European carbon markets traded around 8% lower today on news of the European Commission's (EC) proposal to sell allowances held in the Market Stability Reserve (MSR) to help fund the REPowerEU initiative, which aims to wean Europe off Russia’s fossil fuel exports. If confirmed, this means a moderate increase in the supply of allowances in 2023 relative to levels anticipated by the market. For context, the sale may include 200-250 million allowances relative to the existing annual cap of 1.5 billion allowances. However, recently proposed tightening measures mostly offset this in net AND the TNAC (total number of allowances in circulation) has fallen by 130 million tons in the past year while the cap has been reduced by 34 million tons.

The move serves the dual purpose of softening prices at a time when energy costs are at all-time highs AND raise funds needed for Europe to make dynamic advances in clean energy and independence from Russia. Both are potentially good long-term measures for the climate and for the carbon market. However, this does mean lower prices today in carbon. The reason the market reacted sharply to this seemingly reasonable action is because the MSR had been the main driver in tightening the market and was billed as holding supply out of the market unless the TNAC fell below 400 million tons (it’s around 1.4 billion tons today) or the price of EU carbon allowances rose to multiples of the moving average, neither of which have occurred. It is worth noting however that the MSR will also absorb roughly 350 million tons over the next year, still net tightening the market against the ~200 million it will release. Think of this as a reduction in tightening, not as easing for 2023. This will not be happening this year. Frans Timmermans, the vice-president of the EC and one of the strongest voices for the ETS (Emission Trading Program) was supportive of the approach and the EC noted they will implement it in a way that “does not disrupt the market”. Let’s be clear though, a change in supply forecasts changed pricing models this morning.

We support the acceleration of the decarbonization efforts in the European economy. We also view the MSR sale proposal as reducing political pressure on the carbon markets, which were at peak levels given the war in Ukraine and sky-high energy prices. We're seeing “short term price relief for the market,” as noted by our own Head of Capital Markets, James Maund, and potentially an entry point for long term investors. However, we strongly recommend the European Commission limits any measures that could undermine the market's trust and they must maintain the integrity of the MSR. If this is a limited action, we feel it is a net positive to carbon markets, which we feel needs to be further tightened towards $150 per ton of carbon.

For a little more detail and numbers, the European Commission already uses part of the revenue from selling carbon allowances at auctions to fund its green and decarbonizing efforts. This funding is one of the primary sources of impact as we’ve discussed extensively with clients and on webinars. With renewed urgency for green energy independence from Russia, the EC announced plans to mobilize 300bn Euros to fund the initiative dubbed REPowerEU, which aims to facilitate a rapid energy transition. The plan is to have no reliance on Russian fuel by 2027. Of this $300bn, the EC expects to provide $225 billion in loans and $75 billion in grants. The sale of allowances is expected to fund approximately 20 billion EUR of the grants.

We will continue to monitor this and keep you advised on future developments.