In search of a new narrative
“[The] human brain has always been highly tuned towards narratives, whether factual or not…Stories motivate and connect activities to deeply felt values and needs. Narratives “go viral” and spread far, even worldwide, with economic impact.” - Robert Shiller
Narratives are a powerful force that can sway people, industries and even whole countries into action. However, up until recently economists have dismissed the power of narratives to move economies and markets, taking the attitude that if it can’t be measured then it doesn’t exist. Unfortunately, data doesn’t tell the whole story.
Narratives operate in a reflexive environment, and none more evident than in financial markets. Bullish narratives influence asset prices, which in turn support increased economic activity, resulting in an even stronger narrative, and so on, etc.
The narratives we are told about the economy and markets have the power to drive booms, but they can also lead to busts as well if bearish narratives take hold. Here’s economist Robert Shiller describing how the process unfolds in his book, Narrative Economics:
“In a bubble, the contagion is altered by the public attention to price increases: rapid price increases boost the contagion rate of popular stories justifying that increase, heightening demand and more price increases. In a stock market bubble, these might be stories of the companies with glamorous new technology and of the people who created the technology…There can also be price-to-GDP-to-price feedback, if speculative price increases stimulate purchases and hence more increases, price-to-corporate profits-to-price feedback, and price-to-regulatory laxity-to-price feedback, all mediated by changing narratives.”
Narratives can be relatively short such as the length of time for a boom to develop. For example, in 2001, the UK television show “Property Ladder” was launched. It depicted individuals buying homes, doing them up a little and then reselling them at a large profit. The concept was copied by other countries, e.g. the US TV show “Flip that House”. These TV shows, as well as magazines and other media fed the narrative that you too could become a property millionaire with very little effort. More recently, the narrative among many commentators was that you too could simply buy meme stocks or crypto and you would be wealthy too.
Economic and financial narratives can also be very sticky often lasting decades, especially if they are enshrined in an important financial institution’s identity. One long term narrative from economic history is that of Germany’s central bank, the Bundesbank. It had a stored set of memories directly linked to the traumatic economic experience of the hyper-inflationary Weimar Republic. Investors believed that the Bundesbank would continue with its hawkish inflation narrative even though several decades had past.
Carbon market narratives
The strongest narratives in the EU carbon market over the past few years include a) that there was a scarcity of allowances that would mean carbon prices would be driven higher and higher, b) that carbon prices needed to be very high and stay at that level to bring about an acceleration in industrial decarbonisation, and c) that political will was rock solid and that would perpetuate both ‘a’ and ‘b’ until, at some point there would be a political reaction to stem any adverse economic or social effects .
I originally published the chart below in the middle of March, a few weeks after the Russian invasion of Ukraine sent carbon prices into a tailspin. It shows several of the most prominent articles about the European carbon market published in the FT newspaper since the beginning of 2000 set against the EU carbon price (see Carbon market sentiment check).
You can see some of these three narratives play out as the carbon prices rose from €20 per tonne towards €100 per tonne in late 2021. The two major bullish trends (Nov-2020 to May-2021 and the period Oct-2021 to Jan-2022) occurred after the FT had published articles with the words “higher carbon prices” and “emissions credit boom”.
The peak in EU carbon prices coincided with the FT shining a light on the risk of political disunity over high energy prices, leading with “political blowback” and “EU leaders battle”. In mid-March sentiment appeared to be warming up with “Investing in a lower-carbon future” and “This crisis could be the making of Europe’s carbon market” the most recent articles referring to the EU carbon market. That last FT article in particular alludes to the challenges that the EU carbon market is now confronting.
Crafting a stable narrative
A bit like the Roman god, Janus, politicians often have to look both ways at once, playing both sides of an argument to ensure their survival. It was on show during the early June EU Parliament debate on EU ETS reform. Members of the European Parliament (MEPs) voted to to reject a deal that was both seen as too ambitious, but also too weak in delivery on its mandate. Pascal Canfin, the EU Parliament’s environment committee chair summed up the challenge facing MEPs:
“But you can have two different conclusions: on one side, you have to refrain from putting additional burden [on companies], and on the other side, you have to speed up the green transition. And actually, both are true.”
MEP’s are to reconvene on the 22nd June to vote on an amended proposal. The risk that they face is that they could end up settling on an agreement that pleases no one. That would leave the EU carbon market awash, struggling for direction, and unclear as to the political behind future price direction.1
I argued in an earlier article that the EU carbon market is likely to evolve towards one where forward guidance is key to price formation, ideally where the price remains within a ‘politically acceptable’ band of €60-€90 (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.
Three strong narratives got the EU carbon price to where it is today - allowance scarcity, high enough to incentivise decarbonisation and political will. However, much like a central bank that loses its inflation fighting credibility, all that hard work can easily be undone if the narrative is broken.
Many carbon market investors appear to be focusing on the EU carbon markets attraction as an uncorrelated asset class, remaining broadly stable in the face of spiralling equity, bond and crypto markets.
The EU carbon market needs a new narrative, one that emphasis stability. The ball is now squarely in the politicians court to make that happen. To succeed though they need to craft a narrative about what the future holds, and crucially why it is important that the market should continue to place their trust in them. As behavioural economist, Daniel Kahneman said, “No one ever made a decision because of a number. They need a story.”
If they come up short then the EU carbon market is likely to punish them by forcing the carbon price lower. The next 10 days are critical.
As luck would have it, 22nd June also happens to be options expiry for the June EUA futures contract. Combine that with political news headlines and there is a high risk of carbon prices being whipsawed around.