Politics

For Europe’s Hot Carbon Market, Politics Is the Ceiling

The EU’s carbon credits are not so much a commodity as a political tool. This has fueled an amazing rally over the past year, but it has also limited the market’s potential for financial speculation.

The European Union Emissions Trading System, or ETS, is the world’s largest regulated market for carbon allowances. Annually, European polluters in select industries, notably energy production, must recover a credit for every metric ton of carbon dioxide they emit. A decreasing number of allowances are awarded with the remainder being auctioned. At first, market prices fell, but they have continued to rise since the 2018 reform. On Tuesday, they were trading at 82 euros, equivalent to about $93, up from just 34 euros a year ago.

Designed to encourage industries to clean up, total credit supply will shrink annually, however demand is expected to grow, at least in the near term, with more electricity and an extension of the program. This sounds like a recipe for a one-way bet, and there have been whispers of something akin to a short squeeze, as companies are forced to buy up a dwindling stock of credit.

The European Union’s emissions trading scheme is the largest regulated market for carbon premiums.


Photo:

Matthias Osterl/Zuma Press

What investors need to remember is that politics can push supply the other way, too. Although traded as a commodity, carbon credits are conceptual rather than physical. Market rules can be modified if its price does not meet EU targets.

Combined with stricter regulation and “green deal” subsidies, carbon costs are a key tool for the EU to decarbonize its economy. Many expect the price of the credits to rise significantly above €100 per metric ton, eventually generating additional cash to help fund the transition. Europe views decarbonization as an opportunity to take the lead in the next industrial revolution, as well as an environmental imperative.

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With this goal in mind, ETS is doing well enough that the EU is building on it. It recently proposed a “Carbon Limit Adjustment Mechanism” to impose a carbon price on some imports from regions without carbon taxes. It is also expanding the market: freight is expected to be covered by the existing ETS, while a new one is being prepared for buildings and transportation to reflect different costs and challenges.

Importantly, though, EU politicians also need businesses to remain competitive during the transition period, so ETS remains a work in progress. They will likely step in if the trade-off between decarbonization and competitiveness becomes an issue.

The current rules allow for the injection of additional bonuses, if the rate for six months exceeds three times the average of the previous two years. But six months is a long time, and if the price of carbon jumps enough to threaten its industrial base, the union could change the rules.

EU decision-making usually takes years, but in some crises, the bloc has moved quickly. Sky-high emissions prices are likely to be seen as a crisis: Energy costs are a hot issue, particularly since the 2018 “gilet jaunes” protests in France. Officials used other tools to deal with this winter’s energy crisis, mostly because it was expected to be temporary and carbon emissions prices were not the cause. Significantly higher carbon prices, especially if they are due to speculation, are likely to produce a different response.

Investors are smart about using European ETS balances to hedge against rising carbon costs and bet on a green transition, but there are limits. If too many try to squeeze, it can ruin the party.

A Swiss startup has created a giant vacuum cleaner to capture carbon dioxide from the air, helping companies offset their emissions. The Wall Street Journal visits the facility to see how it locks up the gas for sale to customers like Coca-Cola, which uses it in soft drinks. Compound: Clément Bürge

write to Rochelle Toplensky at rochelle.toplensky@wsj.com

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