High EU Carbon Prices Are Structural, and Inaction Is Not an Option
- The EU ETS is going through a perfect storm of disruptions.
- High commodity prices, regulatory reforms, the war in Ukraine, and political will are the key driving forces behind the current high EU emissionallowance prices. Pure financial players are accused of pushing up prices, but their actual role in price setting is far from proven.
- Though some of the current disruptions are of a transitory nature, the underlying trends are likely to sustain high EU carbon prices in the long run. Rabobank expects a structurally high EU carbon price for the long term.
- However, the war in Ukraine has, to an extent, the potential to reshape the current world economic structure, as well as its energy supply. If war-related measures consolidate, we could see adaptive reactions not reasonably expected before.
- For companies affected by the EU carbon price, having no adaptation strategy is not an option. Companies need to prepare for the future.
If the EU ETS Works, Don’t Touch It, but What if It Doesn’t?
The EU Emissions Trading System (EU ETS), which we explained in our previous article, finally seems to be an instrument fit to curb greenhouse gas (GHG) emissions as it was intended to do. Even in the light of the recent price decline, the EU carbon price is currently high enough to trigger significant investments in technologies to reduce emissions. But it is by no means a perfect tool, and it still has its controversies. The four phases of the EU ETS show that we constantly need to review it critically to ensure a functional market – this will also be needed in the future.
Much of the controversy regarding the EU ETS revolves around the fact that it is an artificially created market that is subject to political will, which has the power to alter the rules of the game. Until recently, critics were pointing towards too low prices as evidence of a faulty EU ETS. Now, the surge in EU carbon prices has sparked new life in the debate about its compatibility with healthy economic development.
Potential amendments to the EU ETS were among the main discussion points at the recent European Council on December 16, 2021. Representatives of several countries called for action to reduce the burden of high energy prices, even if it meant altering the current carbon market design or allowing for a temporary opt-out. The Polish prime minister, for example, claimed that “The EU ETS fell over and is not working” due to the high prices. Yet others, for example the Spanish prime minister, find the questioning of the entire EU ETS system unacceptable.
While design changes are likely to be needed to continuously improve the functioning of the EU ETS market in the long run, such alterations may come at the expense of the stability and predictability of the system. EU ETS-covered companies need a predictable and stable framework upon which cashflow-based forecasts on emissions reduction investments can be based. Striking a balance between the fitness of the market design and its predictability is a complex, continuous task. In addition, the past year has proven that the EU ETS market can be disrupted during normal operations due to factors other than systemic changes. 2022 does not seem to be any different, as even rumors of a potential intervention into the design of the market led to a decrease in the EU carbon price. Moreover, non-structural factors like the regrettable war in Ukraine and its worldwide economic implications bring additional turbulence to the EU ETS market. On top of that, short-term volatility is expected when compliance companies need to surrender their emission allowances at the end of April 2022.
In this way, the EU ETS, as any other market, evolves as a result of the combined effects of sustained background trends and seasonal or unpredictable shocks. The following analysis focuses on the key trends that have been consistently driving the upward price trend registered in the market since early 2021.
Recent Developments in the EU Carbon Price
In 2021, a year when the UK and China introduced their own versions of carbon markets, the EU carbon price almost tripled from slightly above EUR 30/metric ton CO2 to around EUR 90/metric ton CO2 in early December. Elevated EU carbon prices continued into 2022 (see Figure 1) and peaked during February at close to EUR 100/metric ton CO2. Yet, the bullish mood got tempered with the start of the war in Ukraine. While EU carbon prices remain elevated, the beginning of March 2022 brought a temporary price decrease to below EUR 60/metric ton CO2. Some investors believe that recent developments might negatively impact the EU ETS market. On the contrary, the most recent communication from the European Commission (EC), “REPowerEU: Joint European Action for more affordable, secure and sustainable energy,” proposes an even faster decarbonization of EU economies as a solution to the EU’s partial energy dependency on Russian fossil fuels.
