What is the Carbon Market?
The “carbon market” is essentially a price put on carbon emissions to make polluting less appealing to firms. Through the process of trading carbon “allowances”, firms can acquire permits which correspond to the level of their carbon dioxide emission. The European Union’s Emissions Trading System (EU ETS) is the world’s first and largest carbon market for this kind of trading in which they are currently running a “cap-and-trade” approach. With a maximum emission level determined, set to decrease each year, the EU’s overarching goal is to drive firm’s emissions down over time. This “cost-effective” approach has been hailed by the EU as the “cornerstone” of their combat policy to climate change. Primary culprits of the EU’s greenhouse gas reduction scheme include industries such as power plants, manufacturing, and aviation. These firms are limited by the enforced “cap” on their emissions, although, do have discretion to trade these emission allowances as needed. The policy thus far has been viewed by the EU ETS as considerably effective with “Phase III” (2013-2020) seeing an annual linear reduction factor (LRF) of 1.74% - meaning that in that period the EU were able to meet their 20% greenhouse gas reduction target. Looking forward to “Phase IV” (2021-2030), the EU will continue to match their targets with the LRF set to 2.2%. This increased reduction factor was positioned to align with achieving at least 40% GHG emission reductions by the end of “Phase IV” (compared to 1990 levels).
EU27’s International Emission Position
As of 2021, EU27 ranks 3rd out of all polluting economies globally on a per calendar year basis (2793MtCO2). However, a more valuable metric of comparison when examining GHG emissions is pollution per Capita and per GDP. This shows EU27 as a relatively mid-tier offender; 47th in tCO2/person and 86th in kgCO2/GDP. These positionings in the world table offer indication of European improvement having moved down the rankings through years of investment and advancement in renewable technologies. Their position in the global market, however, is one of the biggest reasons why the EU carbon market system has to continue to work effectively and reduce their independent GHG emissions. Acting as a leader on the global stage is an important role of the EU, one which if the EU ETS system were to fail would send ripple effects throughout smaller, newer carbon markets across the world.
European firms’ reactions to Carbon topping a ton
A market once predominantly controlled by European corporations has now moved to a price level in which firms will begin to feel the pressuring effect of using carbon intensive energy and will now legitimately begin to consider alternative energy solutions such as carbon capture, biomethane and hydrogen. Passing the century mark is a clear signal to firms of the direction in which this market is heading in and likely will spur on investments in these clean technologies. However, a lot of renewable technologies require substantial capital investment from firm’s so to be sustainable in the long term. A challenge that key legislation such as the European Green Deal is hoping to combat.
What does the future look like for the Carbon Market?
Looking at the future of the carbon market requires the analysis of 3 aspects of the market itself: past performance, demand perspective and the integral market structure.
- Past performance. This is easily determined when observing the carbon markets price over time as seen below. Two different stories are being told here where firstly from the EU ETS’s inception in 2005 up until the start of 2020, despite shocks, the price level remained relatively low and reasonably consistent with no signs of skyrocketing. However, since 2020 we have seen exponential growth in just a 3-year period. Why is this?
- Demand Perspective is a good starting point for trying to find the answer to this question. Consistent low prices has been pinned down by Bayer & Alkin (2020) as they note that the firm’s judgment on whether the market they are buying into is a “credible institution” is what drives both emissions levels and market price. When firms begin to truly believe that in the future the market may “become more stringent” even at lower price levels they may switch away from carbon use. This business perspective or demand perspective is why prices consistently low despite still reducing emission levels within the EU. What is said for the past 3-year price eruption?
- The integral market structure of the EU ETS is something which, when reviewed, can show signs of why prices may continue to increase at similar rates over the next decade. There is a characteristic of the ETS called the Market Stability Reserve (MSR) which essentially acts as a vault - balancing the total number of allowances in circulation. It operates through a complicated process of balancing the reduction of existing allowances in circulation as well as introduction of more allowances to maintain stability. However, when the MSR holds more allowances than a given threshold, the excess is permanently canceled meaning supply is fixed. With this fixed supply it is expected that the market price will continue to increase to price levels much greater than €100 – proving profitable for avid market investors and proving very beneficial, ultimately, for European climate action.
References:
Bayer, P. and Aklin, M. (2020). The European Union Emissions Trading System Reduced CO2 Emissions despite Low Prices. Proceedings of the National Academy of Sciences, 117(16), pp.8804–8812. doi: https://doi.org/10.1073/pnas.1918128117.
Carbon price: efficient market does its bit for the planet. (2023). Financial Times. [online] 21 Feb. Available at: https://www.ft.com/content/a19b8d5d-e554-4ad8-be0d-49944193e2c1.
Clean Energy Wire. (2014). Understanding the European Union’s Emissions Trading System (EU ETS). [online] Available at: https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system#:~:text=The%20EU%20ETS%20follows%20a.
data.worldbank.org. (n.d.). CO2 emissions (metric tons per capita) | Data. [online] Available at: https://data.worldbank.org/indicator/EN.ATM.CO2E.PC?end=2019&most_recent_year_desc=false&start=2019&type=shaded&view=map&year=2019.
EU carbon price tops €100 a tonne for first time. (2023). Financial Times. [online] 21 Feb. Available at: https://www.ft.com/content/7a0dd553-fa5b-4a58-81d1-e500f8ce3d2a#comments-anchor European Commission (n.d.). Emissions cap and allowances. [online] climate.ec.europa.eu. Available at: https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/emissions-cap-and-allowances_en.
Global Carbon Atlas (2020). CO2 Emissions | Global Carbon Atlas. [online] Globalcarbonatlas.org. Available at: http://www.globalcarbonatlas.org/en/CO2-emissions.