The Carbon Allowance Tale - Part 3: A Financial Instrument
Carbon Markets: Finance
Having evolved from a policy tool to a financial asset, EUAs are becoming a mature and sophisticated market.
In the theory of EUAs Part 1 and 2 we explained that the EU ETS was created as a policytool to lower greenhouse gas emissions in Europe. The initial market design led to a supply surplus, which kept carbon prices low. More flexible supply regulation mechanisms were therefore introduced. They fueled higher prices and helped the market get back on track, more in line with the decarbonisation targets. In the continuation of this effort, regulators have been relying more and more on free-market mechanisms.
Carbon markets open to traders and investors
Until 2018, EUAs could only be traded by compliance actors. In other words, only companies that needed allowances to match their carbon footprint were allowed to participate in the market. As of 2018, emission allowances were reclassified as financial instruments under the updated Markets in Financial Instruments Directive (MiFID II). This ushered in a more sophisticated market, with banks, investment firms, and funds now able to take part in it.
In the following years, a multiplicity of carbon-related financial instruments started entering the trading scene. Large issuers created carbon market trackers: their clients - professional and institutional investors - were enabled to benefit from a financial exposure to the ETS markets. They did not have the option of actually holding EUAs, but simply benefited from price appreciation through derivative trading. The Barclays Carbon ETN (2019) or the KraneShares ETF (2021) are just some examples. Carbon markets were becoming a new investable asset class.
In this context, as EUAs became a financial instrument, they were subject to greater financial oversight. For example, the Market Abuse Regulation (MAR) and the Criminal Sanctions for Market Abuse (CSMA) Directive started to apply to this new asset class: transactions started being tracked and monitored. In turn, it helped create trust from more market participants, ushering in a more attractive system.
More players with increased diversity
The total EUA trading volume went from around €180bn in 2018 to more than €750bn in 2022, supported by an increase in EUA Prices. The number of actors in the EUA financial markets also increased sharply - it has more than doubled within 2 years (from 350 to 800 participants approximately). There were more players in quantity, but the types of actors involved also grew. This wider range leads to a multiplicity of views, strategies, and trading behaviors, helping market stability and price discovery.
The heterogeneous activity also supports liquidity. There are more transactions and it is easier to enter or exit the market. Various participants may have varying time horizons - they are more likely to trade at different times of the year. So, there are less extreme price swings caused by sharp seasonal activity. The number of investment funds, for instance, increased from around 50 to 350 between early 2018 and 2021. In 2022, around 65% of the actors in the secondary market for EUAs and EUA derivatives are financial actors.
The result: a relatively stable market
Volatility is a key concept when assessing a financial asset - this helps us understand how much prices can go up or down within a time frame. Different people in the market want different levels of such price changes. Some want things to stay stable: if prices change a lot in a short time, some investors get careful. They worry about big drops in a hectic market, preferring to stay on the sidelines. But there are others, like speculators and traders, who actually like it when things are changing a lot. In a market where prices are jumping up and down quickly, it can be a good opportunity to buy low and sell high. That's why they like a bit of excitement in the market.
It makes sense to study the financial characteristics of European carbon markets between 2019 and 2022. This is when the new market regime was established, after the introduction of the supply stabilization mechanisms. In this time frame, the EUA volatility was 2.9%. As a comparison, the volatility for equities was 1.2%. Carbon allowances are complex assets, they combine legislative, energy and free-market dynamics. This explains why they are more volatile than the broader stock markets.
However, the volatility of carbon allowances has been relatively stable over the last years, and this is comforting. As we can see on this graph, it has remained within relatively small ranges overtime. There were a lot of macro disruptions in this time frame, but those have not made carbon prices react very violently. The EUA volatility has similar characteristics to that of a commodity. In terms of magnitude, between 2019 and 2022 Natural Gas, Crude Oil and Coal volatilities were respectively 5.1%, 4.3% and 2.7% - this puts EUAs (2.9%) in a reasonable position relative to those other commodities.
Over time, the European Carbon market has become more sophisticated and mature, capable to withstand macroeconomic shocks. Changes by policymakers turned EUAs into both investment and trading tools, responding to various market dynamics. From being strictly regulated, they now resemble commodity assets in broader financial markets.