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Are carbon markets volatile? European Union Allowances (EUAs) are a financial asset. Investment volatility is one of the measures through which we can track their financial performance.
Volatility is an important metric for investors, reflecting the magnitude of price fluctuations within a short timeframe that an asset or an entire portfolio can experience. This concept of volatility is a broad one, there are multiple possible definitions and measurement methods. Volatility is neither “good” or “bad”, as preferences vary among investors. It all depends on their objectives, trading style, risk tolerance, timeline… Just like for every other asset class, it is important to focus on the European Union Allowances (EUAs) volatility before making investment decisions. Carbon markets volatility is similar to that of most commodities, characterized by possible significant price swings in the short and medium terms. However, what sets EUAs apart from other financial instruments is that they are engineered by policymakers. They have a clear objective to be achieved through carbon pricing. So, there is a set price direction in the long term that is required to EUAs to be a successful policytool - carbon prices are meant to go up. The clear directionality allows a long term investor to iron out EUAs’ short term volatility.
Volatility in financial markets refers to the degree of variation or fluctuation in the prices of assets over a specific period. It measures how much and how quickly the prices of these assets change. It is used as an indicator of the level of uncertainty or risk in the market. Higher volatility suggests greater price swings, while lower volatility indicates more stable price movements.
Many speculators have strategies that capitalize on increased volatility, profiting from buying low and selling quickly as asset values fluctuate. Certain financial instruments, such as options contracts, are designed to benefit from market volatility, offering opportunities for profit in fluctuating conditions. Actually, on a trading desk, we call speculators who work with options “volatility traders”.
On the other hand, volatility might be scary for certain individuals, particularly individual investors who prefer stability. They may seek to distance themselves from volatility as it can lead to sudden and destabilizing changes in portfolio value, especially in the short term. Also, big gains or losses in a short period of time may prompt investors to make impulsive decisions to exit their positions (because of the market shocks), which may not always end up resulting in rational or financially sound choices.
Volatility depends on various factors including market sentiment, economic indicators, geopolitical events, investor behavior... Additionally, factors specific to each asset class, such as company performance for stocks or supply and demand dynamics for commodities, can influence volatility. Market liquidity, interest rates, and regulatory changes also play a role in determining the level of volatility.
Volatility can be measured with various timeframes - intra-day, monthly, or even annually. While an asset may have a high short-term volatility (like large intra-hour moves at a specific time of the day), its long-term behavior can be stable and predictable. So, thinking about volatility depends on the timeline considered but in general terms it should account for both short-term fluctuations and long-term trends.
Volatility can be measured using statistical measures such as standard deviation or variance, which quantify the dispersion of returns around the mean. Another commonly used method is calculating the range between the highest and lowest prices over a specific period. Additionally, financial analysts often employ more sophisticated techniques like the use of historical price data to compute volatility metrics such as the average true range (ATR) or the volatility index (VIX).
As mentioned earlier, volatility is driven by factors that vary among asset classes. For instance, fluctuations in interest rates primarily affect bonds, while commodities are less impacted. Similarly, shifts in sector-specific corporate earnings influence stock volatility but have a smaller effect on fixed income assets. Typically, stocks have volatility levels ranging from approximately 1% to 3%, while commodities have higher average volatility levels, up to 5%, when considering the 5-day rolling volatility of returns.
Carbon markets are not a particularly high or particularly low volatility financial instrument. When compared to commodities like natural gas or coal, carbon European Union Allowances (EUAs), have less volatility, as seen on the graph above. EUAs are also less volatile than 10-year US Treasury T-bills in 2020-2024, which are considered to be one of the safest investment options.
Fundamentally, carbon allowances are engineered for price appreciation over time. The long-term directionality of carbon prices is known from the inception of the European Union Emissions trading scheme (EU ETS) - carbon prices are meant to go up. As discussed in our January Newsletter, this financial class reflects the government's commitment to using policy tools to combat carbon emissions by imposing financial burdens. EUA prices will go up if politicians respect their climate promises. Therefore, for investors seeking a long-term buy-and-hold asset, investing in carbon markets can be a reasonable decision.
This feature of clear directionality in the long run makes us believe that 2024 is a good opportunity to start investing in carbon markets. As we have discussed previously, the end of 2023 and the beginning of 2024 brought some downside in the markets. The drivers were energy markets, low economic activity, and regulatory supply changes (as an emergency response to the gas crisis engendered by the war in Ukraine). The market is going to get back to its fundamentals - the demand and supply dynamics will tighten again and prices are forecasted to get back on track.
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