Reflections on the Mechanisms to Protect Against Formation of Price Bubble in the EU ETS Market

The European Union (EU) is facing the challenge and opportunity of implementing the Green Deal while simultaneously initiating the recovery of the economy following the coronavirus crisis. While funding for investment opportunities is often discussed, what is needed above all for the transition is a transparent policy framework that makes investments in climate-friendly technologies economically viable and ensures that companies actually implement the investments in the transition. In this respect, special attention needs to be paid to the EU ETS market itself, in particular to look at the observed increases in the EU carbon price, which are reaching new records per ton.

The purpose of this paper is to answer for one research question whether the EU ETS is properly secured against rising EUA prices and the risk of a possible bubble in the EUA allowances market and whether the EC have any instruments in the EU ETS regulations that will protect participants from the future price shocks. In this respect, it is worth emphasizing that in this paper we focus mainly on the identification of the potential creation of a price bubble on the CO₂ market, reviewing the current legislative instruments in the EU ETS and some elements of this legislation that should be improved to avoid market manipulation and to ensure better market safeguards.

We can observe (Figure 1) increases on EUA prices in recent couple of years. From 17 April 2013 to 22 June 2021, the EUA price increased on the spot market from EUR 2.75 to EUR 52.33 (approx. 1800%). The value of EUR 2.75 is the lowest price of allowances on the futures market in the period after 2007, when it was possible to transfer (bank) allowances between periods. We can see the most extreme price spikes took place two times: in August 2017–2019 and in May 2020–June 2020 when prices rose from EUR 5,3 to 29,4 and from EUR 15,23 to 52,33. In the first case, it was more than a 450% price increase during only 2 years, and in the second one, it was almost a 250% increase during a year. It could mean that EUA prices rise too high and too fast, and some experts believe that this could be a beginning of a ‘price bubble’.

Figure 1

A price bubble according to one of the definitions is an economic cycle that is characterised by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a ‘crash’ or a ‘bubble burst’. Typically, a bubble is created by a surge in asset prices that is driven by exuberant market behaviour. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset's intrinsic value

See: https://www.investopedia.com/terms/b/bubble.asp (June 22, 2021).

Figure 2

Another technical measure to assess the possible scale of the overvalued price asset may be their comparison to a moving average. For example, we can compare current prices to the 200-session moving average on weekly basis charts. This type of average is considered by investors whether the asset is in an upward or downward trend

See: https://www.investopedia.com/ask/answers/013015/why-200-simple-moving-average-sma-so-common-traders-and-analysts.asp (June 22, 2021).

Figure 3

Looking at the current situation, NASDAQ deviates from the 200-session average by about 57%, while the value of Bitcoin is currently about two times (i.e., 130%) higher than this average [it should be taking into account that earlier this year in March 2021, Bitcoin was six times higher than the 200-session average (i.e., 500%), and we can suspect that the Bitcoin bubble could have just burst]. Therefore, comparing the current distance of EUA allowance prices from the 200-session moving average, it is very similar in this respect to the dot-com bubble on the US market from 2000. In turn, compared to Bitcoin, it can be concluded that EUA prices still have a much space to increase (comparing to March 2021 results).

In the literature, we have some examples what could cause a real price bubble. One of these examples has been introduced by American economist Hyman P. Minsky who had identified five stages of this potential phenomenon [Islam J., Hasan M. 2014]:

Displacement. This stage takes place when investors start to notice a new paradigm, like a new product or technology, or historically low interest rates. This can be basically anything that gets their attention.

Analysing what could have influenced EUA price increases we came to conclusion that three of five of Minsky's points could be met. It seems that one of the characteristic pattern for EUA prices is that they do not only reflect the current fundamental factors in the EU ETS, but also future conditions like cap tightening in the EU ETS until 2030 or even after that period, for example, by higher reduction target or stricter changes in Market Stability Reserve (MSR). The latter mechanism is particularly important when we focus on changing market fundamentals. The TNAC

The Total Number Of Allowances in Circulation.

The importance of the EU ETS reform and the activity of hedging funds for the formation of a price bubble are emphasised by Friedrich M. et al. (2020). They believe a price EUA bubble could be caused by an overreaction of the market to the reform of EU ETS. Much of the price run-up follows due to trading activities from speculative investors like banks and hedge funds in anticipation of the (price) effect of the reform. This can be confirmed by growing volumes of allowances.

