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Read about the drivers of the EU ETS price as well as the price dynamics that we have observed in the past.
European Union Allowances (EUAs) prices have been increasing at an average pace of 32.4% per year in the past 10 years. However, they are a highly volatile asset on the short term, with CO2 prices driven by energy prices, weather, macroeconomic conditions, political decisions, and the cost of decarbonation technologies.
The EUA historical price chart since the creation of the scheme tells an intriguing macroeconomic story. Initially, EU ETS carbon prices were too low due to an accumulating supply surplus. This was exacerbated by the financial crisis of 2007 - 2008 and the resulting reduction in economic activity: the demand for carbon allowances was much lower than initially anticipated. It led to near-zero price levels for a significant portion of the period. Later on, as the economy was recovering, regulators implemented market stabilization mechanisms and EU ETS EUA prices began a gradual ascent after 2018.
What happened in 2023? Why were prices flat-tish, with a downward trend, particularly in the latter part of the year?
You can keep up with the real time EU ETS carbon price data here.
Below, you will find the EU ETS carbon price graph since the inception of the CO2 trading scheme.
A significant portion of EUA purchases is driven by compliance needs: the demand comes from industries having the legal obligation to acquire allowances in an amount equivalent to their carbon emissions. The larger the consumption of coal, gas, or oil, the greater the volumes of CO2 released, and the larger the amounts of EUAs required for compliance needs.
The carbon emission levels depend on the type of energy used for industrial production or power generation. For example, producing power with coal is more carbon-intensive than with gas, so it will require the purchase of a greater amount of EUAs for an equal output.
Ultimately, EUA price levels are contingent on demand volumes, those resulting from industries' choices regarding energy sources. Those choices are made according to the broader energy markets price levels and which sources are more advantageous. This is how EUA prices end up being highly impacted by the price levels in those markets.
For example, if gas prices decrease in relation to coal, power plants will favor gas, which has a lower carbon intensity, and lower their EUA demand. So as gas prices fall, so do EUA prices.
CO2 emissions result from industrial activities - more production leads to increased energy consumption and thus increased emissions. More carbon released translates into an increase in the purchase of EUAs. Elevated demand for EUAs, driven by heightened carbon emissions, contributes to higher prices in the market. Consequently, during economic booms with periods of increased industrial activity, one can observe upward trends in EUA prices.
Industrials have to make the following trade-off: invest in decarbonization technologies or continue to pollute and purchase EUAs to match emissions. If advanced, effective, and relatively cheaper decarbonization technologies become available, industries will adopt them, reducing their need for EUAs. Then, demand for allowances will be decreased and have an impact on prices.
The EUA price can be thought of as the point at which the trade-off between investing in low-carbon solutions becomes economically viable, on a per-ton basis. As EUA prices increase, more decarbonation solutions become economically viable.
In winter, colder weather increases energy consumption for heating, leading to higher CO2 emissions and a greater demand for Emission Allowances (EUAs). As a result, during colder periods, the increased buying for EUAs can push their prices higher. Conversely, warmer weather tends to reduce energy-related emissions and demand for EUAs, potentially leading to lower prices in the carbon allowance market.
In summer, the opposite effect is observed: during heatwaves, cooling buildings consume increased levels of energy, pushing prices of EUA upwards.
European carbon allowances serve as the main policy instrument in the fight against climate change - they are designed to fulfill established climate objectives. The implementation of a carbon pricing mechanism aims at achieving those specific targets. The authorities would have failed their decarbonization mission, should the EUA price not be able to incentivize industrials to change their behavior and reduce pollution.
As EUAs are exclusively issued by the European Commission, European Climate ambition plays a crucial role. By having the ability to supply allowances, the authorities can have an impact on how rapidly the issued volumes decrease. The faster the EU wants the economy to decarbonize, the faster it will get the EUA supply to decrease. Following the most simple macroeconomic concepts, price levels increase as supply decreases.
Currently, the new issuance of carbon allowances is reducing at a rate of 4.3% per year. This rate will be bumped up to 4.4% in 2028. The European Commission has been regularly tightening the market with higher reduction rates: the initial rate was 1.74%. This shows the sustained support of the commission for higher prices.
During the initial three phases of the EU ETS from 2005 to 2020, the emphasis was primarily on regulatory aspects. Regulators focused on issuing the appropriate supply in line with the prevailing carbon budget. However, an oversupply issue arose as they released more EUAs than the market ultimately required. The resulting surplus in supply compared to demand led to lower prices in the carbon market. Prices remained below the EUR 30 range at that time.
In addition to the oversupply of allowances, the macroeconomic conditions played a significant role in driving down EUA prices during the first phases of the mechanism. The financial crisis of 2007-2008 led to reduced economic activity, resulting in decreased production, lower energy usage, and reduced emissions levels. This decline in demand for Emission Allowances (EUAs) contributed to a substantial drop in prices, with EUA prices remaining near zero for a significant portion of 2007 and 2008.
Regulators implemented market-controlling mechanisms to address the imbalance between the demand and supply of EUAs. They reduced the structural oversupply and initiated a price recovery. The introduction of the Market Stability Reserve (MSR) empowered them to withdraw allowances from the market when needed, providing a mechanism to tighten supply after the fact (after the initial issuance) and stabilize prices.
After 2018, Emission Allowances (EUAs) were designated as financial instruments under the revised MiFID 2 regulation. This led to increased market participation from various financial entities, including hedge funds and investment funds, resulting in improved liquidity. The diverse objectives and timelines of these participants contributed to greater market stability from a financial standpoint.
After 2020, Emission Allowance (EUA) prices experienced a consistent upward trend due to the factors mentioned above. They oscillated around the EUR 80 range between 2021 and 2023.
The EUA market lacked directionality in the early months of 2023 as participants were recovering from the shocks from the previous months. Indeed, there were significant fluctuations in energy markets, driven by the war in Russia. Concerns about the conflict's escalation added uncertainty to the carbon allowance sphere. Additionally, changes in energy policies (such as Germany transitioning away from nuclear power to embrace renewables and France fully restoring nuclear capacity) contributed to EUA prices remaining flat during this period.
Towards the end of 2023, EUA prices experienced a decline, closing the year around EUR 70. This downward trend was due to decreased industrial activity, leading to less CO2 being emitted in the production processes, and hence resulting in less demand for EUAs. On top of this, a milder-than-usual winter brought lower heating need, also pushing down carbon prices. The correlation between EUA prices and gas prices was almost perfect, and the decline in gas prices contributed to the downward pressure on EUA prices.
In 2024, everyone in the energy and ETS markets is focusing on political announcements: those will enlighten us on the EU's climate objectives for the 2040 horizon. The ambition of these targets will carry importance for EUAs - it can have an influence on supply, for example. Additionally, we should be on the lookout for signs of an industrial activity upturn, as renewed production could drive a resumption in the demand for carbon allowances, driving prices up.
Sources:
The European Commission, 2023. Scope of the EU Emissions Trading System.
The European Commission, 2023. What is the EU ETS?
The European Commission, 2023. Emissions cap and allowances.
Eur-Lex, 2015. Decision (EU) 2015/1814
Investopedia, 2023. MiFID II: Definition, Regulations, Who It Affects, and Purpose
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