On the one hand, the EU’s ever increasing ambition to reduce GHG emissions sends a strong political signal that partially translates into a higher EU carbon price. A high EU carbon price is a significant source of funding   for the EU that can be spent both on investing in the transition towards a more sustainable economy and on helping to mitigate negative and unintended impacts of the EU carbon price. For example, proceeds from auctioning emission allowances could complement the sources available in the Just Transition Fund, aimed at smoothening the transition for regions that are economically dependent on coal. On the other hand, skyrocketing carbon prices in a matter of only a few months can destabilize industries. Excessive volatility brings additional uncertainty, which hampers investment decisions and growth. Companies need longer lead times to feel comfortable making the significant investment decisions required to transition to a less carbon-intensive economy. From this perspective, a gradual and predictable increase in the EU carbon price might work better for the EU in the long run. In this situation, companies would be more incentivized to make long-term investments in sustainable solutions.
What Drives the Current High EU Carbon Prices?
The Role of Financial Players in the EU ETS
Non-compliance financial parties (players that trade EU emission allowances with no obligation to surrender them) are frequently blamed by politicians as the source of the recent price spike. Country leaders in Bulgaria, Czechia, France, Hungary, and Poland have expressed the need to eliminate these so-called speculators from the market.
Excessive speculation can indeed lead to volatile prices and hurt the stability and long-term viability of a market. Yet, the financial players also bring additional liquidity to the EU ETS market. Nevertheless, the line between a normal (beneficial) level of speculation and excessive (harmful) speculation is not easy to draw.
But why would financial entities even want to get involved in the EU ETS market? Firstly, the EU’s ever growing climate ambitions translate into a constant gradual reduction in the yearly supply of emission allowances. This, in turn, is expected to lead to higher prices. Secondly, it is not just a matter of price expectations and potential investment gains. Financial institutions might also be operating in the EU ETS market to offset climate risks in their own investment portfolios.
Are the ‘Speculators’ To Blame for the Elevated EU Carbon Prices?
A simplistic approach to assess speculation in the EU ETS market is to consider short positions from financial institutions on forward EU ETS markets as providing liquidity. Then, we could imagine long positions as a bet on the increase in the EU carbon price. According to Refinitiv, 20% to 25% of all open long positions in the EU ETS market are held by non-compliance parties. While this is a significant proportion of the market, the European Securities and Markets Authority (ESMA) concluded last November that such non-compliance players did not abuse the carbon market and that prices are still driven by economic and political factors.
It is worth noting that this preliminary assessment of potentially abusive activities in the EU ETS market was developed when EU allowances were trading around EUR 60/metric ton CO2 (November 2021) – lower than the price levels that followed in the months after the release of the report. France and Bulgaria criticized this report at the EU Summit in December 2021, calling for a more in-depth investigation. This need was also acknowledged in ESMA’s own report and resonates with the views of researchers at the Potsdam Institute for Climate Impact Research. The latter urged the EU to strengthen the supervision, regulation, and transparency of the EU ETS market to avoid speculation “running wild.”
The researchers in Potsdam pointed to the fact that the number of financial players in the EU ETS market has tripled over the past three years. ESMA recognizes this significant increase, but notes that the number of non-financial parties active in the market also increased in the same period, and the split between financial and non-financial parties is relatively constant (see Figure 2  ). Nevertheless, the increase in the absolute number of financial actors in the EU ETS markets has outpaced the increase in the number of non-financial newcomers. Even if this is the case, a better indicator of the market drive is that the proportion of open positions held by financial and non-financial players did not change significantly over the analyzed period. While there are more financial players active in the EU ETS market on average, individually they have a lower share of the total open positions.
At first sight, the proportion of open positions held by financial players involved in the EU ETS market may seem high. Yet, market liquidity in the secondary EU ETS markets is mainly provided by these institutions. Compliance parties acquire emission allowances to offset their emissions, so these players will generally only sell in the secondary EU ETS market in case of a surplus. Thus, while there are repeated calls from some policymakers to curb speculators’ activity in the EU ETS market, a group of private associations have called for waiting until ESMA releases its final report on potential abuses in the EU ETS market, which is expected to be released in March 2022. Based on the information available, we cannot conclude whether financial players have an abusive position in the EU ETS market.
