Why Do Carbon Allowance Prices Go Up (or Down)?
This week we look at emissions trading systems in the EU and California
If you look at the price trends of emissions allowances in the EU, you will see an uptrend in the cost per tonne of carbon dioxide produced since 2020, but prices seem to taper after hitting a high in 2023:
This led me to wonder: do carbon prices tend to rise over time and what factors determine prices? In this week’s post, we will look at some of the biggest carbon markets (starting with the EU and California) and some of the driving factors.
A quick note before we dive in: in this post we only focus on carbon allowances (the regulated/compulsory part of carbon emissions), and will leave out discussion on carbon offsets (the unregulated/voluntary component) for another time.
Let’s begin!
European Union Emissions Trading System (EU ETS)
To understand the carbon allowance market, let’s start with the biggest of them all: the EU ETS.
Introduced in 2005, the EU ETS is the world's largest carbon market and operates on a cap-and-trade system. The system covers various industries, including power generation, manufacturing and aviation across EU member states.
You may ask: what is a cap-and-trade system?
A cap is the limit of greenhouse gas emissions that are allowed for an entity. For example, an entity operating in an industry covered by the ETS, such as an airline, is only allowed to emit a certain amount of greenhouse gas. This is represented by a certain number of allowances, which gives the entity the right to emit one ton of CO2 or greenhouse gas equivalent.
If the entity emits more than the allocated allowances, it must purchase additional allowances — or trade — from the market.
Where do these additional allowances come from?
One obvious source of additional allowance would be from entities that emit less than their caps.
Another source of allowance would be from a reserve pool (known as the Market Stability Reserve in the EU ETS system), which helps to reduce price volatility.
Certain carbon markets also allow borrowing, which entails the use of carbon allowances from future years for current compliance. As you can imagine, the use of this is probably limited to prevent entities from kicking the can down the road by borrowing from tomorrow’s allowances for today’s emissions.
Another question: how do these entities get their allowances? There are two mechanisms: auctions and secondary markets. In the primary market, the regulator conducts auctions to allocate emissions allowances to participating entities through a competitive bidding process, with winning bidders paying the clearing price for the allowances they acquire.
In the secondary market, entities can buy and sell their allowances, which forms the trade component of the cap-and-trade system.
By placing a financial cost on carbon emissions, the EU ETS encourages companies to invest in cleaner technologies, improve energy efficiency, and reduce their carbon footprint. This market-based approach is seen as a cost-effective way to drive emissions reductions and transition to a low-carbon economy.
So, has the ETS been as effective as it is marketed to be?
It appears so, if we look at 2023 emissions data, which showed a 15.5% decrease in emissions from 2022 levels. Emissions are now 47% below 2005 levels (the year that the ETS was launched) and are on track to reach its 2030 reduction target of 62%.
This reduction does seem to tally with the movement of the carbon allowance prices we saw above, which hit around EUR 100 per tonne in 2023 and trade at around EUR 70 per tonne now.
However, the relationship between emissions and carbon allowance prices may not be so straightforward. As the famous saying goes, correlation does not imply causation.
Since this is a cap-and-trade system, and the regulator’s goal is to reduce emissions by 62% in 2030, we would imagine tighter caps as we get closer to the target year. While the implementation of the cap reduction is a little more complicated, with different phases for different industries, that is essentially what happens in such a system.
If we look at the linear reduction factor that is applied annually to the overall cap (using 2008-2012 baseline emissions as a base), the factor is set below:
2021-2023: 2.2%
2024-2027: 4.3% (we are here now)
> 2028: 4.4%
One way to think about this is that the cap limit will be reduced as we get closer to 2030. If this is translated to a lower supply of carbon allowances, one may infer that the prices of carbon allowances would increase as a response.
But before we jump to that conclusion, let’s look at the demand side of the equation.
As companies pollute less, their requirements for carbon allowance should also go down. How have these companies managed to reduce their emissions? Has greener technology and more efficient methods of production helped companies achieve that goal?
If clean technology can reduce overall required emissions by more than 4.3% per year from 2024-2027, all else being equal, we would see carbon prices moving lower as companies simply do not need to pay for so many permits anymore.
In short, the price of carbon allowances would be determined by the demand-supply imbalance.
A recent Reuters headline suggests EU carbon price may soften on weaker demand from industrial companies and the power sector. Interestingly, another factor that could affect demand this year is the change in the compliance deadline from previous year’s end-April to end-September this year, allowing companies “more time to compile data and purchase allowances”.
Even with the lower forecasts, however, the average forecast for 2026 is still at around EUR 100 per tonne, which means the market generally expects the reduction in cap to play a more significant factor in driving prices.
Before moving to the US to look at a similar scheme in California, a quick side note here: the UK used to be a part of the EU ETS, but now has its own similar ETS program after Brexit.
California Cap-and-Trade Program
In the US, the California’s cap-and-trade program began in 2012 and was expanded to cover Quebec in 2014 through a linkage program. It is also a cap-and-trade program, regulated by the California Air Resources Board and represents “a key element of California’s strategy to reduce greenhouse gas emissions”.
Similar to the EU ETS, its reduction goal is 60% of carbon levels by 2030 (but using 1990 as a baseline year instead of 2005). The cap will reduce by 4% per year, similar to what we saw in the EU.
However, what is unique to the California’s program is that is has a price floor that is pegged to inflation rates, which makes it a potentially good inflation hedge. The price floor rises by 5% plus the CPI.
You may argue that the EU ETS also has a price floor through the Market Stability Reserve to reduce price volatility, but it is not pegged to inflation.
How have California’s carbon allowance prices performed in recent years? Looking at the chart below, you could see that it has risen significantly and hit a fresh high in early 2024:
Why have the carbon prices in California gained so much relative to Europe? Some analysts attributed this to the state’s ambition climate ambitions. Bloomberg NEF estimates the carbon allowance price could reach $63 by 2030.
Rest of the World
ETS programs we covered above (EU, the UK, California and Quebec) represent the among biggest and most mature markets in carbon allowance trading.
Since the start of the programs, EU ETS has generated EUR 152 billion of revenue (as of 2022), whereas the relatively younger Californian program has generated $12.5 billion in revenue (as of 2020). The governments could use these additional receipts on decarbonization plans and to transition to a green economy. Washington state’s newly-launched cap-and-invest program in 2023 has also helped to raise $850 million in revenue. This means that such programs are not likely to end anytime soon.
There are also various ETS programs (either in force or under development) across the world, from New Zealand, South Korea to China:
Summary
Looking at the price trends of carbon allowances in the EU and California, it appears that prices have been on a long-term uptrend. This is likely driven by the supply shrinkage baked into the system, with clean/green technology not developing fast enough to reduce emissions.
In addition to falling supply over the years, these systems also have a price-stabilizing mechanism in the form of a price floor (California) or a Market Stability Reserve (EU). When carbon prices drop too much, these mechanisms essentially provide a support.
Any demand shock from external events may also impact carbon allowance prices. In fact, in Dec 2022, sanctions on Russia led to the EU having to burn more coal amid strained global supplies, in turn driving carbon prices higher.
There is also the argument that higher carbon prices are “existentially necessary”: carbon prices have to rise enough to act as a deterrent to force carbon demand down if we were to successfully move to a net-zero world.
In essence, it does seem that in the absence of a radical shift in technology that would significantly cut carbon demand, it is likely that we will see carbon allowance prices creeping higher in the run-up to 2030 — especially as the carbon market gains more participation.
Nice summary of the main carbon markets.