Global finance looking to profit from carbon and carbon allowances

The entry of speculative investors into carbon markets could distort their working, and the resultant volatility and uncertainty are likely to inflict much collateral damage even as the objectives with which those markets were created remain unrealised.

At a chemical factory in Mumbai in September 2010. China and India are the biggest generators of U.N. carbon credits, which can be used to comply with pollution targets in the E.U. Emissions Trading System, which was established in 2005 and is the most developed carbon market in the world.

C arbon prices in the European Union, or the value of one unit of an E.U. allowance (EUA) that gives the holder the right to emit one tonne of carbon dioxide (or its equivalent of other greenhouse gasses), are soaring. From 33.69 euros a tonne at the beginning of the year, the prices of EUAs traded through the E.U. Emissions Trading System (ETS) rose to a high of 62.75 euros on September 9, or by more than 80 per cent.

Since the ETS was created to generate market-driven price signals that would influence the volume of emissions by firms, a rise in market prices should be welcomed as it would trigger emissions reduction. Combining that with lower caps on total emissions, it is argued, would help a country or a region move in the direction of meeting the goals set for emissions reduction as part of an effort to keep global warming below 2 °C and as close to 1.5 °C as possible. If permits to pollute are more expensive, it will make business sense to reduce emission levels by investing in emission-reducing technologies and processes and exiting from emission-intensive sectors.

On the basis of this perspective, many governments have embraced a strong market-mediated component as an instrument to curb emissions and limit global warming. An international carbon-pricing commission chaired by Nicholas Stern and Joseph Stiglitz argued in 2017 that even with substantially enhanced efforts to reduced carbon emission, the social cost of carbon in 2030 would be closer to $100 a tonne of CO2 equivalent as opposed to the estimate of $50 that came from the United States’ Barack Obama administration. Putting carbon prices on a trajectory that takes them close to such an appropriate social cost of carbon emissions and triggering an adequate emission reduction response would require limiting the supply of carbon allowances. If the ambition is right and allowances are reined in, the market can deliver the desired result, the argument went.

Financial firms’ interest

However, matters are not as simple as that. In practice, the prices of EUAs appear to be rising not only because of excess demand from those who would use these allowances to back their emissions but also because of the entry of financial firms wanting to play with this new commodity, carbon, and the tradable securities, carbon allowances, deriving from it. Looking to profit from an environment in which enhanced climate ambition is likely to lead to a significant lowering of the cap on the available number of EUAs, financial firms expect the market to tighten and prices to rise into the future. These players—energy traders, hedge fund managers and banks such as Morgan Stanley, Goldman Sachs and J.P. Morgan—have been in the carbon market for a long time, often moving in when prices tended to rise and pulling out when prices fell.

But the prospect of a tightening of emission regulations has heightened investor interest. Financial investors are betting on prices rising in the medium and longer term and rushing into the carbon market, pushing up prices even though the current demand-supply balance at the level of actual user firms is not one that would deliver a spike. Once financial investors enter the carbon market, the spiral of speculation unfolds. Thus, in August 2020 the New York Stock Exchange launched a carbon derivative, the KFA Global Carbon ETF, an exchange-traded fund that aims to track the performance of the world’s three most liquid markets for carbon credits. Increasingly, the activity of these speculative players, rather than carbon credit demands from emitting firms, is the determining influence on the price of carbon allowances.

In fact, for some time now, the situation in the E.U. carbon market was one of excess supply, which kept carbon prices low. Surpluses began accumulating after 2009 because of the recession that followed the global financial crisis, which brought prices down. The surplus amounted to around two billion allowances at the start of Phase 3 of the E.U. ETS that was to stretch from 2013 to 2020.

The problem of excess supply has plagued carbon-trading regimes since their inception. Carbon trading was launched following the signing of the Kyoto Protocol, which required the developed countries to make commitments on curtailing emissions, which could partly be met by acquisition at a cost of Certified Emission Reductions (CERs) generated though projects funded in developing countries under the Clean Development Mechanism (CDM).

But factors such as the excessive offsets permitted and the ease of generation of carbon credits because of inadequate verification of their quality undermined the role of carbon trading as an instrument for emissions control. The result was an oversupply of CERs, which was reflected in the low prices of carbon credits. A United Nations high-level panel examining the performance of the CDM in 2012 concluded that it had nearly collapsed. This meant that the carbon market could not play the role it was expected to.

