raised the cost of polluting for businesses such as electricity utilities and will soon do so for manufacturers of products like cement and steel.
To veterans of the niche carbon trading industry, which was established 15 years ago, the price rise made little sense. Coronavirus lockdowns and the resulting deep global recession have cut emissions across Europe as factories have slowed and power demand has fallen. Prices should, they argue, be going down not up.
But the market is evolving, attracting a new breed of trader who cares less for short-term factors such as whether the market is oversupplied this year. Instead, they see an opportunity to cash in on a market whose direction will ultimately be dictated by politics and support for a “green recovery” after the pandemic.
“By 2022 the EU carbon price could easily reach €40,” says Florian Rothenberg at commodities consultancy ICIS. “But if financial investors and speculators believe this the price could easily reach much higher.”
Renewed interest in the EU carbon market could have significant ramifications for European industry. At about €25 a tonne, the carbon price is already high enough to have started to push coal off the electricity grid, with utilities switching to less-polluting natural gas or carbon-free renewables.
The next stage, traders suspect, is for the carbon price to rise high enough — between €40 and €50 a tonne — to start forcing other sectors to invest in cleaner technology and fuels — good for the environment, but a seismic change for industry, the impact of which is not yet fully understood.
Hedge fund manager Pierre Andurand is regarded in the industry as one of the most successful oil traders of his generation. After returning investors a profit of more than 150 per cent in the first five months of the year by betting successfully against the oil price, he is now diverting a small portion of his $600m fund in to carbon.
“We’re comfortable over a five-year horizon that the price has to go up — that’s pretty much a guarantee,” Mr Andurand says. “As long as the EU maintains this commitment to fighting climate change and utilising the carbon market, we’re confident prices will rise.”
He is not alone. Vitol, the world’s largest independent energy trader, is expanding its five-strong carbon team. And in a sign of how important it believes the market will become, it has appointed the former head of European gas — one of its main money-spinners outside its core oil operations — to run the business.
Some of the world’s biggest hedge funds like Brevan Howard and Citadel are also said by rival traders to be playing more of a role, while banks such as Morgan Stanley, Macquarie and Citi have been steadily building their teams, looking to profit both from increased client activity and in-house trading.
Insurers and pension funds are also reported to be taking a bigger interest as a potential hedge against climate-related parts of their portfolios.
For Erik Petersson, senior managing director in Macquarie group’s commodities and global markets team in London, the renewed interest in carbon from investors is a natural reaction to the signals from politicians.
In the face of a deep recession, the EU has not wavered in its commitment to tackle climate change despite the associated costs, if anything redoubling its efforts to cut emissions across the continent. Its revised aim is to reduce greenhouse gas emissions by 50-55 per cent by 2030 from 1990 levels, up from the current target of 40 per cent.
“The market has attracted some new attention over the last 12-24 months due to policymaking announcements for 2030-2050 where the EU is setting carbon goals,” Mr Petersson says. “They are some time away but they are painting a picture of a stronger carbon price essentially required to meet these targets.”
Expectations of where the price may eventually settle vary widely. But in more than a dozen interviews with hedge funds, banks and investors active in the sector, not one said that they believed prices would fall significantly. The only differences were in how far they might rise, over what timeframe and how big the political risk might be should the mood in Brussels change.
For much of European industry, which has spent decades worrying about oil and other fuel prices as one of their main production costs, this requires a dramatic shift in mindset. With oil prices looking likely to remain relatively manageable in the next few years, with plenty of supply available below $60 a barrel, the carbon price may well end up having a much greater impact on their fortunes, especially if the EU cuts the number of credits or “free” European emission allowances (EUAs) available to industry.
“The carbon mechanism is already pushing out thermal generation and the next carbon abatement is likely to come from the industrial sector,” Mr Petersson says. “For them to reduce their carbon emissions and encourage investment you need to see a much higher carbon price.”
Traders estimate the price may need to double to about €50 a tonne in the coming years to have the full impact the EU intends. They compare the situation in the EU emissions trading system, or ETS, to the oil market at the start of this century, when a handful of investors spotted that a decade of under investment in new production and China’s rapid rise meant prices were going to have to go up.
Despite some volatile swings along the way, these trades ultimately made a fortune as crude prices rose from $30 a barrel in 2003 to $147 on the eve of the financial crisis.
But the comparison is not exact. The difference in the carbon market is that the EU essentially holds all the levers of supply, writing the rules and deciding how many EU carbon allowances, or credits, to release — or absorb — to influence the price over time. It has been compared to a supercharged Opec, where rather than controlling roughly a third of supply, as the cartel does in the global oil market, the EU ultimately controls it all.
That is not to say it isn’t a real market. In the short term buyers and sellers often respond to the usual signals of supply and demand. If the economy slows and emissions go down, more participants are likely to sell, as seen this spring when coronavirus curbed demand and prices dropped almost 40 per cent from €26 to €16 a tonne.
