EU carbon allowances (EUAs) exhibit moderate short-term volatility due to demand-side factors, but their declining supply supports long-term price appreciation, making them potentially suitable for long-term sustainable investment strategies. Increased market participation can further stabilize the EUA market.
European Union Allowances (EUAs) are a moderately volatile investment asset. In the short term, their prices can experience fluctuations due to the various demand-side factors. However, over the long term, the trend becomes clearer: carbon allowances are designed for price appreciation.
The supply side stability
On the supply side, the European Union Emissions Trading Scheme (EU ETS) is relatively stable and does not contribute much to market volatility. The total number of carbon allowances available is predetermined by the EU's regulatory framework and is set several years in advance. The cap on emissions and the auction calendar are established well ahead of time, which provides a clear and predictable supply of EUAs. This stability mitigates potential volatility that could otherwise come from the supply side of an investment asset.
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Demand side factors
In contrast, the demand side of the EU ETS introduces more variability. Several factors influence the demand for EUAs, like fluctuations in energy prices, weather conditions, and shifts in energy production sources. These factors can cause short- to medium-term volatility in EUA prices. For example, a sudden increase in energy demand due to colder weather can drive up EUA prices as industries require more allowances to cover their emissions.
Short-term trading behavior and volatility
Short-term volatility can also arise from trading behaviors, especially around significant dates such as the expiry of options or futures contracts. Traders' actions around these events can lead to intra-day or intra-week price swings. However, this type of volatility is short-lived and does not fundamentally alter the broader trends in the EUA market.
EUA volatility and other assets
The EUA volatility is seen as moderate, especially when compared to other asset classes. In 2023, the 90-day average volatility of EUA daily returns was approximately 2.24%. This level is relatively low when compared to commodities like natural gas or coal, which can experience more significant price swings. However, EUAs are more volatile than traditional financial instruments such as government bonds, which are known for their stability.
Market participation stabilizing the EU ETS
The volatility of the EU ETS can be improved by the growing number and diversity of market participants. As there is more participation like the one of private investors entering the market, the trading volumes become more distributed across various investment horizons and strategies. This diversity can help to reduce market volatility, as large, simultaneous transactions are offset by different investing profiles. Increased participation by a broader range of investors can thus contribute to a more stable market environment.
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EUAs may be volatile in the short to medium term, but their fixed declining supply supports long-term price appreciation, making them suitable for long-term investment strategies.
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