In addition to the arguments that financial players are pushing EU carbon prices higher, there is the possibility that they might have also induced a dampening effect on EU carbon prices in the current highly volatile market environment. Due to high energy commodity prices, some traders may have been temporarily put in the position of needing to sell EU emission allowances to free up cash to meet their margin calls for open positions in other energy commodities.
Coal Replacing Gas in Power Production Has Its Fair Share of the Story
The recent EU ETS price surge ran in parallel with other energy commodities, such as coal, gas, and crude oil, that skyrocketed during the past months. Gas prices took the spotlight with a tenfold annual increase in the Dutch TTF market at their 2021 peak last December (see Figure 3). Such high price levels have again put the discussion of energy security and energy poverty high on the EU’s agenda. Furthermore, concerns about a potential reduction or curtailment of Russian gas imports to the EU further exacerbate energy security worries, triggering declarations of intent to re-enable or boost the deployment of potential substitutes. This new reality brought European coal and gas prices even higher than the peaks of 2021.
In the context of the EU ETS, two questions arise: how correlated are the EU ETS and energy prices, and could gas prices be at least partly to blame for soaring EU ETS prices?
The very high gas prices already forced industrial players like Yara International and CF Industries Holdings to temporarily reduce production in September 2021, even before gas prices peaked. Reduced activity directly results in lower demand for EU ETS allowances, which, in turn, can lead to lower prices. Yet we have observed the opposite effect, as mentioned earlier. How can this trend be explained? A partial answer lies in the fact that, in the second part of 2021, more coal was burnt to produce electricity across the EU than in previous years. According to an IEA report, in 2020, it was cheaper, on average, to produce electricity from gas than from coal. That changed from the middle of 2021 (see Figure 3). As a result, coal-fired electricity output in the EU throughout 2021 increased by over 20% (from 330 terawatt-hours to 399 terawatt-hours), versus 2020 (see Figure 4).
The much steeper price increase in gas compared to coal inverted the merit order of the two fuel choices, at least temporarily. Coal power production is much more carbon intensive than gas-fired electricity. For example, in France, the CO2 emissions per kilowatt-hour (kWh) from coal-fired electricity are roughly double those from gas-fired electricity, according to RTE. This translates into the need for twice as many emission allowances for each unit of electricity produced with coal versus gas. This, in turn, puts upward price pressure on EU carbon prices when coal-fired power is cheaper than gas-fired power. This market development has made the current correlation between the EU carbon price and coal stronger than that between EU carbon and gas. To pour further ‘gas on the fire,’ 2021 also had periods of lower-than-expected production from renewables plus the need for extraordinary maintenance of certain French nuclear plants. These events further increased the demand for coal- and gas-fired power and, accordingly, for EU emission allowances.
As long as more carbon-intensive fuel choices, such as coal power, are significantly and consistently cheaper than gas, the electricity sector is likely to continue to apply upward pressure on EU carbon prices. However, in recent days, besides a steep increase in European gas prices, we saw a spike in European coal prices too. This trend could reverse the merit order in the electricity market. The EC’s recent proposal, REPowerEU, allows member states to temporarily tax windfall profits in power markets, which may also have implications for the future relationship between the costs of coal- and gas-fired power. Moreover, gas prices can impact the EU ETS market in various ways. In the context of the war in Ukraine, if shock-elevated gas prices force a significant number of industrial players to temporarily shut operations, it would temporarily reduce the demand for emission allowances. Those fears, even though they are of a transitory nature, have already put downward pressure on the EU carbon price. The EC proposes that member states could help companies reduce the burden of the current high gas prices, potentially lowering the number of companies that would be forced to reduce production.
The Role of Climate Policy and the Resulting Choices
The remarkable growth of EU carbon prices brings into question the functioning of the Market Stability Reserve (MSR), the market-rebalancing mechanism of the EU ETS. The MSR currently in place (see Figure 5.a) is designed to shift the supply of EU emission allowances from periods with oversupply to periods of undersupply. By acting this way, MSR should temper the volatility in the EU ETS market.
