The war in Ukraine has created a new paradigm for Europe’s energy and climate policy. As European energy prices reach all-time highs amid significant volatility, we explore the impact of the conflict on the European carbon market.
- The Ukraine war has created a new paradigm for Europe’s energy and climate policy, as governments scramble to become independent of Russian fossil fuels. The answer is greener, faster.
- Carbon prices have oscillated wildly since the war began, falling from €95/t to €55 in just over a week, before recovering to around €80/t, almost tripled from one year ago.
- Despite record-high carbon prices, coal is running full speed across Europe and emissions are increasing. The signal it gives for investments to move towards a net-zero future is, however, unmistakable. But so are worries that high carbon prices will harm Europe’s industry.
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How are policymakers balancing disruptions in energy supplies and high prices with the need to push forward on the Fit for 55 package to reach EUs 2030 climate ambition? And how can the carbon market help speed up the green transition and break the dependency on Russian fossil fuels?
Carbon price drops decouples from energy prices
After a boom year in 2021 when the cost of emitting carbon tripled in Europe, new records were set at the start of 2022.
Shortly ahead of the Russian invasion of Ukraine, a frequently asked question of carbon analysts was: When will carbon prices reach €100 per ton?
While the cost of energy commodities – gas, power, coal – spiked on the invasion, the immediate carbon market response was a price drop from €95/t (closing price on 23 February) to €55 (intra-day low on 2 March). Since then, prices have recovered to trade around €80/t.
What caused the carbon crash? And its recovery?
Liquidation of EUA positions to cover margin calls in energy, worries over demand disruption and high energy prices, and international investors minimising exposure to European assets created a snowball effect that ultimately caused a full-blown crash.
However, early fears that the invasion would put the climate agenda on the back burner and delay ongoing talks to strengthen its major climate tool – the emission trading system (EU ETS) – seem unwarranted.
Figure 1: Carbon – the odd energy commodity out
Figure 2: The carbon price roller-coaster
A tailwind for systemic change
The war in Ukraine has led European leaders to declare energy security and independence of Russian fossil fuels as a top priority. It strengthens the call for energy efficiency, accelerated build-out of renewable energy and faster reduction of greenhouse gas emissions. The Ukraine war could accelerate the implementation of a more sustainable energy policy in Europe.
In its REPowerEU communication of 8 March, the European Commission notes that following the invasion of Ukraine by Russia “the case for a rapid clean energy transition has never been stronger and clearer”.
Calling energy diversification a matter of energy security, the Commission sketches out the plan to reach independence from Russian fossil fuels, focusing on accelerating and strengthening efforts on measures for energy efficiency and renewable energy.
It remains to be seen whether this will manifest itself in EU members states adopting more ambitious 2030 targets for renewable energy and energy efficiency.
Energy is now front and centre as a policy and security concern, reinforcing the position of those who want to speed up the climate policy agenda. The war fortifies the climate agenda and should boost confidence that Europe is headed towards a low-carbon future.
Getting rid of coal? Not just yet
But right now coal is running at full speed across Europe, despite record-high carbon prices.
Post-pandemic recovery combined with the extremely tight European energy market, rallying gas prices and low wind speeds have led to more coal burn, higher power sector emissions and hence increased demand for carbon allowances.
Many EU member states are in a process of phasing out their coal power plants, but some, including Germany, are now reconsidering their timelines. They argue that coal might be needed for yet some time if Europe is to stop imports of Russian gas. The current level of coal burn, one quarter into 2022, suggests emissions will stay elevated also this year.
Under current market conditions, the carbon price is irrelevant for triggering immediate emission reductions. And even higher carbon prices would not do the trick – coal would still be in the money. Today, a carbon price of close to €200/t would be required to make gas profitable over coal.
It’s a paradox, of course: The merit order of power plants running in Europe is the same now as when carbon prices were one-tenth of what they are today. Does this mean that emission trading is failing its mission?
One mission, two time horizons
Emission trading systems have one mission: To reduce emissions so that climate targets are met. The carbon price is the messenger.
Ideally, the carbon price should trigger reductions now by making electricity generation from cleaner sources more profitable than from dirtier ones.
In 2019, emissions fell by 9 percent mainly because higher carbon prices made it more profitable to produce electricity from gas than from coal. 2021 numbers show the opposite; with a more than 8 percent jump from 2020, last year represents the largest emission increase since the launch of the emissions trading system in 2005.
The carbon price signal should also prompt future emission reductions by giving incentives to renewable energy investments and channeling money into low-carbon technologies to decarbonise the industry.
High carbon prices are fundamentally a sign that the market is factoring in the cost of transition to a greener economy as Europe prepares to reach its 55 percent reduction target for 2030. It is a signal of confidence both in the climate ambition and in emission trading as a tool to achieve it.
Too high, too soon – or just in time?
But some would argue that prices have risen too high, too soon.
Worries that high energy bills are here to stay are shared by households, energy-intensive industries and policymakers from east to west. And while the elevated energy costs can largely be blamed on gas, there are persistent worries that high carbon prices are harming Europe’s industry.
The conflict adds to the worry that European industries are facing production cuts not only due to high energy costs but now also because of outright restrictions on gas use – and that decarbonisation would happen through industry death rather than through the creation of a flourishing green economy.
Few go as far as Poland that wants to scrap or suspend the emissions trading system to remove the carbon cost component, but the situation will continue to weigh on the ongoing Fit for 55 review of the EU ETS.
In a joint statement, a coalition of 11 EU countries called for unity among all member states in the ongoing Fit for 55 negotiations “to ensure an ambitious and swift implementation of the Fit for 55 packages”.
It’s a balancing act. Lawmakers in Brussels and across 27 European capitals have to weigh worries over the energy crunch that is affecting millions of voters right now with the need to reshape the bloc’s flagship climate instrument so that it continues to deliver incentives for emission reductions in the years to come.
With elevated carbon price levels, the EU ETS fosters significant public revenues that are channeled to fund the green transition and can help break the dependency on Russian gas. This fact should smooth the policy debate.