Emissons Markets Development
Emissions trading (also known as “cap and trade”) policies are a market-based approach to reducing pollution by establishing limits on emissions and providing tradable allowances that authorize holders to emit the capped level of greenhouse gasses. The European Trading Scheme (ETS) has become one of the most developed markets of this kind, and it highlights a key price driver of any emissions market: supply and demand. When the EU first implemented the policy in 2005, high numbers of freely allocated allowances in the early phases led to allowances that exceeded emissions, which meant prices dropped to extremely low levels.
Regulations have tightened, and the low, non-binding prices have begun to increase as the market develops. Accelerating the pace of emissions cuts and tightening policy surrounding the surplus reserve led to a substantial increase in prices starting around 2017. The EU ETS has reported generally increasing prices since January, but record prices came in April and May 2021 with EU allowance (EUA) futures exceeding $65/tCO2. Policy changes and growing confidence in the ETS itself followed years of average pricing near $10 and contributed to this growth. Rising allowance prices are increasingly exhibiting a correlation with the price of fossil fuels.
Now, as high seasonal demand and low storage inventories express themselves in higher European natural gas prices, price trends are indicating a circular relationship between demand for commodities and demand for emissions allowances. Higher carbon prices have accelerated the rise in natural gas benchmarks like the NBP and TTF by simultaneously increasing coal futures for delivery at Rotterdam and removing the price-responsive lever of coal-generation substitution. European coal prices have tripled within the past year, propelled by higher emissions costs and relatively higher demand for fuel switching caused by elevated gas prices. As a result of these rallies, both natural gas and coal prices show ~80% correlation with emissions prices in the last six months. Although it has taken time for the correlation to strengthen to this point, its presence points to the growing influence of emissions pricing on the international natural gas market and its eventual feedback to the US through LNG exports. The influence of carbon pricing, which has been relatively ignored up to this point, has finally begun to influence mainstream markets and warrants greater attention in the years to come.
As the EU ETS continues to update policies and regulations, it offers insight into other emerging markets. The US, China, and Japan demonstrate the growing legitimacy of cap and trade as an emissions mitigation strategy. The linked California-Quebec emissions market and the Regional Greenhouse Gas Initiative (Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, Vermont, Virginia) are seeing auction clearing prices below $20, close to prices seen in earlier phases of the ETS. China’s market launched in mid-July and reported prices under $10. Japan also announced plans surrounding a carbon credit market in FY 2022-2023. As these markets evolve, they allude to distinct areas of further research, and there remains an important opportunity to build off of the lessons learned in the EU.
World Bank. 2021. State and Trends of Carbon Pricing 2021. Washington, DC: World Bank. © World Bank. https://openknowledge.worldbank.org/handle/10986/35620 License: CC BY 3.0 IGO.
