Carbon market surges to $270 billion valuation, unleashing global wave of green investments and emission reductions
In the dynamic landscape of financial markets, the collective efforts of investors, corporations, and governments to mitigate the impacts of climate change remain influential. This has led to a significant expansion of the carbon market, a platform where emission credits and derivatives are actively bought and sold. Evolving into a commodity that is tracked and traded akin to other market entities, the carbon market stands as a pivotal force in driving global economic decarbonization. Its role is crucial in establishing carbon pricing mechanisms and motivating polluters to curtail their emissions.
- The carbon market can play a significant role in the decarbonization of the global economy by putting a price on carbon and giving polluters an incentive to reduce their emissions
- Carbon markets have grown to a market value of USD 270 billion1, placing it on the radar of institutional investors as an investable asset class.
- Global macroeconomic forces have impacted carbon prices in the short run, but the long-term outlook for carbon markets and their contribution toward the net-zero transition remains constructive.
Carbon markets for a net-zero transition
Carbon markets are categorized as either voluntary carbon markets (VCMs) or compliance carbon markets (CCMs), which are significantly different to each other in terms regulatory frameworks, impacts, and market dimensions.
Voluntary Carbon Markets (VCMs)
VCMs are unregulated markets that enable individuals, firms, governments and nongovernmental organizations to buy carbon offsets from project developers on a voluntary basis to achieve carbon compensation and neutralization. Compensation includes investing in environmentally and socially useful projects to curb potential carbon emissions and support advancing innovative technologies.
Neutralization includes carbon-emission-reduction projects using natural (e.g., reforestation) and technology-based carbon-capture and -storage techniques. Companies can voluntarily purchase carbon offsets, certified by private standards, as part of their sustainability strategy. The size of VCMs is still relatively small, with approximately USD 1 billion of carbon offsets traded in 2021, currently lacking scale for institutional investors. Also, a lack of high quality (environmental and social integrity of projects) carbon offsets have held back the growth of this market2.
Compliance Carbon Markets (CCMs)
CCMs are alternatively termed emissions-trading systems (ETS) or cap-and-trade programs. CCMs operate as regulated market mechanisms. Regulators auction or allocate a limited number of carbon allowances to regulated companies. Each carbon allowance typically allows its owner to emit one ton of a pollutant such as CO2. Firms that are more efficient in their emission reductions can sell unused allowances to companies that need to purchase allowances for excess emissions. The underlying concept is to let the market efficiently internalize carbon prices, allowing optimal resource allocation and gradually reducing the overall supply of emission allowances3.
Globally, approximately 30 ETS are in operation, spanning 38 national jurisdictions4, boasting a collective market value of around USD 270 billion5. Prominent systems include the EU ETS, North America’s WCI and RGGI, and the U.K. ETS. Notably, the EU ETS, constituting around 90% of global carbon credit turnover in 2021, stands out as the most liquid and developed ETS system worldwide. The market for compliance carbon credits experienced a noteworthy surge in 2021, reaching approximately USD 851 billion, reflecting a 164% increase from the previous year, driven by elevated carbon prices and a moderate uptick in trading volumes6. The timeline below illustrates the phases of market development for EU ETS carbon prices, showcasing its evolution over time.
Timeline of EU ETS carbon price
Different phases of EU ETS
| Phases | Overarching Theme |
|---|---|
| Phase 1 (2005-07) | Phase 1 was a three-year pilot phase aimed to create an infrastructure for the free trade of carbon and establish its pricing mechanism. This phase was marked with lower carbon prices as supply exceeded demand in the absence of reliable emissions data. |
| Phase 2 (2008-12) | The pilot phase (Phase 1) served to create headways in recording verified direct emissions data which proved to be useful in phase 2. Using the emissions data, regulators created an emissions cap for various firms and reduced the carbon allowances supply. However, 2008 global financial crisis resulted in dampened economic activities leading to lower demand for carbon allowances driving carbon prices down. |
| Phase 3 (2013-2020) | The oversupply of carbon allowances in phase 1 and 2 laid the foundation of this phase which mainly focused on regulating the excess supply. This phase experienced an increase in carbon prices on the back of reforms such as “backloading”, Market Stability Reserve, annual reduction of carbon allowance cap etc. |
| Phase 4 (2021-2030) | The fourth phase introduced more stringent policy measures to reduce the carbon emissions for e.g. the allowances supply cap will reduce at a higher rate of 2.22% every year, compared to 1.74% earlier. This phase also focused on providing funding mechanisms for low carbon innovations to help energy-intensive sectors in their transition to low carbon economy. |
Navigating primary and secondary markets in carbon trading
Carbon Allowances: Navigating Primary and Secondary Markets in Compliance Carbon Trading
The intricate world of compliance carbon trading involves the dynamic interplay between primary and secondary markets for carbon allowances. Regulators adopt a twofold approach, either auctioning or distributing allowances at no cost to regulated entities in primary markets, aligning with their emission limits.
