The European Emission Trading Scheme (ETS) experienced a significant bull run from 2017 to 2021 with prices escalating 20 fold from approximately €5/t to nearly €100/t. This surge was primarily driven by the reduction of the previous oversupply of allowances, a result of regulatory intervention. Many market observers, including our team, had anticipated the continuation of this bull run as the scheme expanded and intensified beyond the power sector. This was particularly expected in sectors facing greater challenges in reducing emissions, where carbon abatement costs are significantly higher. However, this expectation failed to materialise, predominantly, in our opinion, due to the European energy crisis triggered by the Russia-Ukraine war. This conflict led to a spike in energy prices, consequently reducing emissions without the necessity for elevated carbon prices. Although there has been some reversal, power emissions for 2023 remain 19% lower than the levels observed in 2021.
The chart shows the evolution of the European carbon price since 2010. Each new phase of the system has resulted in its further tightening and broadening. Phase 5 will start in 2031.
The EU ETS, inaugurated in 2005, operates as a cap-and-trade system, placing limits on greenhouse gas emissions from covered installations and facilitating the trading of emission allowances. However, the system encountered several teething issues in its early years. Challenges included a tendency to over allocate free emission allowances to industries, a consequence of which was a prolonged period of low prices. The aftermath of the 2008 global financial crisis exacerbated the situation, leading to diminished industrial production and subsequent reductions in emissions.
This resulted in an over-supplied market where the envisaged environmental impact was not adequately incentivised due to a lack of market responsiveness and corrective mechanisms.
Phasing and Reforms: in 2013, a significant development occurred with the phasing out of free allowances for the power sector. This move, while prompting a modest uptick in prices, fell short of giving a clear price signal for decarbonisation across various sectors within the scope of the EU ETS.
Fast forward to 2019, the EU responded to concerns of oversupply by introducing the Market Stability Reserve (MSR). This innovative mechanism dynamically absorbs excess allowances, thereby adjusting the overall supply available for trading. The introduction of MSR had a transformative impact, resulting in a substantial re-rating of carbon prices. By February 2022, prices were nearing the €100/t mark.
“Fit for 55” and Geopolitical Impacts: further momentum was injected into the market with the introduction of the “Fit for 55” legislative proposals in 2021, aiming for ambitious emission targets. The projections at that time were for the rules to be amended for the market to be in a steady deficit through the decade. This legislative drive, however, faced an unexpected geopolitical challenge when Russia attacked Ukraine in February 2022. The ensuing market volatility not only impacted power and carbon prices but also triggered concerns among European legislative bodies about the inflationary implications of the ongoing carbon market reform.
The outcome of the carbon market reform agreed in early 2023 preserved the end decarbonisation ambition but led to a backward-dated tightening of the ETS Scheme. The market is therefore expected to be looser initially and tightening significantly from 2026 onwards. A notable policy decision involved the auctioning of €20bn worth of allowances in advance into 2025 as part of the RePower EU package (c 5% of total allowance supply over that period) followed by a commensurate reduction in allowances over the subsequent three years.
