While long restricted to theoretical or limited empirical validations, carbon pricing through emissions trading scheme has been building a track record of large scale success over the past few years. Emboldened by these confirmations, jurisdictions around the world are implementing and rolling out their own compliance carbon markets. Gradually, they are ushering the Age of Carbon.
Putting a price on carbon emissions is widely considered to be the fairest, most efficient, and technology-agnostic way of reducing emissions on a scale and pace aligned with the net-zero objective of 2050. As carbon prices increase, industrial polluters change production and investment patterns, allocating capital to decarbonation solutions. At the same time, consumers change behaviors, shifting purchasing decisions to products with lower carbon intensity.
As opposed to the simpler tax-based mechanism, pricing carbon through market mechanisms, or “Emissions Trading Schemes” (ETS) - also known as “cap-and-trade” - is more flexible and more cost-efficient. 75% of emissions covered by carbon pricing initiatives around the world are under market-based systems, which will be our focus below.
A Pioneer : the EU ETS
The European Union’s Emissions Trading Scheme (EU ETS) was born from the EU’s commitment to reduce its greenhouse gases following the Kyoto Protocol 25 years ago. Since then, it has developed into one of the most effective mechanisms to reduce emissions at scale. Today, while it only covers 3% of global emissions (roughly 1.5 Gt.CO2), it represents 90% of the trading volume of carbon allowances, and 60% of their market value, and it is credited with a 40% reduction of emissions by industrial polluters. It is expanding gradually, covering more and more economic sectors and heightening its ambition. The latest reform, against a backdrop of high inflation, an energy crisis, and a land war on European soil, has shown the unwavering political support of the market.
As climate urgency escalate and climate objectives are increasingly pushed out of grasp, governments around the world turn to the EU’s success as a source of hope and inspiration.
Recent Market Expansion
Over the past few years, the share of global emissions covered by carbon pricing initiatives has risen as countries implement emissions trading schemes: at the time of writing, there are 34 emissions trading schemes around the world covering 9 Gt.CO2 or 18% of worldwide emissions:
One notable example of this recent expansion is China. While the EU is the world’s largest ETS by market value and trading volume, China is the world’s largest by emissions covered. It completed its first full compliance cycle in 2021, covering 4.5 Gt.CO2 or 30% of China’s total reported emissions. As the Chinese ETS continues to develop through its successive maturation phases, more and more allowances will be traded, prices will continue to increase, and new actors (including financial actors like Homaio) will be able to operate on its market. The 2021 spike in the share of global greenhouse gas emissions covered (see above) shows the impact of the Chinese market.
The growth potential of compliance markets is significant, with some suggesting it could exceed the oil market's value by 2025 or 2030. As the world's carbon abatement trajectory require increasingly high carbon prices, as more and more markets come online, and as the scope of each market widens with new industries covered, the market value could well cross the $1 trillion mark, with trading volumes multiples of that.
Financialization of compliance carbon markets
As emissions trading schemes expand and mature, new markets participants become unavoidable for a stable, liquid, well functioning market: financial institutions such as banks, brokers, traders, investment firms, and hedge funds. As they enter the market, they bring with them more sophisticated financial instruments, trading not only emissions allowances but also other products derived from them such as forwards, futures, and options. They add liquidity to the market, improve price and information discovery, lower volatility, and help share risk within the market. Looking at the EU ETS, trading volume is around 10x the annual supply, illustrating the velocity of allowances and the liquidity in the market.
To date, only a few Emissions Trading Schemes around the world are open to financial actors. However, the shift from a commodity market restricted to compliance participants to a financial market is one that all ETS undergo as the grow: Since the EU classified emissions allowances as financial instruments in 2018, other jurisdictions have followed. For example, in 2021, the Republic of Korea opened its emissions to financial actors to improve market liquidity.
We expect ETS around the world to continue to expand in number, in scope (share of emissions covered and number of industrial sectors covered) and in value (price point of allowances). And with that expansion, the number and nature of market participants will continue to increase and broaden. Homaio wants to build the financial infrastructure to unlock this asset class for individual investors seeking strong returns with true impact at scale.
The table below shows the key characteristics of some of the main compliance markets around the world (data from end 2021), illustrating the breadth of possibilities as each market continues to develop and new ones come online. As an example, in December 2022, the European Commission and Parliament reached an agreement to include maritime transport and municipal waste into the EU ETS in the coming years.
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8. The Legislative Frameworks
The EU ETS is rooted in a legislative framework dating back to the early 1990s.