SustainaWeekly - ETS companies face profit squeeze

Economist

Sharp rises in energy and carbon allowance prices have pushed up end-pricing at big Dutch industrial emitters by 44%, still a full cost pass-through is difficult to enforce due to global competitive forces. This puts pressure on profit margins, but also makes investing in sustainability more attractive for companies.

Sectors

The Dutch government has set a policy that every new car to be sold from 2030 onwards has to be a zero-emission car, which should make a significant contribution to a net zero trajectory for the mobility sector. However, a key obstacle is that battery electric cars are much more expensive to buy even taking into account government subsidies.

ESG Bonds

The new issue concession on corporate green bonds reached a multi-year high, despite green offerings having a similar credit quality of that of regular bonds. In secondary markets the green bond index suddenly trades at a wider credit spread than the regular index. The dismal performance of real estate credit this year is one explanation.

ESG in figures

In a regular section of our weekly, we present a chart book on some of the key indicators for ESG financing and the energy transition.

ETS producer prices follow trends in energy prices and CO2 price

• Gas, electricity and CO2 prices rose sharply last year

• This makes investing in sustainability more attractive for companies

• Higher energy and CO2 prices increase the producer price index for ETS-companies

• However, in order to maintain competitiveness, producer prices do not increase as much

It is the period when most listed companies announce quarterly results. Many companies publish their company figures and results. The press releases of many industrial companies - as large consumers of energy - will undoubtedly have a reference to the impact of the rising cost of gas and electricity on the result and also on producer prices. However, this reference alone will not stop there, especially for large industrial greenhouse gas (GHG) emitters. The trend in the CO2 tax (or price) will also have a significant impact on the producer prices of Dutch EU ETS companies and indirectly on the result.

EU-ETS-companies

Within the European Emissions Trading System (EU-ETS), GHG emissions allowances are traded. With this system the EU is able to reduce GHG emissions in an effort to meet climate targets towards 2030 and 2050. This allows the EU to annually limit the number of available free emission allowances. It increases the price for an emission allowance, also known as the carbon price. By doing this, investing in sustainability automatically becomes more attractive for companies.

According to the Netherlands Emissions Authority (NEA), the EU-ETS is the largest of its kind globally. In total, about 10,000 European companies are covered by the system. Collectively, they are responsible for about 45% of EU CO2 emissions. In the Netherlands, about 400 companies participate in the EU-ETS. These companies are mainly active in energy supply (such as electricity and heat production), energy-intensive industrial sectors (such as chemicals, oil refining, food production and metals) and intra-EU commercial aviation. Shipping and built environment will be added later to the system. Most of the current ETS-companies are located throughout the Netherlands, but with a strong concentration in the western Netherlands.

South Holland is home to most ETS companies, particularly around the port of Rotterdam. This includes a multitude of industries, such as petrochemical companies, chemical companies and offshore/onshore-related companies. In North Holland, emissions are mainly caused by steel production in Velsen (Tata Steel). In Groningen, energy supply in particular accounts for a large share of emissions, especially in Eemshaven.

EU-ETS & CBAM

Since its introduction in 2005, the EU-ETS system has been revised three times: in 2008, 2013 and 2021. Most of these revisions were aimed at making the system more restrictive and effective. From 2005-2007, emission allowances were so generously distributed in sectors, which kept the CO2 price extremely low. From 2008-2012, more companies and plants were added. Moreover, nitrogen emissions also became part of the EU ETS system. The CO2 price started to rise again. From 2013-2020, even more GHGs were added to the system and the Market Stability Reserve (MSR) was introduced, creating more flexibility in the supply of allowances for more balance in supply and demand, and thus price stability.

However, with the introduction of the EU-ETS, concerns about carbon leakage also increased. Once the producer price of EU manufacturers increases due to the additional cost of emissions, those same EU manufacturers thereby lose out on competitiveness against non-EU manufacturers (who do not face a price on emissions). EU manufacturers are then more likely to decide to move their production facilities to regions outside the EU-ETS while global emissions are not reduced. Moreover, this reduces the number of jobs in Europe. To address the problem of carbon leakage and create a level playing field for EU producers, the Carbon Border Adjustment Mechanism (CBAM) is being phased in. A three-year transition phase starting on 1 January 2023, with only a reporting requirement for importers. Thereafter - from 1 January 2026 - importers must actually start buying CBAM certificates, the price of which is linked to the CO2 price.

Price trends in industrial ETS-sectors

It is interesting to see how producer prices have behaved under the recent sharp rise in the price of energy (gas and electricity) for non-households and the price of CO2. For instance, the price of gas and CO2 have both increased by over 90% in one year and the price of electricity has risen by over 70%.

Such sharp price increases have also affected the producer prices of firms in sectors covered by the EU-ETS system. In this case, the producer price index in the figures above is the result of the average of the producer price index of the paper industry, petroleum industry, chemical industry, basic metal & metal products industry and construction materials industry. This average price index increased by almost 44% in one year. This is not with the same sharp increases in energy prices and CO2 prices, but still a relatively strong increase, given the historic trend in the producer price index.

Ultimately, producer prices rose less sharply than energy prices. This probably has a strong correlation with companies' strong desire to maintain competitiveness in particular. For instance, the same industrial companies in the US pay five times less for gas than counterparts on the European continent. This makes sharply rising prices for end users of EU-producers highly undesirable. In the end, this will ultimately translate into a squeeze on profits. Many ETS companies are therefore already tempering expectations about results for the rest of this year. After all, energy prices remain relatively high for the time being. Some companies in the chemical industry are also doubly affected by this. This is because natural gas is not only used as a source of energy, but natural gas is also an important ingredient for the final product. For instance, natural gas is an important raw material for making ammonia. And ammonia, in turn, is an important raw material for making fertilisers.

The relationship between gas and electricity prices with producer prices in the aforementioned sectors is strong. Since 2008, the series have followed each other almost closely, with energy prices showing slightly more volatility.

In particular, the relationship between the producer price index and the energy price index is high with a correlation coefficient of 0.71. When corrected for the outlier in the energy price index (red circle in the left figure above), the correlation coefficient increases to 0.86. It indicates that the trend in energy prices is usually an important driver of the trend in producer prices. When energy prices increase too sharply, the effect on competitiveness is also considered.

The correlation is more difficult to observe between producer price index and CO2 price (with a correlation coefficient of only 0.59). There also appears to be a seemingly moderate correlation between energy prices and CO2 price (with a correlation coefficient of only 0.63), but if we correct for the outlier in CO2 and energy price here too (red circle in right figure), the correlation is high with a correlation coefficient of 0.80. The CO2 price is strongly influenced by fundamental trends in energy markets. A study (published in the journal Applied Energy) shows that economic activity and natural gas prices are responsible for most of the variation in the CO2 price. However, this role has gradually diminished somewhat. Because variables such as oil and especially coal prices have now also gained more influence. In addition, other factors also influence the trend in the CO2 price, including energy and climate policies and speculative shocks.