Yet, the MSR mechanism is not perfect. MSR uses the amount of emission allowances in circulation as an indicator of over- or undersupply. While this is clear and transparent, MSR is only a volume-control mechanism, which might be a flawed indicator. Companies might accumulate allowances not only because of oversupply in previous periods, but also as a proactive hedging strategy for future allowance needs. The (over)buying pressure from companies is fueled by the political direction within the EU.
Beyond commodity prices and potential ongoing speculation in the EU ETS market, political will has a decisive role to play in the development of this market. The fact that the EU’s high climate ambitions put upward pressure on carbon prices is not surprising. What is less obvious at first sight is the fact that other policies aimed at stabilizing the economy in the short run also affect the EU carbon price. Examples of such policies would include measures like quantitative easing programs to stimulate consumption. Indirectly, these policies lead to higher emissions due to increased production and thus also to higher demand for emission allowances.
Moreover, member states’ declarations of intent in response to the war in Ukraine could lead to new upward and downward price pressures. Italy is considering bringing coal power plants back into operation if needed. On the other hand, Germany’s announcement of a faster transition towards renewables translates into less demand for emission allowances in the long run. This effect should be mitigated by the cancelation mechanisms foreseen in the MSR (see Figure 5.b).
Besides national responses related to energy security, the EC’s adaptation proposals, released on March 8, 2022, will echo in the EU ETS market. Some of the measures proposed are of a transitory nature, and the EC stresses that their implementation should not alter the mechanisms and price signals of the EU ETS market. Other proposed measures send a strong signal that the EC’s ambition to reduce GHG emissions remains unaltered, if not more ambitious, even in the current situation in the light of the evidenced extreme urgency to decarbonize the economy, not only for climatic reasons. The extent to which member states support this vision will indirectly translate into support for a sustainedly high EU carbon price. As a society, we need to decide where our priorities lie. Ultimately, we can only choose two out of three of the following options: high consumption, low emissions, and low costs. If we want to reduce emissions while sustaining high consumption levels, we must acknowledge that this will come with a higher EU carbon price, at least in the short run.
You Need To Act!
The EU’s ETS system is designed to gradually dry up the supply of emission allowances in an attempt to nudge market players to smoothly but significantly change their business models towards less carbon-intensive ones. Despite its flaws, the current EU ETS model clearly signals to market players that the only way forward is to make their business more sustainable, while leaving the design of the multiple adaptation strategies to the economic agents.
In this context, unless a major shift in policy direction occurs, it is unlikely that we will go back to the low EU ETS price levels seen prior to early 2021. Instead, we expect to see sustained upward price pressure in the years to come for several reasons:
- In addition to the EU’s political ambitions to become net-zero by 2050, there are more elements that hint that EU carbon prices will remain structurally high for the foreseeable future, even if the market currently exhibits extreme volatility, with EU carbon prices moving by even more than 30% within a matter of few days. Germany, for example, plans to introduce a national emission floor price of EUR 60/metric ton of CO2 if the EU carbon price falls under that threshold.
- Furthermore, TTF gas forward prices are still relatively high, which translates into the likelihood that coal will continue to be burnt to meet electricity demand. This, in turn, increases demand for emission allowances.
- Additionally, when the price of an asset increases rapidly in a short time frame, it will often lead to a backwardation situation, where the market expects prices to revert to normal levels in the long run. This might not happen in the EU ETS market, as the forward curves of EU carbon prices remain upward trending. This means that, on average, market participants expect elevated EU carbon prices to persist in the longer term.
Speaking of major shifts, it is clear that the war in Ukraine can trigger them. Besides the impact that it may have on global economic growth, measures to adapt to current highly uncertain conditions may include options never seen before.
In a world with structurally high EU carbon prices, combined with very high and volatile fossil energy prices, companies must speed up their preparations to transition to low-carbon activities as a double-sided risk coverage movement. Exceptional support measures may become an opportunity in these extremely fluid times. Preparation must be based on consistent EU ETS monitoring and on an informed adaptation strategy. The basic planning required for any EU ETS-covered company should include:
- EU carbon price scenarios,
- mapping ETS-related impacts,
- mapping the menu of investment options to reduce emissions,
- mapping of complementary tools,
- periodic (re)definition, monitoring, and update of the strategy
Subsequent articles will elaborate on this process that will help define the leaders, followers, and laggers of efforts to decarbonize European industries.
