For carbon market veterans, recent events have brought back unwelcome memories of 2008-09. Then, as the global financial crisis roiled the world’s markets, the price of carbon dioxide (CO2) allowances in the EU’s flagship Emissions Trading System (ETS) collapsed from almost €30 a tonne (/t) of CO2 in June 2008 to barely €9/t by the following February, only to languish in single digits for the next decade.
It was Russian tanks rolling into Ukraine rather than financial crisis that triggered panic in the markets this time round. The day before the Russian invasion, the price of the benchmark EU allowance futures contract closed at €95.07/t. By 7 March, it had slumped to €58.30, a 39% fall.
However, this time, market watchers say, is different. In the wake of the global financial crisis, recession reduced economic activity, destroying demand for allowances. Meanwhile, the regulators of the EU ETS lacked the ability to address the overhang of allowances that kept prices depressed for a decade. Now, a more robust climate policy is likely to prevent carbon prices sliding towards irrelevance.
“I don’t see the 2009 scenario being repeated for carbon prices,” says Marcus Ferdinand, the Oslo-based head of analysis at Greenfact, an environmental markets analysis company.
“This market is going to run into scarcity between now and 2025… This is what has supported prices in the past and will support prices going forward.”
Indeed, a better analogue for the carbon market than the 2009 price collapse would be its response to the Covid pandemic. Then, despite concerns about economic downturn – and a subsequent fall in EU emissions as European economies locked down – the price quickly shrugged off an initial fall from the mid-€20s to €16/t, before doubling in value by the end of 2020.
Two factors were at play in 2020 and again this year: the Market Stability Reserve, which works to soak up any overhang of allowances caused by a faster-than-anticipated fall in emissions, and the long-term policy commitment by EU member states to the EU ETS as the bloc’s primary tool to get to net-zero greenhouse gas emissions by 2050.
The initial sell-off in the carbon market in response to Russia’s invasion of Ukraine had little to do with longer-term climate policy considerations. Instead, it was due to a combination of factors, including general ‘risk-off’ sentiment, which saw investors – many of which had profited from the rise in carbon prices last year – flee into safer markets. Some sellers included Russian traders, repatriating assets before sanctions bit.
Rocketing prices in energy markets also forced some traders to liquidate positions in carbon to meet margin calls in other energy markets, such as natural gas. Traders using exchanges are required on a daily basis to post cash against their positions to ensure that, if they go bust, their counterparties are paid. Large changes in market prices can lead to substantial calls for additional cash.
Meanwhile, the carbon market saw some support from compliance buyers taking advantage of EU allowance prices that were, briefly, some €40 below the market peak, says Bernadett Papp, Budapest-based senior market analyst at Vertis, a carbon trading and advisory company. “Compliance buyers are continuing to take the market seriously,” she told Energy Monitor.
Since the nadir on 7 March, the price of carbon has recovered, with the benchmark contract opening at €78/t on 16 March. Part of the reason is the forthcoming compliance deadline of 30 April, by which date emitters are required to surrender allowances to match their 2021 emissions.
Another bullish signal for the carbon market is an increase in coal-fired generation. Not only have high gas prices dating back to last autumn encouraged coal plants to run flat out, but policymakers are also considering bringing coal-fired generation back online to reduce the use of Russian gas. Given that electricity generated with coal requires twice as many allowances as the same volume produced with gas, this would increase demand for EU allowances (EUAs).
Just before the Russian invasion of Ukraine, research company BloombergNEF calculated that emissions from the power sector in Germany, France, Italy and the UK could be up to 14% higher from January to September 2022, compared with the same period in 2021. This would equate to demand for an additional 242 million EUAs. Delays to coal phase-outs across Europe “could see this figure rise further”, its analysts say.
However, while increased emissions from coal power is a near-term inevitability, European policymakers see the EU’s climate agenda as a vital part of the response to Russian aggression. “Brussels is doubling down on 'Fit for 55',” says Ferdinand, referring to the package of measures intended to help the EU meet its goal of reducing carbon emissions to 55% below 1990 levels by 2030.
“Long-term, this could be bearish for carbon,” he adds, "because you would see a new dash for renewables which goes beyond what is in the plans right now, and a quicker phase-out of fossil generation to reduce Europe’s dependency on external sources.”
Demand destruction poses downside risk
Another factor that could yet depress the carbon price would be demand destruction among European industries in the face of high energy prices. Ingvild Sørhus, lead EU carbon analyst at Refinitiv in Oslo, points to fertiliser producers in Spain, for instance, reducing production during the current crisis. “If that trend continues, we will see lower emissions from the industry side that could offset some of the increase in emissions from the power sector,” he says.
However, Mariko O’Neil, a carbon analyst at BNEF in London, notes that emissions from the power sector dwarf those from industry. “Industrial demand destruction is something we are watching closely at the moment, but industrials still have a decent cushion from free allocation. It would take a huge dent to affect [overall] demand in the ETS."
Even in a scenario of a severe economic contraction, measures put in place to address an oversupplied market would prevent the carbon price from crashing, analysts note. The MSR began operating in 2019, and is designed precisely to improve the resilience of the ETS to major shocks by adjusting the volume of allowances available to be auctioned by governments. “It provides a safety net for the carbon market,” says Sørhus.
Emitters tend to be more concerned about high rather than low carbon prices and, inevitably, there have been calls to suspend the EU ETS in the face of high energy costs and the Ukraine war. Italy’s business lobby group, Confindustria, called at the start of March for a temporary suspension of the ETS.
However, such a response is unlikely to find much support in European capitals. Government auctions of carbon allowances provide vital revenue for governments, much of which is being channelled to help industry decarbonise. In addition, Sørhus noted that the European Commission, in its 8 March communication responding to the Ukraine invasion, stated that revenues from the EU ETS could be used to provide financial support for lower-income households.
However, for all the doubling down on the 'Fit for 55' agenda, Trevor Sikorski, head of natural gas and carbon research at Energy Aspects in London, does see the Ukraine war slowing down climate policy development, possibly affecting the complex negotiations around the EU's carbon border adjustment mechanism (CBAM). “So much time is going to be spent sorting out the current crisis, the flood of refugees… the energy crisis. These are massive challenges that didn’t exist six weeks ago,” he says.
“That doesn’t mean 'Fit for 55' is going to be ignored, but it is going to take longer to get things agreed,” he suggests, with the first phase of CBAM coming into effect in 2025 rather than 2024.
In the near term, few analysts expect the carbon price to return to the near-€100 levels of recent months. “To get the price back to where it was pre-invasion, you would need a lot of speculative capital to come back into the market,” says Sikorski. “I think that is less likely.” The only certainty, say analysts, is more uncertainty.