Breakingviews - Carbon markets have a Goldilocks problem

LONDON (Reuters Breakingviews) - Frans Timmermans has a Goldilocks problem. The European Union’s climate chief has recently seen the value of carbon permits in the bloc’s much-maligned Emissions Trading System (ETS) soar above 40 euros a tonne, a level just right to incentivise power companies to cut their greenhouse gas output. His challenge is to avoid incurring the wrath of politicians if financial interlopers send prices spiralling higher too quickly.

Steam rises from the Niederaussem lignite power plant, in Niederaussem, Germany, January 16, 2020.

The ETS is carbon trading’s biggest market. According to Refinitiv, 2020 volumes traded exceeded 8 billion tonnes of carbon permits, four-fifths of the global total. That dwarfs jurisdictions like California which also operate “compliance” markets, in which governments decide annual caps on emissions, force big emitters to buy permits, and let the market determine the price. It’s also way bigger than the 100 million tonne size of “voluntary” markets, in which emitters choose to offset emissions via measures like planting trees.

Traders have noticed. While companies that need to use the ETS are still the central players, investment funds have increased their presence from 4% of overall long positions in February 2020 to 7% a year later, according to Refinitiv. Cayman Islands-based, ex-Goldman Sachs bitcoin enthusiast Raoul Pal recently tweeted that the ETS was “one of the greatest macro trades no one is involved in”. And in the last six months, the KFA Global Carbon exchange-traded fund, which mostly invests in ETS credits, has seen its assets jump from $3 million to $60 million.

At first, this excitement looks odd. The ETS, which covers 11,000 companies and nearly half of overall European emissions, has a troubled past. It’s supposed to work by the EU auctioning or dispensing new credits annually, but tapering issuance in line with the desired decline in newly belched carbon dioxide. But after 2008, demand for permits plummeted as downturns cut emissions. That, plus the doling out of free permits to airlines and power utilities, created a 2 billion tonne permit surplus and a carbon price below 5 euros a tonne. By way of context, the entire new issuance for 2021 was only 1.5 billion tonnes.

Two factors explain how Timmermans stopped the rot, and grabbed hedge funds’ attention. Aware that utilities would only start to switch from coal to lower-carbon gas if the carbon price topped 20 euros, the EU in 2019 pledged to remove a big chunk of the permit glut annually. Second, Brussels increased its 2030 emissions reduction target to 55% from 40% versus 1990 levels. With these twin buy signals, carbon prices rose last year even though bloc-wide emissions fell 9%.

In one sense, Timmermans just needs to keep up the good work. An EU review due in June is likely to recommend expanding the trading scheme to areas like building emissions, while tightening the market to reflect the tougher targets. The Goldilocks route would be to do so gradually, letting carbon prices alight at a just-right 91 euros a tonne by 2030. That’s the level at which BNP Paribas analyst Mark Lewis reckons “green” hydrogen, made from renewable electricity and seen by the EU as integral to decarbonisation, becomes competitive enough for big industrial users to ditch the version made from fossil fuels.

Unfortunately, this may be a recipe for further price spikes now. If industrial users of permits and financial speculators know carbon prices are going to rise, both will load up now – carbon dioxide emitters need to ensure they aren’t caught short, while money managers will see a sustainable investment that’s also a safe bet. Casey Dwyer at hedge fund Andurand Capital says prices could hit 100 euros a tonne this year.

If so, that could hammer companies’ operating costs and enrage politicians trying to revive virus-hit economies. Poland, a green energy laggard, would lead calls for a bonanza of new free permits. Last year a government minister, Janusz Kowalski, even called for the ETS to be scrapped.

Timmermans is not totally powerless: after all, the EU is in effect the permit market’s central bank. He could respond to spikes by creating a pot of extra permits to be deployed at its discretion. Carefully managed by a Mario Draghi-like authority figure, that might maintain overall stability despite disparate regional forces.

Yet this is still risky. At its heart, the trading scheme is an artificial market. The more tinkering, the more politically contentious it becomes. And trying to suppress prices runs against the stated aim of cutting carbon emissions. Getting them just right will be harder than it looks.


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