What are the main drivers of the EUA price?
Summary
EU Allowance (EUA) prices are driven by supply and demand. EUA supply is intentionally decreasing to drive long-term price appreciation for green finance, while demand fluctuates in the short and medium term based on factors like energy prices, economic conditions, weather, and technological advancements. This makes EUAs potentially suitable for long-term investing in renewable energy despite short-term volatility.
Understand what drives EUA prices in order to be able to analyze and predict their moves. As any other financial assets, they are subject to the basic economic principles of supply and demand. Carbon allowances are unique - they have a decreasing supply by design, bringing a steady long term price appreciation. The demand for EUAs, on the other hand, relies on many different shorter-term factors. Here is your supply- demand guide to the carbon markets price moves on the short, medium and long term.
Supply-side factors: The long-term drivers of EUA Prices
A market with a purpose
The intentional reduction in the supply of EUAs drives long-term price appreciation. Unlike other markets, the EU ETS was established with a purpose: reducing greenhouse CO2 emissions across the European Union. To achieve this goal, regulators establish climate change targets with a set deadline and calculate the total amount of CO2 emissions that can be released while still meeting the environmental objectives. They then distribute this overall carbon budget across each year until the deadline.
Decarbonizing without harming the economy
EUAs are structured to have a decreasing supply over time because regulators are slowly reducing the allowable CO2 emissions from industries. This gradual aspect of the reduction is essential to avoid harsh economic impacts, as certain levels of CO2 emissions are necessary for ongoing production. Economically and socially, we cannot afford to simply stop all processes from one day to the next.
A steady long term climb
Here are the main features of the EU ETS supply. It is predictable, regulators decide the supply of EUAs in advance, so the market can anticipate future changes. It is also steadily declining, the number of CO₂ allowances available decreases each year in a controlled, gradual manner. As you may recall from your macroeconomics classes, when supply decreases in a market, prices rise over the long term.
How demand affects short- and medium-term fluctuations in EUA prices
To make it easier to understand, we can see demand for EUAs as the carbon emissions that occur at any given time. Below are the main factors that determine how much carbon needs to be emitted for the economy to continue operating.
Energy Prices
Energy prices impact the demand for EUAs. If renewable energy becomes cheaper than fossil fuels, industries switch to these cleaner options, reducing CO2 emissions and lowering EUA demand. Conversely, if fossil fuel prices drop, industries might use more carbon-intensive energy sources, increasing CO₂ emissions and raising EUA demand.
Macroeconomic Environment
Economic downturns, such as recessions, decrease industrial activity and energy use, lowering CO2 emissions and EUA demand. In contrast, a strong economy leads to increased industrial activity and energy consumption, raising EUA demand and prices.
Weather Conditions
Weather conditions can influence EUA demand by affecting energy consumption. Cold winters increase heating needs, which can lead to more CO2 emissions, while hot summers boost air conditioning use and energy consumption. As global warming gets more severe, extreme weather events can cause fluctuations in the demand for EUAs and affect their prices.
Technological advancement
As technology progresses, industries can be enabled to emit different amounts of CO2 while maintaining the same productivity levels. These adjustments can influence the demand for EUAs and have an impact on their prices.
The uneven path of long-term price growth
The decreasing supply of EUAs is intended to drive their long-term price appreciation. However, a range of factors can lead to short- and medium-term price volatility. This combination of predictable long-term growth with short-term fluctuations makes EUAs a good asset for a buy-and-hold investment strategy.
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