Explainer: Carbon strategies of EU utilities

In an emissions trading scheme driven largely by power sector demand, how do the buying habits of some of Europe's biggest utilities – and emitters – affect EU carbon prices?

LONDON(Reuters) - European Union carbon prices are struggling to recover from a record low below €7 a tonne, hit late last year as worries about the economy and an oversupply of carbon permits eroded demand.

Power and heat generation account for some 60 per cent of the carbon dioxide emissions in the EU Emissions Trading Scheme (ETS), which means power sector demand for carbon permits, called EU Allowances (EUAs), largely drives the price.

Some of the largest European utilities and big emitters, such as Germany's RWE and E.ON, generally sell their power production up to three years in advance. They buy the equivalent fuel and carbon permits to lock in profits.

Profit margins among German utilities to generate electricity from coal in 2014, known as clean-dark spreads, have been moving between around €5.80 per megawatt hour (MWh) and €9/MWh since January 1.

At the same time last year, the two-year-ahead spreads CDB1DE-2Y were trading from below €1/MWh to around €5/MWh, according to Reuters' data.

Below are key questions about profit margins.

Q. Are utilities buying at current profit margins?

A. Some are, but the volume of buying varies.

"The (clean dark) spreads are at decent levels compared to what we saw for large parts of last year," said a carbon trader at a large European utility.

"I don't think it's going to be a disincentive to start hedging ... but I wouldn't expect a particularly strong uptick in hedging volumes at the moment," he said.

He said one reason was that the clean dark spreads were recovering from historic lows, thanks to a sharp rise in German power prices compared with relatively stable coal prices.

Another was that large European utilities appeared to be taking a less speculative approach to spread movements than they did in the past.

"If you take an average and do a little bit every week you get a better level overall. The big utilities do a little bit over time, while small utilities ... may try to optimise that (the spread movements)," the trader said.

Q. What is the impact if profit margins fall back?

A. Utility demand could fall and depress benchmark carbon prices to new lows from current levels of around 7.30 euros a tonne.

"If the (clean dark) spreads fall to low levels again, then utility buying will drop off," Trevor Sikorski, an analyst at Barclays Capital, told Reuters.

He said some German utilities would have very little incentive to hedge their forward power generation sales while clean-dark spreads are trading around 2-3 euros/MWh.

"Given that this (power sector) is the buy side of the market and is helping keep the EUA contract at about 7 euros a tonne, a steep reduction in such activity would allow the commodity to drop to new lows," Sikorski wrote in a research note on Monday.

However, analysts at Societe Generale said they do not anticipate that German clean dark spreads will collapse to levels of 5 euros/MWh or lower.

"Higher scarcity of guaranteed capacity will prevent them from doing so," the analysts wrote in a Jan. 20 research note.

Part of the reason is that Germany's power capacity has been altered by the government's decision last year to retire 8 gigawatts of nuclear power capacity in the wake of Japan's nuclear crisis last March, they said.

Q. What is the impact if profit margins rise?

A. Carbon prices could rise, but not by much.

If two-year-ahead clean dark spreads were to rise back to 2008-2009 levels of around 15-18 euros/MWh, some utilities may accelerate their hedging volumes, said a second carbon trader.

But any carbon price rise from increased utility buying is likely be limited by a massive oversupply of permits in the market, he said.

A European Commission draft working paper said the EU cap-and-trade scheme will have a surplus of 2.4 billion emissions permits over the 2008-2012 period because of lower CO2 output as a result of the economic and financial crisis.

"There is not much demand at the moment with the economic situation," the trader said, referring to the euro zone debt crisis.

(editing by Jane Baird)

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