AS FINANCIAL MARKETS become cheerier about the pace of vaccinations and the chances of a speedy economic recovery, the prices of stocks, commodities and all manner of assets are rising. So too are carbon prices in Europe, home to the world’s largest emissions-trading system. Prices have surged by 60% since November; on February 12th they hit a record high of nearly €40 per tonne of carbon-dioxide equivalent (see chart).
Last year the value of global carbon markets hit a record €229bn ($278bn), a five-fold increase from 2017. The European Union’s emissions-trading system (ETS) accounts for nearly nine-tenths of both that value and that growth. In 2020 around €1bn-worth of emissions allowances changed hands each day, as well as plenty of options and futures contracts. There are signs that trading is becoming more sophisticated, as investors take an interest.
For a long time after it was launched in 2005, the ETS barely functioned; a glut of allowances (which give the holder the right to emit a certain amount of greenhouse gases) and cheap offsets kept prices close to zero. But after the European Commission sucked excess allowances out of the market in 2019, it began to thrive.
The ETS is an odd market. The commission auctions allowances nearly every day; it caps the overall supply of permits based on the EU’s politically determined emissions targets. Demand, meanwhile, comes from three types of participant. The biggest source of demand is the power and heating utilities, such as Germany’s RWE and France’s Engie. They buy allowances to cover the emissions from current projects or to hedge against future price increases. Next come industrial firms, such as ArcelorMittal, a steelmaker. Most of these receive free permits, so that the ETS does not encourage producers to move abroad.
The third, and growing, source of demand is financial firms, including banks, such as Goldman Sachs and Morgan Stanley, and hedge funds, such as Lansdowne Partners and Northlander Advisors. These are not required to hold allowances; instead they hope to profit, either by trading on behalf of utilities or by speculating in the futures or options markets.
The recent spike in prices reflects both supply and demand. Auctions were suspended in January, meaning there were fewer allowances being sold. And on December 11th EU leaders agreed to speed up reduction of emissions, bringing them down by 55% by 2030 compared with 1990 levels, rather than by 40%. That signalled a lower emissions cap, meaning eventually fewer allowances and a higher price.
The expectation of higher carbon prices may have prompted industrial firms to start hedging their emissions early this year. That added to demand for allowances—as did unusually cold weather, which boosted the demand for heating. Speculators may have accelerated the price rise, by buoying futures prices. Around 230 investment funds hold futures linked to the EU’s allowances, up from 140 at the end of 2019. They account for only about 5% of the futures market, but it is a growing, bullish share. Long positions, or bets that the price will rise, have doubled since November. Aje Singh Rihel of Refinitiv, a research firm, notes that this measure closely correlates with recent price changes.
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One reason for investors’ enthusiasm is that carbon seems like a one-way bet. Many analysts expect that the EU’s 55% target will require the number of allowances to fall and prices to rise, perhaps towards €80 per tonne. That could be good news for investors. When in 2018 it became clear the commission was going to intervene to limit supply, allowances became the best-performing commodity of the year.
Buy and hold is not the only strategy. Casey Dwyer of Andurand Capital notes that carbon prices are largely uncorrelated with those of other assets, so some investors hold them to diversify their portfolios. They could also be used to hedge against inflation: a higher cost of using fossil fuels is generally accompanied by higher consumer prices.
The presence of financial firms has changed how the market works. Federico Di Credico of ACT Financial Solutions, which specialises in environmental markets, says that the dynamics used to revolve mostly around the commission’s meetings. Now macroeconomic indicators, such as new GDP figures, play a bigger role. Some analysts argue that speculators’ bets cause volatility; others say the consequence has been greater liquidity. Most, though, expect financial flows to grow.
“Once investors start to see it as an ESG trade [that takes into account environmental, social and governance factors], funds will allocate more money to the carbon markets,” points out Ulf Ek of Northlander Advisors. And unlike many forms of ESG investing, Europe’s carbon price, where it is applied fully, seems to benefit the environment directly. Emissions from utilities have roughly fallen by half since the launch of the ETS. By contrast, the industrial sector, which is cushioned by free allowances, has seen little improvement.
What next for the ETS? Some elements, including the overall cap, will be reviewed in June. And the commission has expansion in its sights. One ambitious idea is to connect the ETS to other regions through a carbon border tax. In theory, that would protect European industry from carbon-intensive, overseas competitors. And it may link the ETS to other carbon markets, such as Britain’s soon-to-be-launched ETS, and California’s cap-and-trade system. Complications around design and geopolitics abound, though. Few think the commission’s suggested plan for a border tax by 2023 is realistic.
More likely is expansion within Europe. The scheme covers only 45% of the continent’s emissions. Shipping is expected to join in the next few years. Road transport and buildings may get separate markets, with higher carbon prices. If done well, that expansion should attract more capital and perhaps lead to higher prices. But as the market’s early years show, much depends on implementation. For all its growing sophistication, the ETS is still a political project at heart.
Source: Finance - economist.com
