For those who believe in the “polluter pays” principle, the EU Emissions Trading System (ETS) is starting to deliver. On 7 May, the price of EU carbon allowances (EUAs) closed above €50 per tonne (t) of carbon dioxide for the first time. At the same time last year, EUAs were trading below €20. The question for emitters across Europe, and for investors speculating in the market, is whether the rally will go into reverse – or whether high carbon prices are here to stay.
“There are a lot of supportive fundamentals underneath the market,” says Nicolas Girod, a managing director at carbon markets advisory firm Clear Blue Markets in Amsterdam. “I don’t think we’ll see a correction, certainly not before July,” when the European Commission is due to unveil a wide-ranging climate policy review. “And there are people talking about a price spike … It could go to €70, it could be €100. It’s anyone’s guess,” he adds.
A confluence of factors has been behind the dramatically rising carbon prices. In the past, they were driven by movements in energy markets, specifically the relative prices of coal and natural gas. When gas prices are high, power generators use more coal-fired power and need to buy more carbon allowances because coal emits twice as much carbon as natural gas per megawatt of power produced. In recent months, gas prices have been high, driven by constraints to supply from Russia and Norway, and strong demand in Asia.
Taking a longer-term view
But the market no longer takes its cue only from near-term factors, says Marcus Ferdinand, head of European power and carbon analytics at market intelligence firm ICIS. “Now, all of a sudden, there are players in the market who take the long-term view ... These investors have priced in the [EU’s] 2030 [climate] framework and see the market as a good buying opportunity.”
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This switch in thinking dates back to the election last November of US President Joe Biden. That set the stage for more aggressive climate policy globally, including the EU’s decision in December to increase its 2030 emissions reduction target to 55% from 40% and, more recently, the G7’s pledge to hold global warming to the more ambitious 1.5°C limit set out in the Paris Agreement.
Meanwhile, the European Commission, which oversees the market, appears relaxed about rising carbon prices. Its hydrogen strategy, released last year, suggested that an EUA price of €55-90/t would be needed to make fossil-based hydrogen with carbon capture competitive with fossil-based hydrogen today. In early May, head of EU climate change policy Frans Timmermans responded to questions about EUAs breaching €50 by arguing that intervening in the carbon market “would create a non-market-based price, and that would absolutely undermine the credibility of the EU ETS”.
Timmermans added: “If we want to achieve our goals, I think the price should be much higher … But that’s up to the market.”
Enter the investors
Expectations that carbon prices will have to rise if Europe is to meet its climate objectives have piqued the interest of investors – hedge funds as well as more cautious institutional investors. While the former are trading carbon as they would any other commodity, some of the latter are equity investors buying EU carbon allowances as a hedge against climate risk. As climate policy becomes more stringent, the thinking goes, carbon prices are likely to rise, potentially offsetting declines in the value of carbon-intensive assets. “This makes carbon less of an energy commodity than a financial asset,” says Ferdinand at ICIS.
There is a potential feedback loop underway, with price rises spooking some big emitters. Facing much greater costs meeting their obligations within the EU ETS, they are understood to be hoarding allowances and increasing hedges, fearful of future price rises.
All this goes to explain how prices are rising even as some NGOs warn of a surplus of EUAs in the market that is undermining the incentive for emitters to reduce their emissions. Recent analysis from Sandbag showed that reduced emissions resulting from the Covid lockdown had increased marginally to 1,392 million tonnes by the end of 2020, up from 1,219 at the end of 2019 – a figure not far short of the 1,571-million-tonne cap for sources covered by the EU ETS (excluding aviation) in 2021.
However, analysts at investment bank Berenberg say this surplus “is a red herring: It is already largely tied up by ETS hedging, investors or holders for whom it would be irrational to relinquish their positions”.
Prices set to spike?
So where do prices go from here? Berenberg warns that prices could rise to €110/t by the end of the year as a combination of limits to allowance supply, political signals and hoarding by emitters squeezes the market. This spike, it argues, would trigger a political reaction that would bring down prices.
