The European Union carbon market’s next phase has gotten a lot more interesting with the bloc’s plan to introduce increased emissions reduction targets in June.
The EU first announced plans to increase greenhouse gas reduction targets to at least 55% in the next decade in September. That move coincides with the EU Emissions Trading System (ETS) entering its third phase of action (starting in 2021), also targeting lower emissions.
The ETS works on a “cap and trade” system where an upper limit is placed on the volume of allowable emissions. That cap is reduced over time so that total emissions fall. Companies are given – or can buy or sell – annual emmissions allowances. A violation of carbon boundaries results in fines.
The green economy and renewable energy have been around for a while. Still, not many traders entering the market ten years ago could have forecasted their dramatic rise by the end of the decade.
During the first half of the 2010s, the price of one EU emissions allowance was relatively low and bounced around between four and 10 euros per tonne of CO2. As a result, the cost of emissions to companies was relatively low and did not motivate major changes across the Union’s carbon market.
Many believed that with the European carbon market decreasing its emissions over time, there was ample supply of allowances to meet big emitters’ demand. In return, this helped to maintain low prices for quite some time.
However, since around five years ago, allowances have been on a tear, increasing by a factor of ten from just above four euros per tonne of CO2 to 44 euros last week. Overall, prices have risen by more than 40 percent since EU leaders agreed to a tougher emissions-cutting target in December.
Bloomberg expects carbon prices to hit 100 euros by 2030. The U.K.’s exit from the EU has removed a large, low-carbon power fleet from the market. In effect, the average carbon intensity across the EU is set to become higher, while the number of tradable allowances is steadily withdrawn into the Market Stability Reserve (MSR).
MSR works to avoid a build-up of excess permits on the market, which depresses carbon prices. And when there are more than 833 million spare permits on the market, the MSR removes 24 percent of them annually.
The price increase may cause some political tensions within the bloc. Recently, Poland said record-high prices might derail the EU’s climate goals and called on the regulator to investigate the latest price rally. Policymakers themselves have even warned about harsher targets undermining confidence in the market.
As the ETS looks ahead to its third decade, the market is entering a period of an anticipated future scarcity. Prices may become more volatile than ever.
All the same, carbon markets can urge companies to seek substitutes. As the EU’s carbon price rises, it forces companies to be as emissions-efficient as possible. If the price is right, it could help push deeper decarbonization across the entire economy.