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EU ETS: Carbon price is rising again

20/05/2022 - François-Xavier Branthôme
At 88 Euros/tonne as of May 4th, the price of carbon allowance has increased by 30 Euros (+51%) since its lowest level on March 7, 2022
A recent report of ECB (European Central Bank) showed that he price of emissions allowances (EUA) traded on the EU’s Emissions Trading System (ETS) has increased from below Euros 10 per metric tonne of carbon to above Euros 90 since the beginning of 2018. In general, EUA prices are mainly driven by demand-side factors (such as economic activity and fuel switching) and public policies. Market commentary suggests that major factors behind the increase since early 2018 are likely to have been the introduction of increasingly stringent climate change policies in the EU and globally, alongside various changes in ETS market design. In April 2018 the introduction of the revised EU ETS Directive – which sets the framework for the fourth trading period, from 2021 to 2030 – appears to have enhanced the credibility of the scheme.
The announcement by the European Commission of the European Green Deal in late 2019 is also reported to have supported EUA prices, alongside the endorsement by the European Council of a new EU-wide emission reduction target in late 2020.
The largest share of the EUA price increase has occurred since early 2021 and likely reflects a multitude of factors. Research by the European Commission and commentaries by participants in the EUA market suggest that several factors have led to the acceleration of the price increase since early 2021. 
  First, particularly cold weather in Europe at the beginning of 2021 caused energy demand to rise. In the short term, given production rigidities, higher demand for energy translates directly into an increase in demand for EUA certificates and therefore into higher EUA prices.
  Second, the announcement of the European Commission’s “Fit for 55” package of legislative proposals reinforced the role of the EU ETS as the EU’s major decarbonisation tool.
  Third, phase 4 of the ETS, which started in 2021, also entails a shrinking supply of EUAs over time and updated parameters for the Market Stability Reserve, which will further limit the amount of EUAs available in the market.
  Fourth, the main factor behind the most recent price increases is higher gas prices, which encourage electricity producers to switch from gas to more CO2-intensive coal-fired power generation, thereby increasing the demand for carbon permits.

Role played by speculation
In light of the particularly strong increase in EUA prices over the last two years, the potential role played by speculation has also come into focus. Even if EUA prices are expected to increase to meet increasingly stringent decarbonisation goals, sharp price increases over a short period could imply that firms are faced with quickly rising costs without having sufficient time to adjust production capabilities. In this respect, European Commission research suggests that the price rally may have been supported by increased interest from non-compliance entities, such as investment funds, in the ETS. Market intelligence also suggests that exchange-traded funds and other investment funds may be playing an increasingly important role in the ETS market.
However, the bulk of empirical studies of the drivers of carbon prices have so far focused mainly on structural determinants of price fluctuations and given limited attention to changes in speculation and, at present, tangible evidence of a strong increase in speculative activity related to potential changes in market structure appears scarce. Finally, according to the report published by the European Central Bank (in its ECB Economic Bulletin, Issue 3/2022), a speculation index confirms that, while speculation appears to have increased slightly since early 2019, it seems to remain limited and well below the levels seen during earlier phases of the ETS.
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