Parabolas and Power: Energy Volatility Spills Into Currency Markets
Under pressure since the invasion of Ukraine, European power prices have jumped further over the last week. At the time of writing, German baseload power prices have reached EUR570 per megawatt hour (Figure 1), the highest level ever.
Although this parabolic rise is consequential in its own right, we note the coincident fall of the euro against the dollar, once more falling below parity in 2022 (Figure 2). At the same time, the volatility of the single currency versus its American counterpart has risen, with 1-month option volatility on the currency cross approaching year-to-date highs. It appears that energy price volatility, compounded by Europe’s supply dynamic woes, are largely to blame for the currency’s sudden weakness.
There is also an interest rate aspect to this story: the hawkish narrative maintained by the Federal Reserve, both at Jackson Hole and elsewhere, means that a carry trade remains relatively attractive, to the euro’s detriment. However, not all of this can be explained by carry: the difference between dollar and euro policy rates is less than the 250bps available in 2019, when the euro remained comfortably above parity. This confluence of factors – US interest rates, energy volatility and record inflation – could well mean after two decades, the era of euro strength is at an end.
Figure 1. German Month Ahead Baseload Power Prices
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Source: Bloomberg; as of 24 August 2022.
Figure 2. EUR/USD Spot
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Source: Bloomberg; as of 24 August 2022.
Figure 3. EUR/USD 1-Month Option Volatility
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Source: Bloomberg; as of 24 August 2022.
The Inflation Reduction Act
The Inflation Reduction Act (‘IRA’) in the US represents a landmark piece of legislation for the Biden administration. The Act’s wide scope includes provisions for taxing stock buybacks, increasing tax enforcement and imposing a minimum 15% corporate tax rate for firms with more than USD1 billion of top line revenue.
Aside from the direct implications for investors in those companies, the wider ESG implications of the IRA require consideration. The Act contains USD370 billion in energy and climate incentives, directing more spending towards environmental concerns than any other single area. In our view the most important are the investment tax credit of 30% for renewable projects, the production tax credit of 1.5c/kWh for firms producing renewable power and the extension of existing subsidies and credit for either ten years or until emissions targets are met. This latter feature is possibly the most notable: while existing environmental policies account for around a third of the IRA’s environmental spending, the ten-year extension allows for far more certainty for businesses and investors. Previous environmental tax credits and subsidies were often of short duration, minimising the incentive to invest; the extension should mean that the relative impact of the policy is higher.
However, the Act falls short on a few key measures. Only USD2.9 billion of loan guarantees and grants are provided to incentivise investment in electricity transmission infrastructure. A carbon tax is a notable absence, meaning that the approach could be characterised as ‘all carrots, no sticks’, failing to properly impose costs to those currently freeriding on the externality of carbon emissions. Nevertheless, with some analysts projecting that the policies will lead to emissions falling 10-15 percentage points to around 40% below 2005 levels by 20301, it represents some progress on ESG priorities by encouraging the commitment of greater amounts of climate-focused private capital. However, this is still 10 percentage points away from the climate targets outlined by President Biden after the April 2021 Leaders Summit on Climate2.
With contributions from: Peter van Dooijeweert (Man Solutions – Head of Multi-Asset Solutions), Edward Hoyle (Man AHL – Head of Macro) , Jason Mitchell (Man Group – Head of Responsible Investment Research) and Jess Henry (Man Group – ESG Analyst).
1. Source: Princeton University Zero Lab REPEAT Project, Energy Innovation: Policy and Technology LLC, Rhodium Group, Goldman Sachs Global Investment Research.
2. https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/23/fact-sheet-president-bidens-leaders-summit-on-climate/
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