If the price falls too much — or potentially rises too high — the EU has the ability to tighten or loosen supplies through the “market stability reserve”, or MSR, which was launched in 2019 to in effect reset the market after it had languished under the weight of excess supply built up during the financial crisis.
Nima Neelakandan, head of environmental products trading at Morgan Stanley in London, says that what is happening with prices is an attempt by the market to “find a new equilibrium” driven by a fundamental shift in expectations for the EU’s climate ambitions. Those ambitions are now very often echoed by companies, from Big Oil to Big Tech, which are attempting to respond to investor calls to do more on climate change.
“How much emissions do we want to reduce by 2030 and then 2050 has become the debate and these are very long-term goals, so the market is trying to rebalance itself,” Mr Neelakandan says. “The policy direction and ambition has become a lot clearer. And it’s not just the ambition of the EU but corporates globally.”
The crunch moment is expected next year. The ETS covers about 45 per cent of emissions in the bloc, primarily from utilities and big industrial companies. But it is likely to add more sectors such as shipping under its remit while cutting the distribution of free credits, increasing demand for allowances and in theory driving up the price.
“The EU wants to include more sectors and it wouldn’t do that if it didn’t believe the EU ETS had been a success so far,” Mr Neelakandan says. “That’s all playing into the recent price action.”
There is, however, some disquiet in sections of the EU that carbon could become a one-way bet for speculators. And that the real-world impacts from a price that rises too fast could range from shutting coal plants in Poland to placing additional levies on European industry at a time when pandemic-hit economies are already weak.
The thought of hedge funds or banks getting rich off carbon while other industries struggle sits uneasily with some politicians, even if they back the longer-term goal of making the cost of polluting more expensive.
“Some people might be betting on increased climate ambition in the EU, but you want the EUA price to reflect market decisions rather than speculator ones,” Bas Eickhout, the Dutch Greens MEP, told Carbon Pulse, an industry publication, in July.
When Peter Krembel joined RWE — one of Europe’s biggest utilities and polluters — in 1999, its trading arm was treated as an afterthought by a company comfortably earning steady revenues from its fleet of coal-fired power stations and gas and nuclear plants.
“I was placed in this third-tier operation,” says Mr Krembel, now chief commercial officer for RWE’s supply and trading division. “Stuck down in the basement of the headquarters, we were an appendix at best.”
Two decades on his unit employs 1,600 people and feeds into every facet of the company’s strategy, essentially serving as an alchemist for the broader group. It has turned an unprofitable coal business into the basis of a carbon trading machine that can help smooth RWE’s transition to a cleaner company.
RWE has in recent times bought up enough carbon credits to fully hedge its exposure to the carbon price for the next three years. It is an example of how carbon has forced companies to become more nimble, requiring fleet-footed trading to source cleaner supplies for customers, while also boosting profits with additional speculative positions. The trading arm, which also covers electricity, gas and other fuels, made a third of the company’s €2.1bn in adjusted earnings in 2019.
Mr Krembel argues that curbs on carbon trading would lead to a distortion in the “price signals” companies need, to make the right investment decisions.
“Those markets need to be well organised and well regulated, but then the composition of market participants is not a concern of ours,” he adds. “We need the depth and liquidity additional participants in these markets bring. A market should not be an in-crowd of utilities — that is poisonous to the wider industry.”
Others argue the claim that dozens of funds are driving up the price is overblown. Energy Aspects, a consultancy, said in July that the limited data available on positions suggested most of the buying seen in recent months was coming from utilities and other industrial end users, rather than funds.
“If the carbon price is going to have a significant impact on emissions, you need a high price — probably €50 a tonne plus,” says one hedge fund manager active in carbon markets. “For now it’s mainly being driven by compliance buyers whose perspective has become, ‘well if you could easily see €50 carbon we better buy it now as it’s not going to get significantly cheaper’.”
Others question the role of the EU and whether it needs to step back from the market to allow trading to fully mature. “The supply side is completely fixed by the EU — what they decide to change happens,” says Tom Lord, a trader at Redshaw Advisors. “When it’s so politically driven, it’s not necessarily a good thing for the market.”
While some funds may be taking a long-term view of the price, other energy traders are going further. Michael Curran, head of emissions trading at Vitol, says the goal is to grow in a market they see developing along the same lines as the physical oil market, with arbitrage, storage and logistics trades.
While they too expect the EU carbon price to rise, they believe non-exchange traded products such as carbon offsets — like planting forestry — may be the biggest growth area.
“The opportunity in European carbon credits might be a three times or five times price increase over the coming years,” says Mr Curran. “But if [the price of] EUAs rise it is going to bring up other carbon products like offsets, and the opportunity there might be price growth of 10 to 20 times over the same timeframe.”
Mr Rothenberg, at ICIS, says traders are waking up to the implications of the EU’s long-term aims. “It looks like a good investment,” he says, “especially if you’ve got the backing of the EU.”