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Reducing emissions with carbon allowances

Climate Finance

How investing in physical carbon allowances reduces CO2 emissions at scale.

Reducing emissions with carbon allowances
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Emissions Trading Schemes (ETS) are market-based mechanisms aimed at reducing greenhouse gas emissions. They are one of the most important tools in the policy arsenal for addressing climate change, as they provide a cost-effective and flexible way for countries to reach their emissions reduction targets. In this post, we’ll explore the empirical evidence in the European Union’s ETS, which has been implemented in 2005. We’ll also look at the mechanisms through which an investor in emissions allowances can directly impact emissions reduction.

Empirical evidence of emissions reductions

Emissions from industrial polluters covered by the EU ETS have dropped by 40% between 2005 and 2021, in line with the progressive reduction in the supply cap of carbon allowances.

Of course, the ETS is not the sole reason for emissions reduction; for example, the largest drop occurred in 2020-2021 during COVID lockdowns, when economic output was low and the aviation sector was at a standstill. However, over the period, the GDP of the EU grew by approximately 40%, so the bloc actually managed to decouple its growth with its emissions: over the past 15 years, observed emissions reductions cannot be explained as being the byproduct of lower economic output.

Looking at the data a bit more closely, we notice that emissions reductions were particularly important in sectors without free allocations such as electricity production, versus sectors with free allocations such as the industry sector. This is because free allocations, conceded by the EU to avoid carbon leakage (when an industry relocates its production sites to avoid carbon prices), mute the incentivizing effects of the carbon market. In other words, when a sector was subjected to the carbon market, its emissions reduction was greater.

While free allocations still represent 47% of all allowances, they are being progressively phased out in all sectors, and carbon leakage is instead being addressed with the Carbon Border Adjustment Mechanism.

Finally, peer-reviewed studies have tried to compare observed emissions reduction trajectories with a hypothetical scenario in which the EU ETS does not exist. This is what we call a counterfactual, or a simulation of an alternate reality that could have happened. These studies conclude that ETS sector emissions decline against a the counterfactual scenario as policies become increasingly stringent.

While counterfactual studies hinge on many parameters, they are a supplemental confirmation of the 15 year empirical observations of the EU ETS effectiveness. The scientific, political, and academic consensus is such that jurisdictions around the world are implementing emissions trading schemes to replicate these successes. 

Investing in carbon allowances to drive emissions reduction

When individual investors purchase carbon allowances, they inflect the emissions reduction trajectory of the market in multiple ways, increasing its impact. 

1. The Withholding Effect

Emissions Trading Schemes are designed with a capped supply. That means that each year, the amount of allowances is fixed. It is also a deflationary asset, in the sense that this cap is reduced. For example, when the EU ETS was launched in 2005, there were about 2 billion allowances issues that year (each allowance representing the right to emit one ton of CO2). In 2021, there were 1.5 billion allowances issued, and that cap is reduced by about 80 million allowances each year.

So when an investor purchases allowances, they are essentially withholding a part of the supply from the market. That means that industrial polluters won't be able to use these allowances to emit greenhouse gases. Essentially, the investor is reducing the available supply of allowances, and thus the total emissions budget of the year.

2. The Price Effect

As investors buy and hold allowances, they reduce available supply (the total supply being capped). All other things equal, the price increases. As allowance price increase, industrial polluters have a heightened incentive to invest in decarbonation solutions rather than purchase allowances. The price of carbon allowances is the trade-off point between purchasing allowances or reducing emissions through changes in production or investment patterns. Moreover, all technologies with a marginal abatement cost of carbon that is below the allowance price become cost-effective. In short, the higher the price of carbon allowances, the greater the economic incentive to decarbonize. In turn, as industrial polluters decrease their emissions, so does their demand for allowances, which creates a downwards pressure on price, returning the market to equilibrium.

3. The Cancellation Effect

The cancellation effect is a more technical feature of the EU ETS, linked to the cancellation mechanism implemented on January 1st 2023. In short, a Market Stability Reserve acts as a stabilizing force on supply, adding or absorbing allowances on the market in the case of supply squeeze or surplus. The variable used to assess if the supply is in deficit or excess is called the TNAC, or Total Number of Allowances in Circulations. Allowances held by investors count towards the TNAC. So the more investors buy and hold allowances, the greater the number of allowances absorbed from the market and held in the reserve. And if the number of allowances held in reserve exceeds the previous year's volume, these allowances are irrevocably cancelled. 

In short, the longer an investor holds allowances before divesting, the greater their impact on total supply. And that impact remains even after said investor sold their allowances, creating a positive sum game. 

4. The Frontloading effect

One of the flaws of the EU ETS market design is what we call the backloading of emissions reduction. In other words, politicians and industrials are procrastinating, pushing to later dates the economic effort needed to meet climate goals. This is especially visible in the slow pace at which free allocations are phased out. The pathways chosen require accelerating cuts which we are not certain to be able to achieve.

By creating additional pressure on the market today, we're adopting new solutions faster, smoothening out the effort over time instead of concentrating them in the future. Investors that enter the market today will want to divest a few years down the line, tightening supply today and loosening it tomorrow, spreading the burden over time. 

Final Remarks

There are other, more indirect ways in which individual investors contribute to emissions reductions by investing in carbon allowances. For example, since January 1st 2023, all revenues from the daily emissions auctions must be used by member states to finance climate mitigation strategies. So the greater the price of carbon, the greater the generated revenue and thus the re-investment capacity of member states.

Of course, the EU ETS is the result of 15 years of political debates and compromise between 30 countries. It does have its flaws and shortcomings. Yet it is also the best systemic mechanism that has ever been designed, deployed, and regularly improved to combat climate change. And by including individual investors - those that are the most concerned with climate change - we can help spur a more liquid, more stable, and more efficient market that truly drives emissions reduction at scale. 

This is Homaio's mission. 

Further Reading :

Patrick Bayer and Michael Aklin. April 2020. The European Union Emissions Trading System reduced CO2 emissions despite low prices. PNAS Vol. 117 No. 16

Jacques Delors Institute & E3G. February 2022. No More Free Lunch: Ending Free Allowances in the EU ETS to the benefit of innovation. 

European Environment Agency. 2021. The EU Emissions Trading System in 2021: trends and projections. Briefing no. 17/2021

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