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The Big Explainer

What are carbon markets?

This week Roger Hirst is joined by multiple guests to explain what carbon markets are, also known as emissions markets, and who is trading them, and what is actually being traded? Today these markets are starting to build momentum after a slow start over the past 15 years but they play a crucial role in Europe’s environmental plans.

  • [00:00:00] Welcome to The Big Conversation Explainer. 

    [00:00:10] Carbon markets also called emissions markets, got off to a slow start during the last 15 years, with Europe launching its version to much fanfare just before the global financial crisis. But it took a long time to really get going. Today these markets are now starting to build momentum and play a crucial role in Europe's environmental plans. By putting a price on carbon, these markets reshape incentives for firms. But what are carbon markets, who is trading them and where, and what is actually being traded? 

    [00:00:45] Carbon market is where you regulate emissions and put a price on carbon as an instrument to reduce emissions. So you have carbon markets in several regions. You have in Northern America, you have the Western Climate Initiative, the Regional Greenhouse Gas Initiative, you have trading systems set up in New Zealand. 

    [00:01:08] There's one in South Korea, and China is going to launch its carbon market, national carbon markets by the end of this year, covering whole China's power sector, which then because of large amount of emissions covered, will be the largest in the world by then. 

    [00:01:27] What are the mechanics for the carbon trading market and what is actually changing hands during this process? 

    [00:01:33] The carbon trading scheme is what we call a 'cap and trade' scheme. Basically, the cap is the government sets a predefined emissions reduction part, it will also allocate a certain amount of allowances. 

    [00:01:48] And this emission trading system, or the cap and trade system, is set up as a tool for policymakers to reach their climate ambitions. 

    [00:01:58] So carbon here, we actually in carbon trading refers to carbon allowances. So allowances this is what the authority gives to the what we call compliance entities, so meaning the companies, power plants or industrials who are covered in the emissions trading scheme. So allowances is what will be traded in the carbon trading. So these allowances will be registered in a central registry. So a bit similar to currency or money put in that way. So for this carbon central bank and then compliance entities, they can trade the allowances. So every year you have to submit enough allowances to cover your previous year's emissions, which means if you know that you will be short, you have, you need more allowances, then you have to buy from the market. And if you have surplus, because maybe you've done some measures, so etc. to reduce your emissions, and then you could sell your surplus allowances. And this is the whole also the incentive offer and cap and trade the system. 

    [00:03:19] The European market is one of the most developed, but it has taken time for policymakers to structure an appropriate incentive system which is still evolving. 

    [00:03:28] The European system has been working since 2005, and the test pace started in 2005, it really kind of kicked off in 2008, but for many, many years it has been kind of very low carbon prices because there has been an oversupply of these allowances that you can use to surrender for for your emissions. So with low carbon prices it's not necessarily giving the right incentives to a greening of the European economy, so there has been some policy interventions to try to kind of fix the system. And then you had this policy intervention or kind of the review of the whole mechanism back in 2018, and then we saw kind of prices tripling in in 2018. And then last year, we had the average price around twenty five euros per tonne of CO2 emitted. So the result of that was that last year we saw kind of a drop in emissions from 2018 to 2019 of almost nine percent. And that was kind of largely driven by the coal to gas switch because coal power plants are emitting more CO2 than gas power plants. So we saw a big shift in coal, that has been the basis for for a lot of the power production in Europe, and then you saw suddenly a shift that those coal plants were running less, which is kind of then the carbon price is working in the right  way that you actually have a price signal that is pushing out the dirty stuff. 

    [00:05:15] Over the last 12 months, emissions in Europe have fallen and the effects of the COVID pandemic are likely to push that further. 

    [00:05:21] With a Corona virus hitting the global economy and also hitting hard in Europe, we see emissions dropping quite dramatically also in 2020, because I mean, when power demand is lower, industry activity is lower, so that means lower emissions as well. And on top of that, you will also continue to have this coal to gas switch taking place in Europe this year. However, it's quite interesting to see, even though you have quite a lot of bearish fundamentals at the moment, we see kind of carbon prices are now back above the pre-COVID levels. It's at least an attractive asset, or there are people that kind of bet on the longer term, or a tightening climate policy, and it's also interesting for four long term investors and not only for those that are in the compliance market that needs to surrender their allowances. 

    [00:06:25] This being a regulated market, the supply and demand is not freely floating, but subject to specific limits. 

    [00:06:31] Price setting for carbon is similar to what we call an oil and gas and coal, similar to other energy commodities also power. There is a supply side, there's a demand side. And for carbon, the special parties supply is fixed. It's by the pre-defined by the cap overall emission reduction targets, but then emissions standing on many other factors, then price are determined by the supply and demand balance. 

    [00:07:06] Boardroom's are taking more notice of this market, but as ever it will be the price that changes behavior. 

    [00:07:12] In 2018 and 2019, where prices were kind of coming up to completely new levels, that was kind of also giving an awareness of that carbon that comes with a cost. And then, of course there are some emissions reductions that won't be necessarily triggered at the price of twenty four, five euros, but the prospect that you can actually, that prices can increase with the tightening climate policy in Europe, that's kind of bringing probably kind of the awareness of the carbon costs a bit sooner rather than later to the boardrooms also when it comes to the more long term investments that is needed for industry to reduce their emissions. 

    [00:08:09] Carbon markets have taken a while to build momentum, having started off in Europe over a decade ago, but they are now an increasingly popular tool to regulate carbon emissions. The cap and trade principle sets a cap on the amount of gases that can be emitted and will be reduced over time. Low prices and a lack of appropriate policy meant that the early phase in Europe was relatively sluggish, but interest in volumes have now started to pick up. 2018 was a watershed year with volumes increasing by 45 percent and prices of the European allowance unit tripling from eight euros to twenty five euros per ton, with a total value of 144 billion euros trading that year. Europe saw 2019 emissions fall, though low prices, partly due to the Covid-19 pandemic, could limit any further cuts to emissions in the near future. But the EU emissions trading system is a cornerstone of EU climate policy. It is still the biggest market in the world, though similar markets are being developed in other regions such as China. The aim is to eventually link the EU ETS with other similar global systems.