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EU ETS carbon allowances are designed for price appreciation. Read how regulators have engineered a financial asset to bring carbon emissions lower and what analysts and academics forecast for CO2 allowances prices in the near future.
EU ETS carbon allowances are designed for price appreciation. Just like other assets, carbon prices are determined by the intersection of supply and demand. When supply goes down, prices go up. However, unlike other typical financial assets, EUAs have a tightening supply over time. Their prices are bound to go up. Moreover, carbon pricing (the EU ETS) is a policy instrument, regulators need to incentivize industries to curb their carbon emissions. The end goal is to make decarbonization technologies more cost-effective for manufacturers in comparison to their expense of purchasing EUAs. Finally, academia has been examining the real-life social cost of carbon. Researchers quantify the economic damage inflicted by each tonne of carbon released into the economy. They argue that the actual social cost of carbon significantly surpasses prevailing EU ETS carbon allowance price levels, ranging from €170 to €300 in some models, while others project figures as high as €3000.
The laws of demand and supply consist in the interaction between the quantity of a good available in the market and the demand for it. According to these laws, when the supply of a product decreases, while demand remains constant or increases, the equilibrium price rises. This is because the reduced supply creates a scarcity, incentivizing buyers to compete for the limited available quantity, in this way driving prices upwards.
The primary purpose of EU ETS prices is to incentivize industries to reduce their carbon emissions by making it financially difficult to release carbon into the atmosphere. By increasing the cost associated with emitting carbon, the EU aims to encourage businesses to invest in cleaner technologies. So, higher carbon prices reflect a more effective environmental policy, as they promote the adoption of greener alternatives and contribute to mitigating climate change.
To enhance the effectiveness of the EU ETS in achieving its environmental goals, policymakers have designed the system to ensure that EU ETS prices appreciate over time. This involves gradually reducing the supply of EU ETS carbon allowances, aligning with the principles of demand and supply dynamics that we talked about above. By limiting the availability of allowances, regulators aim to induce a steady increase in prices, thereby incentivizing industries to prioritize emissions reductions and invest in sustainable practices.
Since the inception of the EU ETS, the supply of European carbon allowances (EUAs) has consistently decreased. Following the end of the introductory phases and the start of the third phase of the scheme in 2013, the cap (or amount of EUAs issued at that time) was set at 2,084 billion allowances. However, this cap has steadily declined over the years, reaching 1,386 billion allowances in 2024. Every year, the cap is reduced at a predetermined pace. The current rate of reduction is4.3% annually, with a further increase to 4.4% post-2028.
EU ETS prices are driven by a multiplicity of factors, but the one of the main elements bringing upward pressure in prices has been this diminishing supply. At the beginning of the EU ETS Phase 3 in 2013, EUA prices were staying at levels below EUR 5. However, over time, they have seen a gradual upward trend thanks, as seen below:
As previously highlighted, high carbon prices are an incentive for industries to lower their carbon emissions levels. Decarbonization means that the EU will be brought closer to fulfilling its climate targets, regulators are respecting their environmental promises. So, higher EU ETS prices not only bring upon environmental progress but also confirm the legitimacy and efficacy of regulatory decisions. In other words, a successful ETS is one with high price levels.
Regulators are empowered to introduce market stabilization reforms in the EU ETS, aiming to make price levels more effective. Some price targets have been mentioned in this regard in the past, including a price of EUR 140 to be reached by 2030, as mentioned by the European Central Bank. Additionally, the French government has mentioned a price of at least EUR 100 by the year 2030 in one of their communications. However, to maintain market integrity and avoid disrupting the free market, governments are refraining from being overly explicit and setting specific price targets for EUAs to achieve.
International organizations and NGOs have teams of environmental experts who provide recommendations on carbon pricing. Such reports are often used as a guidance for policymakers and regulators. In this context we can mention figures like a price of EUR 120 to be reached by 2030 proposed in an OECD paper, EUR 160 by the World Bank, EUR 190 by the EPA, and EUR 220 by the IPCC.
Several academic papers have focused on quantifying the social cost of carbon, which represents the economic value of investments required to mitigate the damages resulting from each additional tonne of CO2 emitted into the economy. This metric is a tool for policymakers in evaluating the cost-effectiveness of climate change mitigation measures. It also guides decision-making processes aimed at reducing carbon emissions.
Academics all agree that the current EU ETS price ranges inadequately reflect the necessary compensation for society regarding each additional tonne of CO2 emitted. Various estimates have been put forward with figures such as EUR 174 by Pindyck, EUR 185 by Rennert, EUR 325 by Nordhaus, and even prices as high as EUR 3000 by Kikstra. The wide ranges of these valuations show the complexities involved in assessing the true economic impact of carbon emissions - science, environment, economics, politics are involved, making the assessment of the just price of carbon a challenging task. All we know is that carbon prices are bound to go up.
Sources:
ECB, 2023. How will higher carbon prices affect growth and inflation?
IPCC, 2023. Mitigation pathways compatible with 1.5°C in the context of sustainable development
Pindyck, 2019. The social cost of carbon revisited
Nordhaus, 2016. Revisiting the social cost of carbon
Rennert et al., 2022. Comprehensive evidence implies a higher social cost of CO2
The World Bank, 2017. Shadow price of carbon in economic analysis
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