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

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Carbon credits’ spectacular rally has caught investors’ attention, but the sky’s not the limit for these niche assets

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Designed to encourage industries to clean up, total credit supply will shrink annually, yet demand is expected to increase with more electrification and program expansion, at least in the near term. This sounds like a recipe for one-off bets, and there are whispers of something akin to a short squeeze, as companies become forced buyers for dwindling stocks of credit.

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Investors need to remember that politics can push supply the other way, too. Although they are traded like a commodity, carbon credits are conceptual, not physical. Market rules can be adjusted if its price is not meeting EU objectives.

With tighter regulation and “Green Deal” subsidies, carbon costs are an important tool for the EU to decarbonize its economy. Many expect the price of the credit to rise above €100 per metric ton, eventually generating additional cash to help fund the transition. Europe sees decarbonization as an environmental necessity as well as an opportunity to lead in the next industrial revolution.

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With this goal in mind, the ETS is working closely 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 that do not tax carbon. It is also expanding the market: shipping is expected to be covered by existing ETS, while a new one is being created to reflect their various costs and challenges for buildings and transportation.

Importantly, however, EU politicians also need businesses to remain competitive through the transition, so the ETS is a work in progress. If the trade-off between decarbonization and competitiveness becomes a problem, they will likely intervene.

Existing rules allow injection of additional allowances, if the price for six months is more than 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 jeopardize its industrial base, the bloc could change the rules.

EU decisions usually take years to make, but in some crises, the bloc has acted quickly. Sky-high emissions prices will count as a crisis: Energy costs are a hot-button issue, especially since the 2018 “Gillet Jaunes” protests in France. Officials used other tools to tackle this winter’s energy crisis, mostly because it is expected to be temporary and carbon emissions prices were not the cause. Remarkably high carbon prices, especially if due to speculation, could trigger a different reaction.

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

Write Rochelle Toplensky at [email protected]

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