Forward guidance
EU climate ministers may soon begin to “mumble with great incoherence.”
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“monetary policy is 98 percent talk and only two percent action.”
-Ben S. Bernanke, former chair of the Federal Reserve
At a meeting of EU environment ministers last week, the French government proposed amending the rules underpinning ETS1 to ensure a more predictable carbon price outlook.
“We must act swiftly to improve price predictability and the visibility offered to players,” French Climate Minister Agnes Pannier-Runacher, Bloomberg reports her as saying after the meeting, the minister making the case for “an ETS price corridor, defined in line with the EU’s emissions reduction target.”1
As I explain in The Fear Index, high carbon price volatility imposes a significant cost on firms seeking to cut their emissions, and for companies wishing to invest in new climate technologies:
“The level of funding required to invest in industrial decarbonisation is enormous, requiring a multi-decade long commitment, and high sunk costs. Exposure to high carbon price volatility makes it much harder for these large-scale projects to be seen as ‘bankable’ by investors.”
Analysts at Copenhagen Business School and NYU Stern have been able to quantify this relationship, examining the link between EU carbon price volatility and the share price of ‘carbon solution providers’, including companies involved in installing carbon capture units, manufacturers of wind turbines and solar panels, etc:
“a one standard deviation increase in the Carbon VIX is associated with a 15.7 basis points relative decrease in the stock returns of carbon solution providers. Put another way, a 10% increase in the Carbon VIX has the same detrimental impact on investment in decarbonisation as a €12 per tonne decline in the carbon price.”
Volatile exchange rates discourage inward investment, making it more expensive to agree terms with trading partners. In response, governments often seek to manage their exchange rate, moderating the pace and extent of currency appreciation or depreciation. The carbon price is the ‘Currency of Decarbonisation’. As such there is a case for authorities to also moderate carbon price volatility, especially if doing otherwise threatens the EU’s ability to meet its climate targets, or otherwise imposes too high a cost in term of competitiveness.
Although details of how France proposes to improve predictability for investors in ETS1 are scant, the Bloomberg article makes reference to two potential mechanisms: the introduction of an ETS1 floor price, and a requirement on the European Commission to publish reference price trajectories. While the former would appear to require a formal, binding change to the rules underpinning ETS1, the latter suggests a more informal approach, instead guiding market participants towards a politically desirable carbon price outcome.
I’ve discussed the potential pitfalls involved with introducing a EU carbon floor price before (see A carbon floor price is a bad idea: Meddling in markets built on trust is rarely successful). First off there‘s the challenge involved with identifying a suitable price floor - not just one that suits today’s conditions, but tomorrow’s too:
“It needs to be sufficiently high to incentivise decarbonisation, but not so high that it proves unsustainable, whether that is in suffocating the markets ability to find the right equilibrium price or provoking a backlash from industry and politicians having to renege on their commitments…The government can never be sure that the floor price is the correct one, nor that the floor price escalator is set appropriately to account for market conditions tomorrow that could be very different from the assumptions made today.”
Second, the experience of central bankers trying to defend their currencies does not bode well, illustrating the scale of the challenge for the EU’s climate ministers:
“Rather than the market finding its own level, intervention by a central bank tends to have the opposite effect of that which is intended…Whether explicitly or not the market begins to understand where the pain point exists for the central bank. Rather than representing the boundary of where the market is allowed to go, the exchange rate that is defended often acts as a magnet, even inviting attack by speculators, especially if its not seen as sustainable.
In contrast to a hard-and-fast rule underpinning a future ETS1 floor price, the publication of reference price trajectories by the EC harks back to an earlier innovation by central bankers - forward guidance.
“Forward guidance attempts to influence the decisions of investors, businesses and households by providing a series of guideposts for the expected future path of monetary policy. For example, instead of simply cutting interest rates to stimulate economic activity, central bankers would communicate their policy intentions, suggesting that they expected rates to remain low in the future.
Central bankers resorted to forward guidance when they found their existing monetary tool box to be inadequate at influencing medium and long term interest rates. Stable long term expectations of low interest rates give people the confidence to bring forward major purchases or investments, such property.”
It’s a situation the EU’s climate ministers have been in before. In the aftermath of Russia’s invasion of Ukraine in spring 2022, Peter Liese MEP, the lead lawmaker who steered EU ETS reform through the European Parliament, and Jos Delbeke, a key architect of the EU ETS both sought to shape carbon market price expectations through verbal intervention (see Whatever it takes: Why forward guidance in the EU carbon market is here, and is set to stay).
“Much like central bankers, the EU’s politicians want a Goldilocks scenario: not too hot so that the carbon price reaches socially unacceptable levels, nor too cold that decarbonisation technology isn’t incentivised.
By providing forward guidance, the EU hope to conjure up the magic of the central banks: suppressing carbon price volatility, lowering the cost of net-zero capital, and spurring the investment required to pivot away from Russia and achieve its climate change ambitions.”
Despite my stab at a prophetic subtitle, forward guidance has taken a backseat during the past two years. The EU carbon price fell from €100 per tonne in early 2023 to below €60 per tonne in spring 2024, and although the carbon price has recently rebounded in a natural gas-infused rally, it remains broadly in the €60-$90 per tonne range advocated by Liese and Delbeke. EU’s climate ministers have not felt the need to verbally intervene in the market.
The question now is what prompted the French government to propose introducing measures to stem price volatility and provide a better framework for countries wanting to invest in decarbonisation? Was it the degree to which price volatility has affected investment recently, or are they making an implicit suggestion that carbon prices could soon turn too high, and too volatile? Are they pre-empting the need for another dose of verbal intervention?
If the next 12-24 months does see a return to verbal intervention by EU climate ministers then they need to be careful what they wish for. The publication of reference price trajectories is not a free lunch. It can easily switch from a Goldilocks scenario - not to hot, not to cold - to one where Goldilocks get eaten.
Investors with long-only, long-term exposure to the EU carbon market could be the first casualty. A narrow price band, that builds in slow and gradual price appreciation could snuff out investor interest. Furthermore, although a smooth trajectory could help those companies where government has a stake in its success - political, commercial or otherwise - smothering the carbon price signal might prevent innovative new firms from benefitting from sharply rising prices.
In short, where one person sees carbon price volatility as a risk to avoid, another sees it as an opportunity to lean into. The challenge in seeking to manage the carbon price too tight is that it snuffs out both.
An informal reference price trajectory would need to be flexible enough to cater for all manner of economic, political, and social factors. As central bankers have learnt using forward guidance in their approach to monetary policy, its important to give advanced signals to the market as to how their price expectations could change given developments in these underlying factors.
Words matter.
Former chair of the Federal Reserve, Ben Bernanke was acutely aware of his responsibility to be careful with his choice of words:2
“The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has. The downside for policymakers, of course, is that the cost of sending the wrong message can be high. Presumably, that’s why my predecessor Alan Greenspan once told a Senate committee that, as a central banker, he had “learned to mumble with great incoherence.”
The EU’s climate ministers could now face the same delicate balancing act.
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https://www.bloomberg.com/news/articles/2025-03-27/france-proposes-eu-carbon-market-changes-to-improve-stability
https://www.brookings.edu/articles/inaugurating-a-new-blog/