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ESG Focus: Carbon Markets To Reduce Chinese Iron Ore Demand

ESG Focus | Dec 08 2021

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ESG Focus: Carbon markets to hit China iron-ore trade

China’s green taxonomy homes in on circularity, suggesting a -28% fall in seaborne iron-ore demand within five years – not to mention metallurgical coal.

-Carbon-market agreements to hit Oz miners
-Higher carbon prices and the CBAM connection
-The China, CBAM and Australia connection

By Sarah Mills

COP26’s carbon-market agreements could hit Australian miners within the next five years, say analysts.

The world’s nations reached an agreement on a framework for carbon markets under Article 6 of the Paris Agreement, which analysts expect will free transition capital and raise carbon prices.

 “Global agreement on carbon mechanisms will unleash market forces, but also increase transition risk,” says Credit Suisse in its recent COP26 Watch.

While article 6 does not have direct implications for voluntary carbon markets, the internationally transferred mitigation outcomes (ITMOs) and the new market-based mechanisms are likely to reduce the pool of available offsets in the voluntary market, pressuring prices (see Article 6 summary below).

The EU and US also agreed to a deal to abolish tariffs and restrict access to products that don’t meet carbon intensity levels.

Higher carbon prices and the CBAM connection

Observers consider one of the main achievements of COP to be the decision to price carbon high enough to incentivise a green transition.

“Agreement on the rule book should see strong growth in the coverage of emissions trading schemes and the voluntary market: in our view, the foundations of a global carbon price have been put in place,” says Credit Suisse in its COP26 Watch.

Credit Suisse expects this will result in sharply higher carbon price and transition risk and estimates the resulting average Carbon Earnings at Risk (CEAR) for miners will increase from 14% to 102%.

Macquarie agrees, expecting prices in voluntary carbon credits will be “on fire”, and notes European carbon prices hit new highs in late November.

Bloomberg Green reports Europe's carbon price almost tripled in 2021, and the cost of permits has risen more than 140% this year – a move that favours gas over coal.

Clean Energy Transition expects permits will continue to rally strongly over the next few weeks as utilities buy allowances for the year's emissions burning.

The EU’s Emissions Trading System is pricing carbon at EUR60 in preparation for the introduction of the carbon border adjustment mechanism (CBAM), which is expected to have a significant impact on Australia’s resource companies over the next five years, particularly upon iron ore and metallurgical coal exporters.

The CBAM applies to steel, aluminium, ammonia, cement and electricity.

CBAM developments may indirectly hit Oz miners

Analysts say that on a direct basis, the affect of CBAM will not be too bad on Australian iron ore and metallurgical coal exporters, but if the EU extends the tax to upstream products, the risk for Australia will be significant.

They say China is the big directive and that CBAM’s effect on Chinese exports is likely to significantly decrease iron ore and met-coal demand within the next five years. 

China’s recently published green taxonomy focuses strongly on circularity, as the manufacturing giant moves to kill two birds with one stone.

“On current projections, within five years time, China’s products will be 10% less competitive and, as the largest importer to the EU, it recognises the threat and is moving very fast,” says one analyst.

“Already, China is massively accelerating its arc furnace development. This is likely to result in a 28% fall in seaborne iron ore demand. Basically there will be less metallurgical coal and less iron ore.”

The exact timing of the tipping point within the next five years is more difficult to discern, given the capital intensity of the industry. 

Blast furnaces are long-term investments so much will hinge on decisions around new infrastructure.

The transition is also likely to spur capital investment in green projects which is supportive of the iron ore price, as witnessed recently when China stocked up for its transition and covid-driven demand spikes. 

China is also seeking to engineer a soft landing for its property market over the next year.

Some analysts expect these factors could underpin demand into FY23, possibly even FY24. But once the balance tips, it should be all in one direction out to a five-year timeframe. 

