How to think about political risk in carbon markets
All commodity markets are political, you just need to understand the game that’s being played.
Whether it is oil, sugar or rice or something else, government intervention isn’t too far away.
Environmental markets such as carbon are a particular type of political construction in which artificial scarcity is created through regulation. And so the response from some investors when observing the increase in carbon prices over the past couple of years is that well, the rules of the game are set by politicians, and so the rules can also be changed at any moment.
Politicians will start to bulk once industries start closing and people lose their jobs they say. Essentially, their point is that politics is essential to carbon markets, but also its greatest Achilles heal.
Critics often point to the fallout the gilets jaunes (Yellow vests) protests as an example of how quickly policies can change. Higher environmental taxes on the transportation sector was billed as an environmental policy but seen as a revenue grab. The nationwide unrest forced Emmanuel Macron’s government to back down.
There’s reason to be critical of politicians of course, but to dismiss carbon markets as subject to the whim of political preferences misses two crucial details. The first relates to the design of the EU carbon market, while the second is a misunderstanding of the political reaction functions in markets.
First off, carbon markets are likely to fare better if they can channel a fair proportion of funds generated by carbon pricing back to the broader population in the form of tax deductions or something similar. As I mentioned earlier, that was the issue with the taxes on the transportation sector in France.
Indeed, this redistributive policy is happening right now in Europe as a direct result of the EU Emissions Trading Scheme (ETS). It’s just that no one is talking about it. In mid-September the Spanish government announced that it was going to use €900 million in carbon allowance auction revenues to compensate households for rocketing energy prices.
This is in line with the ETS Directive’s suggested use of auction revenues, which supports “financial support in order to address social aspects in lower- and middle-income households”. The higher that carbon prices in the EU ETS rise, the more auction revenue available for member state governments defray the costs for their citizens. At the current carbon price level of €78 per tonne the EU’s carbon market is valued at over €120 billion.
The second factor that critics miss is that political preferences are subject to constraints. In his book, Geopolitical Alpha: An Investment Framework For Predicting The Future geopolitical consultant, Marko Papic identifies four main constraints that limit the actions of politicians (in order of importance):
First, the political economy. This is by far the most important as without political capital the politician is powerless. Key factors to gauge political capital supporting environmental markets include popularity of green parties, time in power, legislative maths, the support of environmental groups and global momentum in support of similar policies.
Second, the macro-economy and the financial markets. Macroeconomic constraints include high energy prices, industry competitiveness, the unemployment rate, the degree of protectionism afforded to certain industries and the current account deficit. Financial market constraints on the other hand relate to the degree to which markets are quick to discipline policymakers. For example, financial markets may initially give a political leader the benefit of the doubt. However, after a certain point confidence may begin to crumble, upon which the political leadership will be on a tight leash by the markets.
Third, geopolitics is a powerful constraint. EU member states must make calculated estimates of the impact their actions have on other states, which is a combination of both internal constraints (domestic politics and macroeconomics for example) and external constraints (how others will react, given their own domestic constraints).
Fourth, constitutional and legal positions, an example of historical preferences that have become constraints. For a political leader to sidestep this final form of constraints (for example by wanting to bail out of the EU ETS), weakens his or her position with the previous three constraints.
This leads me to say that the single fundamental factor you need to watch in order to understand political risk in carbon markets is the preferences of the median voter. You may have heard of the median voter theorem (MVT). Developed in the 1950’s, the MVT suggests that to stay in power politicians should approximate the policy choices of the median voter.
If for example the median voter places environmental and social policies over those focused on economics and industry, then that is what politicians are constrained by. The recent German election is an example of the increased importance that the median voter places on environmental issues. The increase in search volume on Google for the term “carbon” is also an example of the preferences of the median voter.
So ignore the FUD about carbon markets being subject to the whims of unpredictable politicians. Pressure to change the rules of the game may come in time, but it will be flagged in advance by the median voter.