What role does financial activity play in the EU ETS?
Summary
The EU ETS benefits from financial actors, including individual investors, who enhance market liquidity, reduce volatility, and improve price discovery, making it a more effective tool for decarbonization and green finance. The expansion of financial activity with spot transactions contributes to a more dynamic and resilient trading environment within the European carbon market. This increased participation and demand leverage free market dynamics for optimal results in carbon neutrality.
The European Union Emissions Trading Scheme (EU ETS) is both a policy tool and a financial market. The more market participants there are, the more robust the market becomes. After all, what is a marketplace without any participants?
Opening up the EU ETS to financial actors’ participation
The inclusion of financial participants in the EU ETS following the MiFID II reform in 2018, was a major step in the EU ETS development. Before this reform, the market was made up of compliance entities—those required to meet emissions reduction targets. Such a narrow focus can lead to high volatility due to the low volumes and the strong seasonality of compliance buying and selling
Reducing volatility and improving price discovery
The involvement of participants for institutional investing and speculation has introduced a wider variety of trading strategies to the EU ETS. Unlike compliance entities, which operate based on regulatory deadlines and have to buy EUAs with similar time horizons, financial actors engage in different activities that enhance market stability. The more exchanges there are at different times with different volumes, the stronger the EUA price discovery. This smooths out price fluctuations and adds robustness to the market. This greater market sophistication contributes to a more balanced and resilient trading environment.
EU ETS market liquidity
The presence of more financial actors has significantly improved market liquidity. By acting as counterparties for trading compliance entities or other market participants, financial players ensure that there is always a buyer or seller for EUA transactions. Also, financial participants make it easier for smaller parties to enter the market - since there are large volumes and many trades continuously throughout the day, it is easier to execute exchanges at real time prices. The European Parliament has highlighted in a research paper that excluding financial actors from the EU ETS could jeopardize market liquidity and price formation.
Individual Investors Enhancing the Financial Dynamics of the EU ETS
As the EU ETS market evolves, it continues to grow and adapt to real life market conditions. For example, in 2024, financial activity in the EU ETS expanded with the introduction of spot transactions for individual investors. This new financial activity enhances the market's role by increasing participation and demand, contributing to a more dynamic and resilient trading environment.
It is no coincidence that the most effective decarbonization policy tool leverages the dynamics of the free market for optimal results. The increasing financial activity in the EU ETS has grown in size and importance, enhancing its effectiveness as a policy tool.
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