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More Speculators and Fewer Permits: The Changes in Carbon Trading Markets Due to Covid-19

image credit: https://lao.ca.gov/Publications/Report/3719
Rakesh  Sharma's picture
Journalist, Freelance Journalist

I am a New York-based freelance journalist interested in energy markets. I write about energy policy, trading markets, and energy management topics. You can see more of my writing...

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In theory, the idea behind the carbon emissions market is sound. It connects entities willing to pay for pollution and those already have a reserve of assets that can mitigate pollution. It might not make sense for a carbon-polluting utility to suddenly shift from cost-effective fossil fuels to expensive renewable sources to generate electricity. But they can allay the effects of pollution from their power plants by purchasing carbon credits.

Utilities are important actors in carbon trading markets. While it is difficult to find data about transactions and participants in the carbon emissions market, a 2015 EU study estimated that 94% of players in the EU emissions trading markets were utilities and financial actors, such as financial institutions or traders. “Although no rigorous data are available, many sources converge in asserting that the weight of financial actors and utilities is very strong and that the activity of industry and more largely of regulated firms is marginal,” the paper’s authors state. In California’s cap-and-trade program, utilities earn free allowances. They then sell these allowances to generate revenue that is reimbursed to ratepayers as climate credit on their utility bill.

The entire idea of a cap-and-trade program is clever but its implementation has not been completely unsuccessful.

The 2015 study concluded that the EU emissions trading market allowed the market’s biggest emitters, utilities being one of them, to avoid radical innovation and impeded structural changes required to switch to a low-carbon economy. Closer home, California’s cap-and-trade market, the largest such program in the country, encouraged the state’s oil-and-gas industry to pollute more,the industry’s carbon emissions rising by 3.5% since cap-and-trade began. A 2019 policy brief at the University of California, Berkeley found that land owners were overstating their emissions reduction capacity to garner more money from the state.

How Has Covid-19 Affected Emissions Markets?

The Covid-19 crisis has transformed the market, however. Emissions have fallen, resulting in a precipitous revenue decline. For example, quarterly auctions raised more than $300 million in revenue in the last two years. Last May, they raised just $25 million. At the same time, corporates and countries have announced ambitious carbon emission reduction targets, signaling a flood of funding into renewable energy sources and infrastructure. An underlying shift in infrastructure means less pollution.   

Less carbon emissions translates to fewer carbon allowances for trading. In Europe, a year-long effort is underway to overhaul the emissions trading program. The number of permits in the EU Emissions Trading System (ETS) system reduced by 1.74% annually earlier. This year onwards, it will decline by 2.2%. Considering that the region is trying to become carbon neutral by 2050, that pace is expected to accelerate further in the future.  

Meanwhile, California EPA Secretary Jared Blumenfeld wrote in a letter last year that the agency was investigating the “extent to which the state’s climate strategy should rely on the cap-and-trade program reductions relative to other approaches” after the Covid-19 crisis. One of the approaches being considered is that of tracking allowances in trading markets. This is primarily to prevent banking or the practice of buying credits at a cheaper price during the early days and storing for use or resale in later years. Estimates peg the number of such allowances to between 100 million and 300 million. According to the Legislative Analyst’soffice, banked credits could drive up the total number of credits and encourage more pollution, resulting in more emissions as California races to reach its aggressive targets of reducing greenhouse gas levels below 40 percent of its 1990 levels by 2030.

The Entry of Speculators

Another consequence of the deliberations might be fewer free permits. Government policy is to slow price increases for allowances and limit emissions at the same time. The latter effort is already underway in California but the slowing of price increases for allowances might take some time. This may be partly because a decline in the number of allowances could trigger a competitive bidding process for them.

Speculators are already taking an interest in these markets. In Europe, carbon emissions futures are one of the year’s best trading commodities. They have surged by more than 20 percent to $49 per metric ton this year as traders are betting on an increase in prices for permits due to EU climate goals. The previous record high for carbon prices was $31 per ton in 2006.

Hedge funds are betting that the price could breach the $100 per metric ton mark later this year. The situation is not too different across the pond. Previous research has proved that carbon futures are successful in predicting carbon spot prices.

The entry of financial speculators into emissions and higher prices for allowances could mean good things for utility balance sheets. As the price of allowances rises, utilities can bulk up their balance sheets and utilize their allowances, free or banked, to fund further changes to their generation and distribution infrastructure.

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