Since 2015, when the Paris Agreement was first adopted to address climate change and the ultimate objective of limiting global temperature rise in this century below 1.5 degrees Celsius was set, all 186 countries committed to economy wide carbon cutting goals. [1]

Over the past 12 months in particular, ‘Net Zero Emissions by 2050’ has dominated political discussions and news headlines, setting the race for decarbonization in full pace. Carbon pricing has become one of the main paths for reducing emissions. For example, over 25 countries have implemented a carbon tax, European Union Emissions Trading Scheme (EU ETS) has been operating as one of the biggest carbon trading systems since 2005 and China’s national emissions trading scheme (ETS) is expected to launch in mid-2021.

This article will explore the ETS mechanism, discuss the sharp price rally at the start of February and consider some of the future market implications of rising carbon prices.

The Mechanism Behind Carbon Pricing

To start, let me highlight that there are two main ways carbon is priced – emissions trading systems and carbon taxes. The latter directly sets a price on carbon by taxing greenhouse gas emissions and unlike an ETS, the price is predetermined by the state but the final emissions reduction outcome of the policy is unknown. Many critics of carbon tax schemes highlight inefficiencies such as over issuance of permits, industries lobbying regulators and the administrative complexities which reduces the efficiency and impact on carbon emissions. Emissions trading schemes operate as cap-and-trade systems where there is a cap on total greenhouse gas emissions which is distributed among emitters who receive a pre-allocated carbon budget. [2] There is a fixed supply of emissions and through the free market mechanism, this ensures that the polluters pay and there is an incentive for companies to reduce emissions and invest in low-carbon alternatives.

Coronavirus – An Unexpected Surge in Carbon Prices

An extension of this theory would be that when economies are facing recessions, global demand is falling and industry carbon emissions are lower, then the price of carbon should also fall accordingly. While this held true for the decade following the 2008 Financial Crisis, where economic slowdown led to emissions allowance surpluses and caused a slump in prices, we have witnessed the opposite effect during the Coronavirus pandemic. A French consultancy firm, Sia Partners reported a 58% decrease in daily carbon emissions in April 2020 after most coronavirus lockdowns had been put in place. The graph below shows the change in emissions across the 27 EU member states split by sector. [3]

This trend affected countries like France, Spain and Italy the most where economic activity had been greatly suppressed but almost all member states have faced the same downward trend in emissions consumption over the past year. [5] However, on July 13th 2020, the EU carbon credits surged above 30 euros/tonne for the first time since 2006 and the sustained out performance in comparison to other commodities was likened to carbon intensive companies stocking up during the initial price fall of almost 40% in March and momentum investors creating a long rally as prices rose which can be seen on this graph below.

There were several policy announcements during the year which focused on reducing carbon goals between 2030 and 2050 such as the EU targeting to cut 2030 emissions by at least 55% and the UK committing to an 80% reduction in carbon emissions by 2050 relative to 1990 levels. [4] This affected trader’s sentiment in the carbon market to focus on the long-term price stability as long as the climate change focus is retained. While this is the opposite reaction to central bank’s expectations of the global lockdown restrictions’ effect on the market, it works favourably as they aim for prices to rise to $100 by 2030.

Such investor sentiment leading to rapid momentum-led price increases will be a large cost to energy-intensive sectors such as steel, utilities, cement, and power.

When considering the steel sector, the carbon price rise to 25 euros/tonne in 2019 caused ArcelorMittal to close 3 million tonnes of steel production and research done by Eurofer revealed that Europe’s steel sector was generating 2.5 million jobs and was valued at 128 billion euros. [6] The threat of these operations migrating outside the EU would lead to significant industry decline.

On the other hand, the Utilities sector is expected to face a lower impact of price increases as the inelastic demand would allow them to deflect increased costs onto consumers. The cost of the Utilities sector’s carbon emissions is estimated to be twice its total earnings in the case of a price rise to $120 by 2030 according to S&P Global Trucost and their analysis revealed that only 40% of the sector’s valuation would be at risk because of sustained demand. [7]

With the increase in price competitiveness, it will be essential to consider the speed of technological advancement in different industries as low-carbon alternatives may not become available fast enough in aviation and agriculture. This is due to these sectors not having seen much innovation, unlike the power and transport sectors where heavy research and investment in solar and wind power, biofuels, and electric vehicles has been underway for some time already.

Poland’s Energy Sector: The Biggest Threat to the EU’s Vision?

The potential harm to traditionally carbon-intensive sectors can already be seen by the effects of the pandemic on Poland’s coal industry. As the virus forced Poland into lockdown, overall energy use fell 5% in q1 2020 compared to the previous year’s data. Energy use from coal specifically fell around 12% as they extract 74% of electricity from coal and the EU’s climate goals have driven the coal industry costs higher, leading to cheaper electricity provided by green alternatives. [8] Up until 2019, Germany used to produce substantially more coal-fired electricity than Poland through lignite; in 2020, Poland became Europe’s biggest coal producer as Germany invested heavily in green technologies.

Tougher restrictions set by the EU ETS on industrial emissions standards along with banks’ reluctance to provide financing to coal-intensive companies have made it increasingly difficult for Poland’s energy and coal companies to survive or even invest in greener projects. The state-owned coal companies pose additional problems to government’s coal assets and the associated debt which will cause negative spillover on other industries. Additionally, Poland’s climate and energy plan in December 2019 revealed that coal is still predicted to account for 28% of their electricity production in 2040; this renders Poland’s coal industry as one of the largest obstacles to the EU’s carbon neutrality by 2050 plans.

What Factors Could Determine Future Carbon Prices?

Similar scenarios may be faced by other EU member states in different sectors as the carbon market starts to price in EU’s climate goals into the new equilibrium price of carbon permits. Over the next few months, it will be interesting to monitor trading activity in China’s emissions trading scheme and compare its efficiency of carbon pricing to the EU ETS. Additionally, with China’s aim to become carbon neutral by 2060 while Biden is pushing for 2050, there are several discussions over a potential EU-US carbon frontier tax that could change the future of carbon pricing drastically.

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