Macquarie reports in its Global Iron-ore Miner report that iron ore is finding seaborne cost curve support and that Australian iron-ore miners experienced a strong start to December.

"On a combined basis, we expect a sequentially stronger quarter as miners with a December year-end have historically ramped up their exports," says Macquarie.

The broker notes that Chinese steel mills margins have improved sharply and that "it is possible better margins will drive a small rebound in steel production before the next policy driven curtailment hits northern mills".

Rio Tinto and Vale recently lowered production guidance. 

Covid-induced supply chain issues are also in the mix, the fundamentals are clear, say analysts.

Macquarie says despite support emerging, the risk for Australian miners remains to the downside in FY22 but spies a rebound in FY23, with BHP the clear winner.

The China, Australia, CBAM axis

“China is already removing tariffs from scrap metal in anticipation of an explosion in electric arc furnaces,” says one analyst.

“There will be a massive global increase in demand for direct reduced iron.

“Under new carbon rules, iron purity in steel will need to be above 66%. Most of Australia’s ore is 62% and ore of that purity is rare.”

In October, Rio Tinto ((RIO)) and BlueScope Steel ((BSL)) announced intentions to explore low-carbon steelmaking and are partnering to build a processing facility to 65% purity.

Analysts say Rio Tinto will be using the partnership to scope out costs for higher investment in this area.

The Port Kembla Steelworks plant will use green hydrogen to reduce iron ores for use in electric smelters.

Meanwhile, scrap is set to become more valuable and analysts expect it should start to trade at a premium to iron ore.

To provide perspective, BHP Group ((BHP)), in its Pathways to Decarbonisation Series, says the direct and indirect emissions footprint of traditional steelmaking is roughly two tonnes of CO2 per tonne of steel produced.

This compares to gas-based production of direct reduced iron of 1.4 tonnes.

Electric arc furnace production is just 0.4 tonnes.

Sims ((SGM)) is an obvious beneficiary.

Steel is completely recyclable and is already the most recycled materials on earth.

However, the world faces a shortage of scrap metal, BHP estimating a -50% shortfall in supply to meet global demand by 2050.

Hence producers are examining biomass, hydrogen, and carbon capture options.

Thermal electricity affected to lesser degree

Analysts say the agreement on a carbon price affects thermal electricity generation to a lesser degree and that it mainly affects arbitrage opportunities in land-adjoining countries.

However, outside of covid-inspired supply-chain driven volatility, the supply and demand fundamentals for thermal energy remain poor and once the world exits covid and supply constraints ease, the prognosis is also poor. 

In the meantime, while analysts see signs that energy prices may have peaked, volatility is expected to remain.

Morgan Stanley also forecasts a mild impact on coal power industry near term but expects future tightening is likely.

Thermal coal accounts for the majority (40%) of China’s emissions, followed manufacturing and properties at 23.2% (again pointing the bone at metallurgical coal).

Other CBAM developments

Meanwhile, the US and EU announced a deal to remove tariffs on steel and aluminium for two years, agreeing to negotiate a carbon-based arrangement on trades for the two commodities to reduce carbon intensity and production. 

Both agreed to work towards permanently removing the tariffs globally and restricting access to products that don’t meet carbon intensity levels yet to be determined.

Rio Tinto meanwhile has reaffirmed its commitment to decarbonisation but says it will now take a staged approach without compromising the competitiveness of its aluminium business – in other words, it is confident it can walk the tightrope.

Key agreements for Article 6

-A minimum of 2% of the issued A6.4ER units will be cancelled to encourage emissions mitigation. This would result in a 51 MtCOe of extra abatement of global GHG emissions and Eur2.8bn SOP revenue for adaption. It would also reduce supply, increasing carbon prices.

-A 5% levy will be applied to the crediting system, which will be transferred to an Adaption Fund, not including Certified Emissions Reductions issued since 2013.

-No double counting is permitted in ITMOs – a mitigation transferred abroad must be uncounted by the country that agreed to transfer it.

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