Double whammy: European power and carbon prices
Soaring power and carbon prices are affecting European corporates, with significant implications for credit portfolios.
First, we have seen a significant increase in the level and volatility of European power prices. There are numerous reasons for this price shock, including geopolitical tension, production issues in nuclear and renewables, and years of underinvestment in gas. The power-price increase will be felt by consumers, but the impact is also very immediate and pronounced in certain industries.
The second concern is the steep rise of the cost of carbon that is determined via the EU emissions trading system (ETS). The EU ETS is the cornerstone of Europe’s climate change policy and, while the price of carbon is designed to rise over time, the sharp near-term increase will have important implications for companies with high emissions covered by the scheme.
Winners and losers
European utilities sit at the centre of these issues. The impact on them varies widely, depending on whether companies are net consumers of power or if – and how – a company produces power it can sell to the market. We believe fully integrated utilities should be better insulated. Those with a greater share of renewable production can actually benefit, as their output can be sold at higher prices without paying the higher carbon cost. We are cautious on companies with a worse production mix and those that may be forced to buy additional capacity at high market prices, as we have seen recently with EDF*.
Industrials based in Europe are also facing challenges related to these elevated input costs. Companies such as auto suppliers that operate with tight margins and limited capacity to pass on higher energy costs are vulnerable, in our view. Industries such as construction and materials face a potential double whammy: paying more for both power and carbon permits. Given they operate in a global market, they could be put at a disadvantage versus foreign competitors by paying higher prices to operate their factories and to offset their carbon emissions. Bonds issued by these industrials have performed well during the COVID recovery, but going forward we think these headwinds are not sufficiently priced by the market.
We believe that such risks also create opportunities, and through LGIM’s utilities and industrials Global Research and Engagement Groups we have identified sector-specific themes to discuss with management teams.
For example, we have asked cement companies for more transparency about their carbon-hedging policies and the impact on their margins under different carbon-price scenarios. In our engagement with utilities, we want to understand the impact on their capex spending and their future financing needs. This should enable us to manage and properly price these risks and continue to build robust euro credit portfolios.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.