Options traders put bullish pressure on EUAs while brown spread is nearing critical lows

This is a condensed version of our analysis for ICIS EU carbon subscribers that was originally published on 23 Mar 2018 15:15 CET.

The EU ETS has experienced significant bullish price movements over the last couple of days and weeks. We believe that the latest price movements might have been partially triggered by certain price levels forcing option traders to buy the underlying futures to hedge the option position. In our opinion, similar price movements might be in the pipeline once the €13 is breached.

Main points

• Since the beginning of the year, both the ICE and the EEX have shown heavy increases of open interests (OI) in their options contracts
  • While the majority of options trading is taking place on the ICE, heavy increases are currently taking place on the EEX as well
    • Since the beginning of EEX option trading in December 2016, less than 1m OI was built until 12 February 2018 (in all EEX traded option contracts)
    • In mid-February, the OI for EUA options on the EEX (expiry Dec-18) rapidly increased and accumulated to an OI of around 24.9m for call options and 34.3m for put options on 22 March
  • On ICE the current (22 March) OI for call options (expiry Dec-18) is at 184.1m for call and at 95.7m for the put options
• Especially high is the OI for call options at strike prices between €12 and €18
  • • The OI for call options with a strike price of €12, both exchanges added up, is around 11.5m (expiry Dec-18)
    • For €13 strike price approximately 18.7m (expiry Dec-18)
    • For €14 strike price 15.1m (expiry Dec-18)
    • For €15 strike price 25.6m (expiry Dec-18)
    • For €16 strike price 16.3m (expiry Dec-18)
    • For €17 strike price 0m (expiry Dec-18)
    • For €18 strike price 19.7 (expiry Dec-18)
• Furthermore, options with Mar-2018 delivery at ICE were last traded on 14 March with 8.6m call options being exercised

Analysis

• We believe that the strong uptick in options trading is connected to the appearance of new players and strategies in the market in recent months
  • In our opinion, it is possible that heavy EUA demand is currently coming in from players who have previously sold call options (without owning the underlying) at the strike price of €12-€13 and are now exercising hedge strategies to protect against potential losses
  • This could also explain in part the steepness of the recent price increases, as those strategies are rather price insensitive once the underlying reaches roughly the level of the strike price
  • As soon as the next strike price level of €13, €14 or €15 is reached, this could trigger even heavier buying as the OI of the call option with a €15 strike price alone is 25.6m
• On top, additional demand might have entered the market last week from options running into delivery and the call option sellers needed to buy the underlying for delivery

sources: ICE, EEX

• Such bullish EUA price trend could however trigger significant fuel switching as clean dark/brown spread are suffering currently under high carbon price
  • Market developments
    • Both the dark and the spark spread stayed relatively stable over the last three months, as the increased carbon price was set off by falling costs for coal (see more)
    • The increasing carbon price has only partly led to an increased baseload power price
    • Meanwhile, the increased carbon costs have pushed the brown spreads (lignite) down to dangerous levels not seen since early September 2016
  • Clean dark spreads (CDS)
    • As hard coal prices have recently fallen, we do not see an acute risk of massive fuel switching (coal to gas) in the short-term
  • Clean brown spread (CBS)
    • The CBS could pose a bigger risk than the CDS as the fuel costs are stable, and the spread largely exposed to the baseload power price
    • If German baseload power continues to stay more or less stable while the CBS decreases another €2-4/MWh as a consequence of increased carbon prices, several lignite assets might not be economically profitable anymore, which means hedging could be substantially reduced for that time period
    • This, in turn, could depress carbon compliance demand severely and lead to a EUA price correction
    • This has already happened several times in the past – we, for example, expect that the correction in Jan/Feb 2016 was at least partly driven by falling CBS in Germany
    • This could lead to strong loss of EUA demand from the compliance side once that CBS level is reached
  • Overall this means that the generation assets in the power sector of utilities can be handled as real options on the carbon price as the carbon price would be the decisive factor for fuel switching

Stefan Feuchtinger is Senior Analyst – EU Carbon & Power Markets at ICIS. He can be reached at Stefan.Feuchtinger@icis.com

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