CRU: EU Steel: Why Carbon Matters More with COVID-19

The European steel industry in crisis again? Sure enough, the industry is currently facing a perfect storm of collapsing demand, prices and high iron ore costs. This will naturally be attracting our clients’ time and resources. But it is especially important in such downcycles to take a strategic view of the future and anticipate structural change. Underlying pressures from global excess supply and low-cost international competition continue. However, as outlined in this Insight, European steel’s underlying comparative advantage is increasingly being shaped by carbon policies: since 2018, on average, carbon costs as a share of marginal production costs of EU steel mills has more than tripled. CRU Consulting provide insightful, data-driven advice to producers, investors and governments seeking to understand and address fundamental questions regarding their industries, portfolios and investment strategies as the energy transition gathers momentum.

EU carbon prices are holding up despite cyclical pressures

Europe’s carbon market has remained firmer than many other commodity markets so far since the onset of COVID-19. At the beginning of May 2020, the price of emitting a tonne of CO2 in the EU Emissions Trading Scheme (ETS) stands at €20 down from a peak of around €23 when the COVID-19 crisis emerged in March. This contrasts markedly with trends observed during the Global Financial Crisis (GFC) when the carbon price crashed by around 2/3rds as permits were sold off to generate cash for industrial and power producers.

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Why are carbon prices more stable? On the face of it, this may appear surprising. EU industrial production is set to fall by more than 7 percent in Q2 2020 – a similar rate of contraction to the depths of the GFC crisis in early 2009 – reducing the demand for CO2 allowances (and thus the implied stringency of the total emissions limit, or ‘cap’). Moreover, gas prices have fallen to historical lows of around US$2.0/MMBtu, reducing the cost of substitution away from coal fired power production (although recognising that thermal coal prices have fallen substantially also). The answer is mostly due to policy.

Today, the ETS is far more established, having been extended to cover new gases (such as nitrous oxides) and sectors, including aviation. This increases its liquidity, reducing volatility. Moreover, the new Market Stability Reserve (MSR) – a mechanism to ensure that any temporary surplus of allowances is held “off market” to prevent a price crash – and the expectation of an ever stricter cap in the next Phase (IV) of the scheme starting in 2021 incentivises firms to save rather than sell any spare allowances. This further limits downward price pressures (see here for further discussion of the new ETS policy rules).