Figure 4

As one of the results we came to conclusion that EUA prices are rising too high and too fast. That is why the EU ETS market is extremely volatile, which is on the one hand unfavourable for EU ETS compliance entities, but on the other hand, it is very beneficial for speculators. For such entities, an extreme volatility means more money. It seems the EC do not have an effective tool to stabilise the EUA price right now. Definitely, such a tool cannot be called the mechanism in Article 29a of the EU ETS Directive [Directive…2003] allowing for the release of 100 million allowances from the MSR and their auctioning in the event of a sudden increase in the EUA prices [Decision…2015]. The main rule from this article states ‘If, for more than six consecutive months, the allowance price is more than three times the average price of allowances during the two preceding years on the European carbon market, the Commission shall immediately convene a meeting of the Committee established by Article 9 of Decision No 280/2004/EC’. We find evidence that with the current structure and interpretation of this provision, it is practically impossible to trigger this mechanism. But even the EUA price would reach to extremely levels, and there is no guarantee to trigger the mechanism. The reason is another subjective condition that must be met, which is the observed price changes ‘does not correspond to changing market fundamentals’. This concept can cover virtually every change that affects the EU ETS, and since it is being changed continuously, the question arises, which change does not ‘substantially’ affect the market. The condition is also calling a meeting within the Climate Change Committee, which also could take some time. All these Article 29a provisions may suggest that the EC has a decisive voice in this matter, and it depends solely on its interpretation whether any market intervention will occur.

We can find out that the current structure of Article 29a can cause some problems with right interpretation. That is why there are a few options of interpretation of the Article 29a mechanism, which are circulating and probably all evidenced it is practically impossible to trigger this mechanism. In this paper, we examined three of them which are listed below.

Figure 5

Based on The Intercontinental Exchange (ICE) and European Energy Exchange (EEX) EUA price data (spot market), the first option indicates that EUA prices have to reach on average EUR 74,43

The arithmetic average of EUA spot prices on the ICE and EEX exchanges for the 2-year period from 1 January 2019 to December 2020 was calculated and multiplied by the number 3.

The second option indicates that EUA prices have to reach on average EUR 89,11

The arithmetic and weighted average of EUA spot prices on the ICE and EEX exchanges for the 2-year period from 1 January 2019 to December 2020 was calculated and multiplied by the number 3.

All three Article 29a simulations indicate that the launch this mechanism is very unlikely. Therefore, the structure of the wording of this mechanism in the EU ETS directive should be changed in such a way as to enable a faster response to the sharp increase in EUA prices. A great example of a mechanism, which can be shortly activated, is the twin mechanism used by the United Kingdom in UK ETS – the so-called Cost Containment Mechanism (CCM). It is triggered, if the average price of allowances on the futures secondary market is twice as high as the average price for the previous 2-year period for 3 consecutive months. As we can see, the average price has to be only two times higher (three times in the EU ETS) and only valid for 3 months (not 6 months as in the EU ETS). In line with this provision, from 10 May, this price was calculated at GBP 44,74 (EUR 52), which means that with the current prices for allowances in the UK ETS, the CCM mechanism may soon be applied.

