Carbon prices have tumbled in the wake of Russia’s invasion of Ukraine, decoupling from the broader energy complex, despite the steep rise in gas prices, which should have incentivised gas-to-coal switching, raising emissions and so driving up the demand for European emissions allowances (EUAs), says research organisation Fitch Solutions.

From a peak of €96/t carbon dioxide-equivalent (CO2e) on February 8, to their trough at €58/t CO2e on March 7, EUAs lost about 40% of their value, the agency states.

Prices have since partially recovered, rising to €77/t CO2e as of March 17; however, they have yet to recouple with energy prices.

"The recent bounce may in part be attributed to an easing of some of the more technical downward price drivers. The initial selloff was at least partly a result of companies selling their excess credits to raise cash to cover their liquidity needs, either to meet margins calls or ballooning energy costs. The market had been in a strong bull run since 2020 and the long trade had become somewhat crowded, leaving a large number of positions to close out," Fitch Solutions says.

Further, the scope for gas-to-coal switching in Europe may be less than is commonly assumed. Fitch's power analysts note a number of factors that may limit the level of coal capacity that can be brought back online, including that utilities have been winding down their supply chains and coal itself is currently in short supply, with European inventories seasonally low.

Any expectations for gas-to-coal switching may also have been overshadowed by concerns of demand destruction stemming from high energy prices and broader inflationary pressures, dragging on overall economic growth in the region and forcing some industrial players to reduce their operating rates.

"Our country risk analysts have already revised down their real gross domestic growth forecast for the Eurozone in 2022 from 4.1% to 3.3%, reflecting expectations for weaker consumer spending and a drag on both fixed investment and net export levels, due to sustained price pressures and supply chain issues. Further downward revisions may also be in sight, should sentiment deteriorate more than expected, further disrupting activity in the bloc," the agency states.

Additionally, it may not be practical for some to temporarily revive their coal plants, while others will fear reputational damage should their emissions increase as a result. Moreover, some gas-to-coal switching had already occurred in 2021, after European gas prices soared amid the broader energy squeeze, and high-frequency data for 2022 does not point to significant further switching beyond these levels, it adds.

There may be some support at the policy level. The European Union and the UK have been rapidly phasing out coal, but, since the conflict began, a number of policymakers in Europe, including European Commission VP Frans Timmermans, have noted its potential to alleviate pressures on the regional gas market and ease reliance on Russian energy. In support of these aims, coal plants due to shutter this year could be kept online and some capacity not currently operating could be brought back.

"Overall, our analysts remain firmly bearish on the outlook for coal-fired generation in the region, forecasting its share of total generation in Western Europe to fall from 6% in 2021 to 1.4% in 2031. However, it will continue to play a more dominant role in Central and Eastern Europe, falling from 25.3% to 22.3% over the same period," Fitch Solutions states.

Uncertainty over the direction of travel for European energy policy in the wake of the Ukraine crisis will also have been a factor. In particular, there may have been some concerns that climate policies would slip down the agenda, as energy security considerations took hold.

However, the REPowerEU strategy has helped to reassure market participants and may have contributed to the partial recovery in carbon prices. REPowerEU will seek to diversify gas supplies, speed up the roll-out of renewable gases and replace gas in heating and power generation.

"Our outlook on the long run remains bullish, as the European Union moves to strengthen the emissions trading system, broadening its coverage, reducing free allowances and decreasing the number of EUAs auctioned each year, in order to raise carbon prices to levels consistent with the Paris Agreement," the agency notes.

OTHER COMMODITIES
Brent crude oil prices have tumbled this week, falling from an intraday high nearing $140/bl in early March, to about $103/bl. Several factors are at play – Covid-19 infection rates are soaring in China and the government has reimposed stringent lockdown measures in response, threatening to undercut global demand already at risk from high oil prices.

More generally, demand-side concerns are mounting, as spiralling energy prices, sustained inflationary pressures, tightening monetary policy and spillovers from the Ukraine crisis mar the prospects for global economic growth. Supply-side fears were also somewhat tempered this week,owinge to continuing progress on the Iranian nuclear deal and budding optimism over negotiations between Moscow and Kyiv.

"That said, the two sides remain deeply divided on key issues and our Political Risk analysts do not anticipate a near-term resolution to the conflict, with fighting likely to continue into the second half of the year, in their view.

"Moreover, the combination of crude import bans, financial sanctions and self-sanctioning at the company level is having a substantial impact on Russian oil exports, with consensus expectations for a 1.5-million- to two-million-barrel-a-day disruption in April.

"We currently forecast Brent crude to average $82/bl in 2022, while noting substantial risks to the forecast in light of the ongoing uncertainty around Ukraine," Fitch Solutions notes.

Meanwhile, industrial metal prices have weakened since the stunning rally seen in the days after Russia's invasion of Ukraine. Fitch Solutions highlights that nickel, aluminium, copper and palladium are Russia's largest metal exports, accounting for a significant proportion of global seaborne supply, and facing the greatest upside risks to prices in the coming months as supply dynamics remain uncertain.

"While we note that the strong rally in metal prices seen in the last two weeks would be hard to replicate in the coming months in terms of magnitude, we caution that there remains significant risk of further upside to prices should there be an escalation in the conflict or further sanctions or trade restrictions placed on Russia."

In general, Fitch Solutions sees prices of metals remaining elevated in first half of this year at least as the Ukrainian invasion evolves, and sanction uncertainty heightens investor panic and speculative buying.

Further, for precious metals, Fitch has revised up its 2022 gold price forecast from $1 700/oz to $1 900/oz and its 2023 forecast from $1 650/oz to $1 800/oz on the back of the Russian invasion of Ukraine that has sparked an uptick in the demand for the safe-haven asset as investors adopt a risk-off sentiment.

"While gold prices are hovering near their all-time high of $2 075/t, and will be dictated largely by the war in the coming months, we expect US dollar strength and recovering bond yields to cap gold's rally," the firm says.

Gold is being supported by the Russia-Ukraine war, rising global inflation and the still persisting Covid-19 pandemic. However, on the other hand, the US Federal Reserve's normalisation of monetary policy, recovering bond yields, strengthening dollar, as well as the continued easing of restrictions as vaccination rates continue to rise, will put a lid on gold prices.

"While we expect significant price volatility going forward, especially as the conflict in Ukraine evolves, we expect gold prices to remain elevated in the coming years compared to pre-Covid-19 levels."