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Why do carbon markets matter to COP26?

Hæge Fjellheim
Hæge Fjellheim
Director of Carbon Research at Refinitiv

Carbon markets are a key tool for countries to cut their greenhouse gases and meet their Paris Agreement commitments. The cost of polluting is rising in Europe, parts of North America, South Korea and New Zealand. Most likely it will do so in China, the latest country to launch a national emissions trading system.


  1. Prices for allowances in national and regional carbon markets worldwide are going up.
  2. Emission trading will play an important role in reaching more ambitious climate targets.
  3. Banks, trading houses, and even hedge and pension funds are getting in on carbon trading.
  4. Markets are increasingly incorporating both green and socially just elements.

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One of the success criteria for the Glasgow talks will be whether negotiators manage to finally agree on the missing piece of the Paris Agreement rulebook – the Article 6 provisions on carbon markets that will govern cooperation across borders to mitigate greenhouse emissions.

Meanwhile, prices for allowances in national and regional carbon markets are going up, incentivising the shift to net zero. What matters most is action on the ground.

There is talk of a global carbon price, including in the margins of COP26. It is not realistic in the near term. However, while a global price on carbon is not on the cards, the role of carbon markets worldwide is growing. We identify four trends defining the major carbon markets today.

Datastream: The foundations for building your own macroeconomic analysis, creating market scenarios, and testing investment strategies should be deep and rock-solid

Trend 1: Carbon prices are surging

Prices for allowances in national and regional carbon markets worldwide are going up. The most significant example of this trend is in the European Union’s emission trading system (EU ETS), but the North American carbon markets (Western Climate Initiative or WCI, which includes the state of California, and the northeast’s Regional Greenhouse Gas Initiative known as RGGI) are also seeing ever higher carbon prices, as is the New Zealand ETS.

The figure below shows price developments in key carbon markets from January to September 2021. In this period, European carbon allowance prices rose steadily, gaining 80 percent. The jagged line shows the average of prices in all 8 Chinese pilot emission trading schemes, some of which have been operational since 2013 (China’s national ETS started trading in July and is not included in this figure). New Zealand, WCI, and RGGI started the year on a flat trend, and started rising from May. South Korean allowances dropped in early Q2 before beginning to rise from July.

Carbon prices in key carbon markets

Monthly average prices. Indexed (Jan 2021=0).

Carbon prices in key carbon markets

The EU ETS, launched in 2005, covers power generators and heavy industry – these must surrender annually an allowance or permit for every tonne of carbon dioxide they emit. Throughout much of the previous decade, demand for EU Allowances (EUAs) was modest, leading to depressed prices and little attention outside a group of regulated emitters and specialised traders. This changed in August 2018, when EUAs started an upwards trend that has led to permit prices around €60 per tonne of CO2.

Similar dynamics are playing out in other carbon markets, with the futures contract for the WCI’s traded units (CCAs) gaining almost 38 percent from January to September, RGGI’s going up 15 percent in that timeframe, and New Zealand Units up nearly 70 percent.

 

Trend 2: Higher climate ambitions increase relevance of emission trading

It’s no coincidence that carbon prices are rising in economies where governments are getting real about addressing climate change: emission trading is set to play an important role in reaching those governments’ more ambitious targets. Recent carbon price rallies in these markets reflect participants’ expectations of a tight emission permit supply-demand balance.

The connection is most obvious in Europe, where current carbon price levels are fundamentally supported by the block’s new 2030 target of bringing emissions 55% below their 1990 levels. Over the years, each time the EU’s headline target has been changed, the supply of permits in the EU ETS is made tighter.

Similarly, a price rise in the units traded in the WCI started to accelerate in the wake of the climate summit the Biden administration hosted in late April, where a more stringent federal emission reduction target (to reduce net GHG emissions by 50-52 percent by 2030 compared to 2005 levels) was announced.

While this has no direct impact on the supply-demand balance in the WCI because it is a regional programme covering only California and Quebec, it likely influenced overall market sentiment: more US climate ambition creates a general expectation of future supply side tightening given the further emission curtailment that will be needed to reach those loftier targets – WCI member California is after all home to 12 percent of the US population.

