Figure 1: ETS around the world, ICAP[2]

The "cap" in the cap-and-trade principle sets a maximum limit on the emissions that industries and companies covered by an ETS can produce. This strict cap ensures that emissions remain below a specified threshold. Typically set on an annual basis, the cap is progressively tightened over time, reducing the allowable emissions within the ETS each year. An illustrative case is the EU ETS, which aims to reduce emissions by 62% by 2030 compared to 2005 levels.[3]

When defining a cap, regulators aim to balance environmental targets with economic feasibility, ensuring that economic activity and supply chains are not unduly stressed while aligning with climate science on required emission reduction targets.

Globally, these systems vary significantly in scale, scope, and regional implementation, showcasing the flexibility of the cap-and-trade model to address diverse regional needs and capacities. For instance, China’s national ETS, launched in 2021, quickly became the largest in the world, covering an estimated 5 billion tons of CO2 emissions annually.[4] This contrasts with the EU’s long-standing ETS, which covers just under 1.5 billion tons of CO2 emissions annually.[5]

Despite their differences, all ETS share a common goal: to incorporate the cost of emissions into production chains and incentivise companies to reduce their carbon footprint.

The EU Emissions Trading System

Launched in 2005, the EU ETS is the world's first major carbon trading scheme. It plays a crucial role in achieving the European Union’s commitment to a 55% reduction in GHG emissions by 2030 compared to 1990 levels, as outlined in the Fit-for-55 package under the European Green Deal.[6]

Each year, participating companies within the EU ETS track and report their GHG emissions using standardised methodologies compliant with EU regulations.[7] This ensures consistency and accuracy across member states. Verified annual emissions are then reported to a designated national authority. Companies must acquire EU Emissions Allowances (EUAs) to cover their emissions, with each allowance permitting the emission of one tonne of CO2 equivalent GHG. At the end of the year, companies surrender allowances equal to their total emissions.

The cap in the EU ETS sets the maximum allowable emissions for regulated entities across Europe, corresponding to the total number of EUAs issued by the EU Commission annually. Companies cannot emit more than their allowances cover, therefore enforcing the cap through allowance supply. Industrial activity levels are therefore a dominant driver in the demand for EUAs.

Several other market dynamics also influence the trading of EUAs. Factors such as economic activity, monetary policy, fuel prices, weather conditions, and regulatory changes impact demand. For instance, EU-wide regulations that introduce stricter emission reduction targets can lead to higher allowance prices as companies anticipate tighter future caps and purchase more EUAs in advance.

This market-driven approach assigns a price to carbon emissions across Europe, incentivising companies to invest in cleaner technologies and practices to reduce emissions cost-effectively. EUAs are allocated across industrial sectors based on the emissions an “efficient” company would generate to produce a given level of output product. This benchmark is derived from the top 10% most efficient companies in each sector.[8] If a company's emissions exceed its allocated EUAs, it must purchase additional allowances.

Entities that keep emissions below their allowances can sell surplus allowances to those exceeding their caps, creating a financial incentive to reduce emissions. The cost of allowances thus becomes integral to companies' financial and strategic planning. High allowance prices can increase operational costs, pushing companies to innovate in emission reduction strategies. This dynamic supports a competitive and responsive market where the price of carbon drives business strategies towards sustainability.

Price behaviour in the European Emission Allowances (EUA) market is influenced by various factors, leading to a dynamic and sometimes volatile market environment. Throughout 2023 and 2024, the EUA market saw distinct price regimes, with record highs (April 2023) and multi-month lows (February 2024). These fluctuations were driven by energy prices, regulatory changes, economic activity, and market sentiment.

Energy Market Dynamics

The European energy market is characterized by a diverse energy mix, where the marginal cost of power generation and the resulting emissions vary based on the relative prices of different fuels. In particular, the interplay between coal prices (tracked by the Rotterdam Coal Futures benchmark below) and natural gas prices (Dutch TTF Futures benchmark) directly influences this mix and the associated emissions of the energy market, which in turn affects EUA prices.

Figure 2: Coal, Natural Gas and EUA prices, Refinitiv data

Power producers often switch between coal and natural gas for electricity generation depending on the relative prices of these fuels and EUAs. Coal-fired power plants emit approximately 400 kilograms of CO2 per megawatt-hour (MWh), while natural gas-fired power plants emit about 200 kilograms of CO2 per MWh.[9] With coal-fired power plants emitting roughly twice the amount of CO2 compared to natural gas-fired plants for the same energy output[10], this difference in emission intensity makes fuel switching a significant factor in determining EUA demand and prices.

When natural gas prices are low relative to coal prices, the profit a power producer can make from generating electricity using natural gas (spark spread) is higher, even after accounting for the cost of carbon emissions (clean spark spread). Consequently, power producers are incentivised to switch from coal to natural gas, reducing their emissions and their need for EUAs.

Conversely, when natural gas prices are high and coal prices are significantly lower, the profit from generating electricity using coal (dark spread) can be more attractive, even after considering the higher coal emissions costs (clean dark spread). This scenario can lead to increased coal usage and a higher demand for EUAs.

