The Carbon Price is Right

EU Reaches 100 Euro Mark

There was an interesting piece of news a few weeks ago in late February: for the first time ever, the price of carbon in the EU hit 100 euros ($106.57) per metric ton.

Why is this interesting news?

Well, if you’re wondering why carbon even has a price, or who buys it, fear not. Let’s break it down.

In order to have a 50% chance of limiting global warming to 1.5˚C above pre-industrial levels, the Intergovernmental Panel on Climate Change (IPCC) says we need to stay within a global carbon budget. While there are challenges related to how the budget is calculated, let alone how it should be divided and used, it is pretty clear that more emissions lead to worse outcomes. As I mentioned last week, these outcomes have disproportionate impacts on vulnerable communities.

The EU has a goal of reducing emissions by 55% from 1990 levels by 2030. Launched in 2005, one of the strategies they have employed to hit that target is an Emissions Trading System (ETS), which specifically works to reduce the emissions from over 10,000 factories and power plants in the EU. The EU then sets an annually decreasing limit on the greenhouse gases (measured in tons of Carbon Dioxide equivalent or CO2e, based on global warming potential) companies can emit, and this limit is divided into "allowances". These allowances, which are either free or can be bought through auctions, essentially give companies the right to emit a certain amount of CO2e (free allowances are for industries considered integral to member-state economies or that are harder to decarbonize). In total, this covers about 40% of the EU’s total emissions.

If a company emits less than their allowances allow, they can sell their unused allowances to other companies who need more, creating a market for emissions allowances that fluctuates based on demand. The more companies have to pay for EU allowances to cover each tonne of CO2e they produce, the greater the incentive to invest in low carbon technologies and fuels.

The revenue generated from the sale of allowances goes back to the member state governments where the allowances were auctioned. While a portion of the revenue is required to be used to address social challenges related to climate change, member state governments can essentially invest the revenue how they wish in projects that support the transition to a low-carbon economy. Member states are also required to report on how they use this revenue for transparency and accountability purposes. For context on how much revenue this can generate, Germany’s revenues from auctions totalled more than €6.8 billion in 2022.

This takes us back to that piece of news in February—that the price of carbon passed 100 euros per metric ton. While the system is designed for a baseline price increase over time, this spike was driven by increased demand for allowances after the EU’s strained power sector worked to satisfy the needs of citizens after supply shocks. Russia’s war in Ukraine led to a cutback in Russian gas imports, which fuelled a 7% increase in EU power generation from coal. Increased emissions meant that companies had to buy more allowances, shooting up the price of carbon.

The other driver of increased demand for allowances has been from utility companies looking to hedge their exposure to future price increases. By buying carbon credits now, they can lock in a price for the carbon they will need to emit in the future, thereby reducing their exposure to potential price increases.

While power companies are required to purchase all the permits to cover their emissions, many manufacturing companies receive free permits due to the risk that high costs could prompt companies to relocate to regions without carbon costs. This means only 57% of the carbon permits in the EU ETS are purchased. Free allocations are set to be phased out by 2034, which will dramatically increase the costs of manufacturing companies if they continue to emit in high volumes.

The dual impact of higher carbon prices is that companies are incentivized to invest in lower-emitting technologies and fuels, while member state countries receive greater revenues to advance the transition. Passing the 100 euros per metric ton threshold is more of a psychological milestone than anything, and could influence companies to take their own emissions reductions more seriously.

As you can probably guess, there have been mixed reactions across EU member states to the price spikes. Poland, which heavily relies on coal for electricity generation, has blamed the high prices on market speculation and called for EU intervention to control sudden surges. Similarly, last year, Spanish Prime Minister Pedro Sanchez proposed the implementation of a carbon price cap to address the issue of rapidly rising inflation.

Other member states view a robust carbon price as the right signal to investors and industry on the urgency of transitioning from fossil fuels. These varied reactions reflect the challenges faced by EU countries in striking a balance between reducing carbon emissions and minimizing the economic costs.

Whether the psychological price signal moves the needle further towards decarbonization of carbon-intensive industries in the EU or not is open to debate. That said, 2023 will definitely send a blow to the pocketbooks of high-emitting companies, while also boosting the capacity of member states to invest in climate action from their ballooning allocation revenues.