CO2 emission prices are likely to hit €50 ($55) per tonne by end of 2020, with a risk of an overshoot to €80 if the European Union (EU) macro picture brightens up, said the Bank of America (BofA) Merrill Lynch in a new report.

However, an EU recession may send carbon below €20 per tonne (/t), added the BofA Merrill Lynch Global Research report.

European CO2 emission prices hit €30/tonne in July, up from just €4 in mid-2017. This rally was triggered by the Market Stability Reserve (MSR), a mechanism that will sharply reduce credits sold at auction between 2019 and 2023. The deficit created by the MSR is the reason we have been bullish CO2 since mid-2018.

In the first half of 2019 (1H19), the rally in carbon prices was tempered by reduced CO2 emissions due to low natural gas prices. Since July, the drop to €25/t has come on macro woes. Still, hard coal-to-gas switching is almost maxed out and further displacement out of lignite only happens at +€45/t, with very limited capacity to actually switch. Thus, the EU power sector may need to see CO2 prices over €50/t to keep adding new renewable energy investments.

Carbon prices are extremely sensitive to demand shocks above a certain threshold, the report noted.

A drop in GDP and thus demand for CO2 credits can have the same effect on the emissions balances as a price induced-abatement. For instance, EU GDP fell by 8 per cent vs. trend in 2008. A recession of this scale could permanently destroy 200 mtpa of carbon credit demand. Under these conditions, CO2 prices would likely drop below €10 and stay there until 2030 as the system would be well supplied.

Even a small recession on the magnitude of 2001 would cost about 100mtpa of demand cyclically, likely enough to balance the market without any abatement.

“Under this small recession scenario, we estimate CO2 prices would drop below €20 and stay below this level to 2030. Of course the EU could then try to prop up prices with a supply side intervention, though this would likely take several years,” BofAML said in the research report.

Optimize emission hedges with futures and options

Many emitters such as power producers, refineries and airlines, are naturally short CO2 credits. One way to meet demand over the usual hedging horizon is to buy emission credit forwards/futures or physical inventory. Buying out-of-the-money (OTM) call options is another alternative to hedge upside CO2 risks, though options are expensive with implied volume at 55 per cent.

So hedgers may want to take advantage of a strong put skew (OTM puts more expensive than OTM calls) by selling OTM puts to help fund the OTM long calls, i.e. a long collar. On the other hand, some industries including cement and steel producers are actually net long emissions credits in the sense they have enough inventory to cover their needs beyond their usual 1-3 year hedging horizon, perhaps even all the way to 2030.

These long emissions holders may consider taking profit on some of these over-hedges to reduce their exposure to a fresh EU recession. – TradeArabia News Service