Thus, as natural gas prices rise, more coal is used, leading to more emissions and greater demand for EUAs, which raises their price. The immediate decisions of power producers regarding fuel usage depend heavily on these relative costs of natural gas versus coal, creating a strong correlation between natural gas and EUA prices in the current market regime. If the TTF price falls, the market anticipates a switch to natural gas, reducing EUA demand and prices. Conversely, if the TTF price rises, the market expects a shift back to coal, increasing EUA demand and prices.

However, natural gas and carbon prices are likely to decouple when lower gas prices no longer incentivise further fuel switching within European power markets. This could happen if the infrastructure and operational constraints limit additional switching from coal to gas, even if gas prices drop further. At this point, the carbon market would need to rely on other factors, such as stricter regulations and increased investment in renewable energy, to drive price increases. Understanding this potential decoupling is crucial for predicting future market dynamics and planning effective capex management strategies.

Figure 3: Strong Gas-EUA correlation in 2024, Refinitiv data

Regulatory and policy environment

Geopolitical events, regulatory announcements about future cap reductions, and the expansion of the ETS to additional sectors have contributed to recent market uncertainty.

Under the revised ETS Directive, the EU ETS began covering greenhouse gas emissions from maritime transport in January 2024, including emissions from all large ships (5,000 gross tonnage and above) entering EU ports.[11] Additionally, stricter emission caps have been implemented each year since the beginning of ETS Phase 4, not only reducing the supply of EUAs but also influencing medium-term market sentiment regarding their future availability. Between 2021 and 2023, the cap decreased at a rate of 2.2% per year. To align with the EU’s 2030 climate target (a 62% reduction compared to 2005 levels), the reduction factor will increase to 4.3% per year from 2024 to 2027 and 4.4% per year from 2028 onwards.[12] These changes are likely to increase demand pressures for EUAs in coming years.

In contrast, near-term market sentiment remains bearish. Tighter monetary policy continues to transmit strongly across the EU and the resulting high interest rates mean that industrial activity has remained largely subdued within the Euro-area in recent months.[13] Recent political decisions are also having significant impact on EUA pricing. To accelerate its energy transition and reduce dependence on Russian fossil fuels, the EU launched the REPowerEU plan.[14] A key element of this plan involves "frontloading," or selling ETS allowances earlier than initially planned. This strategy increases the supply of allowances up to 2026, exerting a price-dampening effect during these years.

The current low carbon price may signal to industrial corporations that investments in emissions abatement and decarbonisation efforts can be delayed closer to 2030. However, with the EU’s 2030 and 2050 emission reduction targets being written into law, a tightening of EUA supply and a rise in prices is inevitable in the medium to long term. This presents a unique opportunity for companies to use cost savings from the lower EUA prices to invest in efficiency and renewable energy measures across their factories. Delaying these investments will almost certainly have a negative financial impact if the medium- and long-term forecasts for EUA prices are accurate. As we detail below, the EUA market demonstrates a consistent trend of structurally stable upward price shifts year after year.

Figure 4: Historical EUA price regimes, Investing.com data

In the figure above, histogram bars display the frequency of carbon prices within specified ranges, illustrating the market's spread, skewness, and concentration. The Kernel Density Estimates (KDEs) provide a smoothed continuous curve representing the probability density function of market pricing, offering a clearer picture of the underlying structural distribution and multimodality in the EUA market.

In 2021, the carbon price distribution was broad, with a mean price of €54 per tonne and a standard deviation of about €12, indicating a volatile market. By 2022, the distribution tightened significantly, with the mean price rising to €81 per tonne and a standard deviation of €7.50, reflecting increased regulatory pressures and market stabilization. In 2023, the distribution peaked sharply, with the mean price surging to €84 per tonne and the variance decreasing further. Despite the higher average prices, there is reduced price volatility, reflecting a more stable market environment.

Our analysis reveals a clear upward shift and increasing concentration of prices over the years, indicative of escalating compliance costs for industrial corporates and strategic shifts by market participants to secure allowances in anticipation of stricter future regulations.

References

[1] International Carbon Action Partnership, Emissions Trading Worldwide: 2024 ICAP Status Report

[2]  https://icapcarbonaction.com/en/ets

[3] EU Commission, Our ambition for 2030

[4] https://icapcarbonaction.com/en/ets/china-national-ets [5] https://icapcarbonaction.com/en/ets/eu-emissions-trading-system-eu-et [6] Council of the European Union, Fit for 55 [7] https://climate.ec.europa.eu/sites-0/emission-trading-system-mrv-reporting_en

[8]|https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/free-allocation/allocationindustrial-installations_en

[9] Carbon dioxide emissions factors (ourworldindata.org)

[10] How much does natural gas contribute to climate change through CO2 emissions when the fuel is burned, and how much through methane leaks? | MIT Climate Portal

[11] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=COM%3A2023%3A654%3AFIN

[12] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=COM%3A2023%3A654%3AFIN

[13] Chart 5: Manufacturing PMI

https://www.ecb.europa.eu/press/economic-bulletin/html/eb202401.en.html

[14] REPowerEU (europa.eu)