What to make of soaring carbon prices?

by: Hans van Cleef

The European Emission Trading Scheme (EU ETS) is a beautiful, but vulnerable instrument. It is a tool designed to reduce CO2 emissions within the industrial and energy sectors and thus to achieve the climate objectives. But this instrument is part of a bigger scheme, where political goals and the profit-seeking of investors and speculators come together. A difficult mix?

Last Monday the price of EU ETS reached another record high. The emission rights that are traded under the EU ETS rose to a price of EUR 40.64 per tonne of CO2. With that, the rise that had already started in early March 2020 continued. In 2020, the main support came from the then still to be approved plans to reduce European CO2 emissions by 55% compared to 1990, instead of 40% by 2030. The recent support for the price came mainly from the cold weather and from market speculation.

Due to the low temperatures, we are burning more gas and using more electricity to heat our homes, among other things. This is driving up the demand for emission allowances. Coal and gas plants are now running at full capacity to meet demand. Especially during twilight hours, or on days when there is little or no wind and the sun is not shining sufficiently, the need for this traditionally generated form of electricity is high. When energy companies emit more CO2, they have to hand in extra emission allowances to compensate for these carbon emissions. If they no longer have these emission rights on the shelf, they have to buy additional rights on the market.

Emission rights can be obtained in two ways: via the auction at the European Energy Exchange (EEX) or via the Intercontinental Exchange (ICE). Emission rights are auctioned on a daily basis. That is, it resumed since 29 January. Before that, the auctions were halted for a while due to the completion of phase III (2013-2020) and to prepare for the start of this new phase (2021-2030). In phase IV, the number of available emission allowances will again decrease more rapidly in order to achieve the intended 55% CO2 reduction by 2030. In this way, the European Commission (EC) tries to create scarcity and stimulate companies to make their activities more sustainable in a faster pace. But from 29 January onwards, daily auctions are held again and companies that fall under the EU ETS, and therefore need these allowances for their activities, are able to send in their bids. These auctions set the tone for the trading prices of the EU ETS. On a daily basis, some 70-115 bids are submitted to the auction, of which 40 are successful on average, divided among an average of 20 parties. Only on 3 February were there remarkably few successful bids and winning parties. A day on which ‘coincidentally’ the price rose particularly quickly.

Through futures trading, other market participants can also buy emission rights. Futures are contracts that you buy now for a delivery of, in this case, emission rights at a later date. As a result of market speculation, prices can be pushed up sharply. Many investors assume, anticipating the new policy of the EC, that the price will rise as the policy becomes more strict. Companies can also take advantage of favourable price moments by buying allowances on the trading exchange and storing them for future CO2 emissions. The difference with companies buying the emission rights is that investors do not use these rights for their intended purpose at all. These parties purely use these to speculate on price movements. So they will sell them again before delivery. Derivatives have also been created whereby the price is dependent on the EU ETS price, but delivery will never take place. Often we see that the price of a particular investment can fluctuate sharply due to the buying and selling of these speculative investors.

Is the recent rapid rise in the CO2 price beneficial or not? The benefits are clear. A higher price for EU ETS allowances provides an incentive for companies to become more sustainable. And since this applies to all companies within Europe, a higher price will not be at the expense of a competitive position (unless you compare it to companies outside Europe). Especially now that the EU ETS price is higher than the national CO2 tax, the competitive position of Dutch companies remains equal to those in neighbouring countries. Another advantage of the higher price is that it increases the belief in the functioning of the instrument. For years, the EU ETS price has fluctuated around EUR 5/tonne. This was, according to some, far too low to call it an effective instrument and to speed up carbon reductions. Now that the price is eight times higher, the pressure increases on most CO2 emitting companies to undertake action. After all, they need these emission rights and would otherwise pay more and more. As a result, confidence in the instrument is rising.

However, the increase in market speculation also increases the likelihood of profit-taking. The number of CO2 emission allowances in circulation will decrease more and more in the coming decades. At the same time, market speculation will increase. The possible consequence is ever-increasing volatility and large price movements: upwards, but also downwards. Sharp price decreases are regularly followed by outrage from policy makers who argue for an (even) higher carbon price or an instrument that has a stable price development. Unlike most companies that know the market risks and know how to deal with them, some policymakers do not always cope well with these market forces. If they go in the ‘wrong direction’, these price movements can undermine confidence in the EU ETS once again.