 Throughout this article, when we refer to “carbon price” we refer to European Union Allowance (EUA) price. This instrument is a tradable unit that gives the holder the right to emit one metric ton of CO2 or the equivalent amount of other greenhouse gases (nitrous oxide and perfluorocarbons).
 Among others, the main propositions revolve around mitigating the retail price burden on households, reducing the EU’s energy dependency and securing energy for the next winter, speeding up the energy transition through accelerating the integration of renewables, and electrification of built environments and industries.
 In accordance with the auctioning system of the EU ETS Directive, at least 50% of emission allowance revenues generated by member states should be used for climate- and energy-related purposes. For the period between 2013 and 2019, 78% of EU emission allowance auction revenues were spent for such purposes.
 Additionally, 100% of the proceeds from the solidarity mechanism allocation should also be spent for climate- and energy-related purposes. Under the solidarity mechanism allocation, 10% of the auctioned allowances are redistributed to the 16 countries most in need of support. Poland is the main beneficiary of this mechanism.
 Data collected by ESMA is classified in five broad categories: investment firms or credit institutions (i.e. mainly banks), investment funds, other financial institutions, operators with compliance obligations under the ETS Directive, and commercial undertakings (i.e. non-financial counterparties other than those with compliance obligations under the ETS Directive). These categories are further aggregated in Figure 2.
 Most of the newly issued EU emission allowances are auctioned by member states through the regulated European Energy Exchange (EEX) market, which serves as a primary market (also called spot market). As for the secondary markets (futures markets), EU emission allowances are predominantly traded through the EEX and Intercontinental Exchange (ICE) markets. Nasdaq Oslo also serves as a secondary market for EU emission allowances.
 Open positions only represent EU emission allowances that are put up for trading on the secondary market. Open positions do not represent the total number of EU emission allowances in circulation.
 International Emissions Trading Association, Eurelectric, the European Federation of Energy Traders, and the International Swaps and Derivatives Association are among the signatory entities urging the EU not to intervene in the EU ETS market. These organizations represent, among others, utilities, NGOs, and traders.
 Short-run marginal cost calculated using: Dutch TTF day-ahead gas prices; EU ETS December 21 contract; API2 Rotterdam front-month contract (from Montel); lignite fuel costs = EUR 1.5/MWh; variable operating and maintenance costs = EUR 2/MWh; plant-efficiency factors = hard coal: 38, lignite: 37%, fossil gas: 55%; carbon-intensity rates = hard coal: 0.83 tCO2e/MWh, lignite: 1.1 tCO2e/MWh, fossil gas: 0.37 tCO2e/MWh.
 The merit order represents the way in which power generation facilities are ranked based on their marginal costs, from the cheapest to the most expensive. In this way, the merit order curve ensures that at each moment in time the cheapest available power sources will operate.
 IEA, Average CO2 intensity of power generation from coal power plants, 2000-2020, 2000-2020, IEA, Paris
 Prices in power markets are set based on a merit order curve, a curve which ranks power producers from the cheapest to the most expensive. The current pricing mechanism of the internal energy market allows amortized plants (such as old nuclear or hydro power plants) to obtain incomes way over their costs under circumstances like the current high gas prices.
 As of 2023, a cancelation mechanism will be attached to the MSR, such that, under certain conditions, part of the EU emission allowances stored in the MSR can be permanently cancelled.
 High consumption levels require elevated production of goods. If we use fossil fuel energy sources to produce these goods, this results in higher emissions. Thus, to reduce emissions while catering to a high consumption appetite from society, we must invest in sustainable alternatives. As such, investments are sometimes more costly than running “business as usual.” High emission allowance prices could come to support their viability and the transition towards more sustainable economies.
 For example, on March 4, 2022, in the EEX secondary forwards EU ETS market, EU emission allowance prices for December 2025 contracts (EUR 74/metric ton of CO2) traded slightly higher than December 2022 contracts (EUR 68/metric ton of CO2).