Other analysts are more cautious. ICIS sees prices moving sideways this year, before rising to the mid-60s towards the end of the decade. Budapest-based advisory firm Vertis Environmental Finance is estimating that prices will average €51 in 2021 and rise in subsequent years.
There are an awful lot of signposts pointing one way. Any market whose supply only shrinks, over time, under law, would do the same thing. The price has gone up to meet the politics. Alessandro Vittelli, market analyst and independent journalist
However, according to Jahn Olsen, head of European carbon at Bloomberg New Energy Finance (BNEF), the EU ETS is in “a new paradigm”, with prices likely to trade in a €48-60/t range for the next couple of years, before climbing to €70-90 over 2024-27 and above €100 towards the end of the decade.
Certainly, most of the arguments are on the upside for carbon. The July Fit for 55 package is expected to include proposals to extend the EU ETS to new sectors – intra-EU shipping, road transport and buildings. It aims to set new emissions targets to bring the EU ETS in line with the new 2030 55% goal. And it could include a proposal for a Carbon Border Adjustment Mechanism. This is designed to protect EU industry from imports from jurisdictions that don’t price carbon.
“There are an awful lot of signposts pointing one way,” says market analyst and independent journalist Alessandro Vittelli. “Any market whose supply only shrinks, over time, under law, would do the same thing. The price has gone up to meet the politics.”
High prices priced in
Olsen at BNEF agrees. “Everyone, even traditional opponents of the ETS, the likes of the cement and steel industries, Poland, Hungary, Romania, accept that we will need a high price to meet the EU’s new ambitious targets.”
That is not to say that rising prices are guaranteed. For example, Bernadett Papp, a senior market analyst at Vertis, notes that the EU ETS directive allows for member states to cancel allowances due to be sold to coal-fired power generators if those plants are retired early – but it does not mandate their cancellation. Were member states to sell those allowances instead, that would put pressure on prices.
Equally, she describes the presence of speculators as a “Damocles sword” hanging over the market. Should they decide to exit en masse, the price could fall rapidly. Meanwhile, over the longer term, high carbon prices will incentivise investments in emissions reduction technology. Should that happen more rapidly than anticipated – similarly to the effects of Chinese solar photovoltaic mass production – carbon prices could head south.
In addition, the July package could yet disappoint the bulls. The EU is divided on the case for aggressive climate action – at the May Council of Ministers, opposition from Eastern European countries led by Poland forced a postponement of discussion of the Fit for 55 package. Any perceived watering-down of the EU’s climate ambition could trigger a sell-off among speculators. Even an as-anticipated package could trigger profit-taking: “This is a market that tends to buy the rumour and sell the fact,” says Girod at Clear Blue Markets.
Speculators in the spotlight
There are also calls to try to reduce the influence of speculators in the market. In May, Green MEPs issued a position paper on EU ETS reforms that included measures to restrict speculation in the market (although they also called for a price floor to keep prices above €50/t). However, the commission has resisted such calls in the past. First, one person’s speculator is another person’s provider of liquidity. It is also very difficult, in practice, to differentiate between investment-driven speculation and “legitimate” trading and hedging by emitters.
The rising prices and, crucially, high levels of volatility raise questions over the efficacy of Europe’s carbon market, say analysts. For emitting companies that want to fund investments in emissions-reducing technology using carbon allowances, volatile prices make that more difficult.
“We have seen prices range from €4 [in 2018] to more than €50. This is very difficult for compliance entities to deal with,” says Papp at Vertis. “What they need is a stable price signal, less volatility and a less changeable legal environment. That is what they need to make long-term investments to reduce emissions.”
“The question is, how much volatility can the compliance side digest while continuing to make investments?” asks Ferdinand. “But if there comes a point where volatility is constantly too high to make sensible investment decisions, then obviously that can turn into problems. We’re not at that point yet, but this is a discussion we need to have.”