In China, it’s too early to tell whether there’s a connection between climate ambition and carbon prices, as the country’s national ETS only just began seeing transactions in late July. China formally submitted it Nationally Determined Contribution (NDC) to the UNFCCC on the eve of COP26. The updated NDC reiterates previously announced targets of peaking CO2 emissions before 2030 and achieving carbon neutrality before 2060.

Those targets are now supported by an action plan “1+N”, which includes emission trading as one of many elements the government will use to meet its climate pledges. With plans to expand the scope of the national ETS to heavy industries such as metals and petrochemicals over the next few years, we expect the national ETS to become a core policy instrument for China to achieve its climate goals. The price of Chinese Emission Allowances (CEAs) should rise accordingly.

The bottom-up logic of the Paris Agreement, that every five years countries should strive to commit to more ambitious national goals (Nationally Determined Contribution, NDCs) based on overall global stock-takes defining where we are headed with the sum of contributions on the table is illustrated below. More ambitious national goals would translate into tighter market balances in the world’s emissions trading systems, resulting in higher carbon prices incentivising the shift to net zero.

The Paris Agreement review cycle towards greater climate ambition

Paris Agreement Review Cycle

Trend 3: Financials are getting in on carbon trading

Though cap-and-trade programmes are intended to incentivise emitters to cut their greenhouse gas output so they avoid paying for permits, players that do not have a compliance obligation (are not “covered entities”) are increasingly participating in the markets for these allowances.

Banks, trading houses, and even hedge and pension funds are getting in on the action to maximise profit, and to use emission allowances as a proxy to counterbalance climate related risk in their general investment portfolios.

In Europe, financials pulled out of the EU ETS after the 2008 economic crisis but started to build positions again following the carbon price rebound that started in 2018, attracted by the prospect of the EU increasing its climate change mitigation ambitions. Non-compliance participants currently hold 20-25 percent of the long positions in the EU ETS futures market, according to data from the ICE exchange.

Financials’ participation is also on the rise in the WCI: non-compliance entities bought one-third of the offered current-vintage allowances offered on the Q3 auction in August, whereas they only purchased 20 percent of the allowances offered at the Q2 auction in May.

Carbon markets offer both green credibility and liquidity, a combination that is appreciated by an increasing number of investors. The presence of financials has contributed to lift prices in emissions trading systems in advanced economies, and the inflow of private capital into compliance carbon markets signal that capital seeks a combination of green, credible and with good return. Ideally, some of the capital should also be made available to finance the green shift in emerging economies.

Trend 4: Markets must be both green and socially just

ETS designs increasingly attempt to incorporate those affected by climate change policies. Europe’s new ‘fit for 55’- programme includes funding to facilitate a “just transition” toward new careers for the affected workers in coal mining regions and increasingly directs EU ETS revenues to fund the green transition.

Also, the notion that climate policy must be “fair” is garnering attention with the recent spike in energy prices. The European Commission suggests that member states can use ETS revenues to help struggling households and industries afford energy resources. In North America, California’s ETS rules stipulate that a certain percentage of the proceeds from allowance auctions must be earmarked for energy projects in disadvantaged communities, i.e. areas whose population suffers most from higher fuel prices and hotter temperatures.

But more than short term alleviation of effects of high carbon prices, the revenue component of emission trading systems offers a unique opportunity for governments to steer support and investments to help fund the transition to net zero. Paradoxically – the inherent pain that rising carbon prices lay on polluters, signalling the need for change, will be softened as revenues available to finance that change will also grow.

With no global carbon price in sight, carbon markets around the world are delivering carbon price signals that spells change. And while prices are at very different levels, reflecting different climate ambition and ETS design options across regions, measures to impose carbon taxes at the border could in practice serve to level out those differences.

This blog is based on a longer report by the Refinitiv Carbon Research team which is available here, alongside other reports including COP26: Implications for the voluntary carbon market. Find the with latest updates and analytics from the Carbon Research team on Eikon: Live prices, data, supply and demand estimates, short and long term market and policy comments and price forecasts.