The higher carbon prices on the EU’s Emissions Trading System (EU ETS) of the last three months have caused cross-sectoral concern. Many are placing unsubstantiated blame on speculative trading. But with speculation a minor problem at best, is flooding the market with more carbon allowances a solution or a dangerously reckless move?
In the EU, carbon is quickly becoming a more valuable commodity. On 8 February 2022, the price of CO2 hit an all-time high of €98.49. This marks an increase of around 130% over prices in early 2021, and more than a 200% increase since early 2020. The severity of the climate crisis justifies tightening the supply of emissions allowances to ensure the carbon price can finally do its job and reduce emissions sufficiently.
A number of EU countries, including Poland and Spain, have been actively asking for measures to restrict trading on the EU carbon market, blaming excessive speculation for the sharp increase in electricity prices. Energy-intensive industries have also voiced concerns over price spikes, saying that such sharp changes harm their capacity to invest in the green transition.
MEP Peter Liese, the European Parliament lead on the reform of the EU carbon market, has always refuted the theory that activity on the carbon market is to blame for high energy prices, repeatedly stating that climate measures are “not the cause of high energy prices but the solution”.
Despite this, he recently announced the intention to amend the EU’s ETS to make it easier for the bloc to add carbon allowances into the market, appeasing those who believe that speculation is driving high carbon prices.
High on carbs
Liese’s proposed changes would make it easier for additional allowances to flow into an already oversupplied carbon market. According to his proposal, 100 million allowances would be released to the market if, for more than six consecutive months, the average price of allowances is more than double the average during the two preceding years. However, half a year of higher-than-average carbon prices is not enough to determine whether speculation is the cause. This move would be an outsized reaction by the EU to a minor problem.
The implications for the atmosphere, however, are all too real. Such changes would mean that more carbon emissions would be permitted each year. Even without these changes, emissions in the ETS already appear to have increased in 2021 and estimates foresee another rise again this year. If it continues on this track, the EU will not even achieve its unambitious 55% reduction in emissions by 2030.
A better way out of instability
While speculation is almost certainly not the cause of current fluctuations, it could become a threat to the functioning of the ETS in the future. However, should this happen, the ETS, as it currently stands, already includes options for the European Commission and EU member states to intervene in the market.
Unfortunately, those rules only apply in case of rising prices, but there are no measures in place which would prevent significant future drops in the allowance price. This was plain to see when the price of carbon on the EU ETS plummeted by €30 in less than a week in early March and there was no mechanism available to stabilise this volatility.
A priority before tackling potential speculation is the strengthening of the EU ETS as it undergoes its current revision process by EU policymakers.
There are significantly more effective ways to provide a meaningful price signal for industrial sectors to decarbonise while improving the predictability and transparency of the market. As a starting point, the oversupply of carbon credits must be reduced, by lowering the ETS’s cap to align with actual emissions, and the handout of free emission allowances must end.
EU policymakers must promote and enact a strong reform of the EU ETS for a reduction in emissions that yields at the very least a 70% reduction in emissions in the ETS by 2030.
Specifically, for Article 29a of the ETS – the one Liese intends to amend – we do not recommend weakening the price trigger so more allowances come to the market sooner. It is important to keep in mind that Article 29a applies only for price increases which “do not correspond to changing market fundamentals” . This provision is vital to uphold in order to maintain a functioning carbon market with sufficient regulatory predictability.
What is speculation and how does it affect the EU ETS?
The EU ETS is a market on which emission allowances are sold to and traded between industries, utilities and airlines in order to allow them some flexibility on their path to decarbonisation.
Most allowances are held and traded by polluting companies that need them to comply with the ETS. However, banks, investment firms and brokers also participate in the market. In doing so, they provide a necessary service to the companies affected by the ETS, helping to establish more market liquidity and price visibility, and allowing operators to hedge against future price fluctuations.
A small percentage of allowances are also owned by financial actors that have nothing to do with the ETS itself but have invested in these commodities for pure profit. This latter, “speculative”, behaviour could be detrimental to the functioning of the EU carbon market if it accounted for a large share of the overall market activity. But speculative activity only accounts for around 4% of activity in the ETS, and is not the main cause of the price increase on the ETS market, according to a preliminary report by ESMA, the EU’s authority that contributes to safeguarding the stability of the bloc’s financial system, which is supported by market analysts.
The ideal carbon market
A high carbon price, combined with reduced volatility and more predictability and transparency, is fundamental to drive industrial decarbonisation. Ideally, carbon prices should rise steadily, without sudden spikes.
But blaming financial speculation, the ETS, and climate policy for spiralling energy bills is disingenuous and unhelpful. If anything, high energy prices reflect a historic failure to decarbonise rapidly enough, leaving us dependent on volatile fossil fuel supplies.
Free allowances also contribute to the volatility and unpredictability of the market. Due to the free emission allowances in the market, industrials’ compliance, banking or hedging strategies are more diverse and often less sophisticated or market-oriented. As a result, the freely allocated allowances are not available to other market actors which risks increasing price volatility and complicates compliance risk management.
It is of utmost importance that the EU sets a high standard with its revision of the ETS, for a stable carbon market that encourages and enables industry to rapidly decarbonise, and that prepares the continent for the climate challenges ahead.
This is the updated version of an article which first appeared in Carbon Pulse.