Figure 6

Another risk for the EUA's market is the possibility of potential price manipulation. One of the example is using the primary market to manipulate the price in the secondary market. This kind of behaviour could have happened during first Polish EUA auction in 2021, which was cleared at 38 EUR, that is above 1,5 EUR the secondary market price. Immediately thereafter, the price on the secondary market increased significantly to nearly 38 EUR level. Theoretically, it could had been done on purpose – someone who offered an enormous price and finally bought allowances at the auction (offered bids on Poland auction amounted to 50 EUR/EUA) could previously have bought long-future EUA contracts on the secondary market (using, for example, the financial leverage). Doing so would allow this entity to earn a fortune. It seems such a case can be seen as a kind of market manipulation in accordance with the provisions of Art. 12 (2e) of Market Abuse Regulation [Regulation…2014]: (…) ‘The following behaviour shall, inter alia, be considered as market manipulation: (e) the buying or selling on the secondary market of emission allowances or related derivatives prior to the auction held pursuant to Regulation (EU) No 1031/2010 with the effect of fixing the auction clearing price for the auctioned products at an abnormal or artificial level or misleading bidders bidding in the auctions’. This kind of market behaviour should be detected by an exchange operator (EEX), and the competent authority of Member State exchange is situated (German Financial Supervision). But with the current structure of primary CO₂ market, there is no certainty that this type of market behaviour will be identified so quickly that it will not disturb the EUA price movement. To avoid this situation, the Auction Regulation [Commission Regulation…2010] should be changed. As a reminder, there is a provision concerning the auction cancellation: ‘(…) Where the auction clearing price is significantly under the price on the secondary market prevailing during and immediately before the bidding window when taking into account the short term volatility of the price of allowances over a defined period preceding the auction, the auction platform shall cancel the auction’. This provision works only one way, as it only applies to situations where the price is significantly lower than the price on the secondary market. However, when the price is significantly higher, the auction is not cancelled. This gives a room for manipulation, because such a speculator is sure that the auction always will take place clearing abnormally high in relation to secondary market price. It seems that this kind of practice should be thwarted just at the stage of auction regulation, and that is why there should to be a similar mechanism cancelling the auction when the EUA auction price is significantly higher than the secondary EUA price. The second example of potential price risk manipulation is the Financial Times publications. There has been a trend that as soon as a specific ‘EUA price forecast’ article appeared in this newspaper, prices rose sharply in the short term. This was the case in February 2021 when one of the hedge funds announced that it expected EUR 100 per EUA this year. After this information had been published, the market reacted immediately EUA spikes. This case could be also treated as price manipulation as the Market Abuse Regulation (MAR) provision stated in art. 12 (2d): (…) ‘The following behaviour shall, inter alia, be considered as market manipulation: (d) the taking advantage of occasional or regular access to the traditional or electronic media by voicing an opinion about a financial instrument, related spot commodity contract or an auctioned product based on emission allowances (or indirectly about its issuer) while having previously taken positions on that financial instrument, a related spot commodity contract or an auctioned product based on emission allowances and profiting subsequently from the impact of the opinions voiced on the price of that instrument, related spot commodity contract or an auctioned product based on emission allowances, without having simultaneously disclosed that conflict of interest to the public in a proper and effective way (…)’ It seems there is also (as ‘auction case’) a lot of room for abuse and price manipulation, and competent supervisory authorities should watch this carefully.

Figure 7

It is interesting because both of the preceding examples could be calling a kind of market manipulation according to MAR provisions. It seems this kind of loopholes in legislation acts need to be improved and better market safeguards in MAR and auction regulation provisions should be ensured.

We can conclude that specificity and structure of the EU ETS with the possibility of banking allowances through a 10-year compliance period and the EC's efforts to constantly reform this system by increasing the reduction target and tightening the cap (not only by the Linear Reduction Factor (LRF) but additionally by MSR reserve) encourage CO₂ market participants to buy a lot of allowances. The EU ETS compliance entities have been changing their hedging strategies, purchasing more allowances now and keeping them in their accounts rather than selling to avoid future shortages. There are also other market participants who buy EUAs to take profits such as long-term investment funds and short-term market speculators, which can be expected that their activity in the market will grow in coming years. All these demand factors have a big impact on EUA price stabilisation, which is rising too high too fast. This may lead to an EUA price market bubble as we saw earlier on the dot.com bubble in 2000 in USA and we probably observe now on BITCOIN.

As we examined earlier in this paper, the EC does not have an effective instrument to avoid the price destabilisation in the market. Moreover, it seems that current market legislation (e.g. the MAR directive) may encourage market speculators to manipulate the EUA price. The EU ETS compliance participants should have some kind of guarantee that when an extreme situation occurs on the market (when EUA prices increase too high and too fast as we seen today), the EC has a transparent and immediate mechanism that is automatically triggered. Such a ‘safety valve’, in which various options are presented below, would be indispensable for stabilization to the EU ETS participants contributing to a better planning of future investments and to bear lower operating costs.

In addition to the options previously mentioned, there is another possibility that should also be mentioned that was not covered in this article. We find it important for further research the possibility of introduction of flexibility mechanisms between the EU ETS and non-ETS, that could be used to reduce the price of allowances in the EU ETS, while increasing liquidity in the market. As an example of combining the non-ETS and EU ETS, a mechanism can be proposed that would be based on the possibility of using units generated in non-ETS (coming from projects implemented in non-ETS) and using them in the EU ETS to emission compliance obligation.