Once these entities secure their allowances, the stage shifts to secondary markets, where trading occurs to meet emission obligations. This trading landscape encompasses spot transactions as well as derivatives contracts like futures, options, and swaps.
The graphic below provides an overview of the diverse stakeholders engaged in compliance carbon markets, illustrating the complex web of participants shaping the dynamics of this vital market.
Compliance carbon markets’ trading flow
Short-term macroeconomic turbulence in carbon prices
Amidst current macroeconomic uncertainties, including concerns about inflation, economic growth, and energy price fluctuations, a less noticed trend has emerged in the form of recent volatility in global carbon prices.
This shift has taken place independently of the usual correlation with oil prices. Following the Russian invasion of Ukraine and subsequent international sanctions on Russia, carbon prices in the EU ETS experienced a significant drop of approximately 40%, declining from EUR 97 to EUR 58 in the first quarter7.
Interestingly, the traditional positive correlation between carbon and oil prices turned negative, reaching -0.27 during this period. The details of this correlation shift are outlined below, shedding light on the nuanced dynamics at play in response to recent geopolitical events.
Rolling 3-month correlation between returns of Brent crude oil and EU ETS carbon price
European carbon markets navigate uncertainties amidst Russian energy dependence
Europe’s reliance on Russian fossil fuels, particularly gas, has created a ripple effect in carbon markets. The increased volatility in energy prices, driven by uncertainties surrounding economic sanctions on Russia, has left carbon markets in a state of flux. Despite expectations of higher carbon prices due to European countries considering a return to coal-based power plants to meet energy needs, EU carbon prices experienced a sharp pullback in March 2022. Several factors may have contributed to this temporary downturn:
- Liquidity Concerns: The broader market sell-off triggered by the Russia-Ukraine conflict prompted some investors to liquidate carbon positions. The open interest for EU carbon futures contracts on the Intercontinental Exchange saw a decline to around 545,000 contracts by March 7, 2022, from its year-to-date peak of about 567,000 contracts8 as of January 18, 2022.
- Economic Headwinds: Apprehensions about a potential recession and reduced economic activity likely led to decreased demand for carbon allowances, resulting in lower prices.
- Supply Dynamics: The distribution of 2022 free allocations may have influenced market dynamics during this period.
Despite this recent volatility, EU regulators remain steadfast in their commitment to the comprehensive implementation of the “Fit for 55” proposals. This initiative aims to achieve a minimum 55% reduction in net greenhouse gas emissions by 2030 compared to 1990 levels9. This resilience underscores the EU’s determination to navigate challenges and advance towards ambitious climate goals.
From concept to catalyst: Unveiling the power of carbon markets
The fundamental concept driving carbon markets is to efficiently internalize the price of carbon, empowering regulators to entrust the market with optimal resource allocation. The pivotal role of this market lies in its connection to global warming mitigation and the pursuit of achieving net-zero emissions. In an upcoming blog post, we will delve into the diverse applications and use cases of carbon derivatives, illuminating their emergence as a dynamic asset class within portfolios. Stay tuned for insights into how carbon derivatives are transforming from a concept into a catalyst for sustainable and impactful investment strategies.
Dated: August 2022
Sources:
1“Carbon Markets Year in Review 2021.” Refinitiv.
2“Phase II Report Summary.” Taskforce on Scaling Voluntary Carbon Markets, July 8, 2021.
3As of 2020, EU ETS emissions were reduced by 43% from their 2005 levels. For more details, please see: Nissen, Christian, et al. “
4According to World Bank data, as of April 1, 2021.
5Jiang, Betty, et al. “Carbon Markets: The Beginning of the Big Carbon Age.” Credit Suisse.
6Carbon Markets Year in Review 2021.” Refinitiv.
7The EU ETS is the world’s first major carbon market and remains the largest one.
8“Carbon Markets Year in Review 2021.” Refinitiv.
9“REPowerEU: Joint European action for more affordable, secure and sustainable energy.” European Commission, March 8, 2022.
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