Energy markets align amid carbon volatility

Author: Christopher Rene


• Carbon continues to test new highs
• EUA volatility replicated in European energy markets
• EAX-TTF month+2 correlation tightens in March

LONDON (ICIS)--Heightened carbon market volatility has increased the influence of EUAs on the wider energy complex in March with the price correlation between spot Asia LNG and European gas markets also turning stronger.

After a disconnection in January and February, the ICIS East Asia Index (EAX) and Dutch TTF have reconnected.

The two markets have become increasingly interlinked in the past two years with Asia accounting for the majority of global LNG demand while Europe remains something of an LNG balancing market given its large storage capacity and coal-to-gas switching capability.

In the absence of region-specific volatility in the coming months, it is likely the strong correlation could continue.

Carbon price changes have an important role in European coal-to-gas switching.

The ICE EUA Dec ’21 is in a bull run, with a new settlement high of €42.99 ($51)/tCO2e recorded on 17 March. The contract was trading above €43.50/tCO2e early on 18 March.

Speculative activity, compliance buying and the wider energy complex have triggered gains, despite the lack of strong fundamental support, and a fresh bullish push will hinge on their contribution.

Financial speculators have increased their presence in the carbon market this year and the latest Commitment of Traders (CoT) report by trading platform ICE confirms that investment funds have increased their carbon net long positions significantly.

ICIS Analytics has previously identified speculative buying as a key driver of the EUA uptrend in 2021.

The extent to which this continues will depend on whether new speculators join the market and the ability of incumbents to defend their long positions, with fears of inflation and a market correction additional concerns.

Compliance buying also lent support ahead of the 30 April deadline with entities covered by the EU Emissions Trading System (EU ETS) required to surrender EUAs in line with their emissions activity.

Previously, it was possible to make up shortfalls by borrowing from free EUA allocations from the year ahead.

However, with the switch to a new EU ETS phase this year, 2021 allocations cannot be used to cover demand from the 2013-2020 phase.

The expectation that some companies might have to cover shortfalls by purchasing EUAs at a premium from financial institutions, which tend to hold substantial volumes in their portfolios, may have contributed to the recent price surge.

Despite this, supply fundamentals are bearish and should weigh on the carbon market. Monthly EUA auction volumes will hit a 2021 high of 70m in March, 10m more than February.

The wider energy complex also revealed strong bullish signals.

At the start of week 10, ICE Brent futures hit 15-month highs following an attack on Saudi Arabia’s Ras Tanura, the country’s largest crude export terminal.

By the end of week 10, key contracts in major European gas and power markets had reached year-to-date highs.

While carbon and oil contributed to curve gains, prompt contracts found further support amid the expectation of cooler, less windy weather in the second half of March.

The month-to-date ICIS East Asia Index (EAX) calendar month+2 delivery correlation to the TTF equivalent climbed to 0.89, up from 0.49 in February.

With Asian demand retreating in the global market, following the passing of peak winter consumption and tightened regional margins, EAX prices have become less volatile and aligned more closely with the movements at the TTF.

More companies in Asia are now actively trading the TTF which has become a significant market for LNG hedging.

Annualised correlations between the TTF and EAX have trended upwards in recent years amid increased competition for LNG cargoes between the regions.

Oil volatility has also been reflected in global gas spreads, with correlations hitting three-month highs.

The announcement of continued OPEC+ production cuts in early March, followed by the attack on Ras Tanura, boosted Brent prices.

Volatility is likely to remain amid the potential for further OPEC+ cuts and pandemic developments.