Confronted with a similar problem afflicting the ETS in 2013, the European Commission decided to hold back the flow of allowances into the system by “backloading” the issue of new allowances, or reducing annual issues during 2014-16, by postponing the scheduled issue of 900 million allowances to 2019-20. In 2019, the Commission set up a market stability reserve to which a rule-determined number of surplus allowances were transferred, some of which were to be eventually withdrawn if the surplus crossed a certain threshold. Managing the EUA surplus to make the ETS effective was the main concern of those overseeing the regime. However, the situation of excess supply was only aggravated by the production declines and demand recession that followed the onset of the COVID-19 pandemic.

Given this background, the sharp increase in prices in 2021 is indeed surprising. As noted, one explanation seems to be the role of financial investors, soaking in cheap liquidity, who have discovered and rushed into this new “commodity” or alternative asset. The role of these investors in driving prices is also indicated by the fact that the prices of carbon credits have been rising in jurisdictions outside the E.U. too, where emission reduction ambition falls short of that in the E.U. and where the rules governing carbon markets are not as compelling. The World Bank reports on 29 ETS initiatives covering 38 national and 29 subnational jurisdictions. There is no “global” carbon market, only regional, national or subnational markets.

But the ETS, established in 2005, is the most developed of these markets and the test case. All E.U. countries and Iceland, Liechtenstein and Norway participate in the ETS. It accounts for close to 90 per cent of the global carbon market, which Refinitiv valued at 229 billion euros ($272 billion) in 2020. (Refinitiv is the new avatar of Thomson Reuters and is a global commercial provider of financial market data and infrastructure.) The ETS also accounts for an overwhelming share of the 10.3 billion allowances traded globally.

Net zero emissions

The rules that apply under the ETS are tightened across phases. Tightening involves hastening the pace of reductions in permitted emissions, increasing the share of allowances available at a price determined in auctions rather than free of cost, and raising the penalty for non-compliance (specified in dollars per tonne of carbon equivalent). In the fourth phase of the E.U. ETS, beginning this year and stretching to 2028, the total number of emission allowances will decrease at an annual rate of 2.2 per cent compared with 1.74 per cent during the period 2013-20. This is seen as in keeping with the July 2021 decision of the European Commission to legislatively bind itself to achieving net zero emissions in 2050, with an intermediate target of an at least 55 per cent net reduction in greenhouse gas emissions by 2030. To realise the latter, the sectors covered by the ETS must reduce their emissions by 43 per cent compared with 2005 levels.

It is this ambition that has whetted the appetite of financial investors as they expect the heightened emissions reduction commitment to support an increase in EUA prices. Their intervention amplifies that price increase. It could be argued that by raising EUA prices, speculators play a positive role. But there are two problems here. First, financial investor presence increases price volatility to a far greater degree than results from changing production and emission levels associated with the business cycle. Periods of recession see a decline in demand for permits and a fall in prices. And demand for EUAs spikes in buoyant economies, raising prices. Superimposed on this “fundamental” volatility is the volatility that results from the speculative forays of financial investors.

Such speculation-induced volatility is hardly suited to a smooth market-led transition to a climate-friendly economic structure. Carbon prices that trigger a switch out of coal, say, could subsequently fall to levels where from a pure profit maximisation perspective the switch may appear completely unwarranted. What such uncertainty would do to business decisions is unclear.

Second, with widely different emission reduction targets and the uneven spread of regulatory carbon trading systems across jurisdictions, businesses in some locations would face greater pressure to transition to high-cost technologies and processes that reduce emissions or shift out of carbon-intensive sources of energy supply. European businesses, for example, may find the asks they face much more stringent than those their global competitors face, leading to them being outcompeted by imports. However, the pushback from the profit-driven private sector can trigger responses that could be destabilising. One example of this is the E.U. decision to institute the carbon border adjustment mechanism, which, starting 2026, would impose levies linked to the level of E.U. carbon prices on imports of steel, aluminium, fertilizers and cement seen as originating from factories that do not meet E.U. emission standards.

The initiative threatens to trigger a trade war, with many nations exporting to the E.U. raising objections despite the E.U.’s claims that the levy is not a protective tariff against a nation but a penalty imposed on individual polluting firms.

The fundamental problem lies in the position that in an increasingly integrated world of nation states with different laws and rules carbon markets and the prices they throw up can be expected to incentivise profit-seeking firms to smoothly transit to climate-friendly technologies and sectors. That is a difficult ask in itself, given the fundamental instability of market economies. If, in addition, carbon markets are allowed to be distorted by speculative investors who expect to reap profits by outguessing rivals, volatility and uncertainty are likely to inflict much collateral damage even as the objectives with which those markets were created remain unrealised.