The path to a global carbon price
Why carbon markets will converge and become increasingly correlated
Compliance fundamentals underpinning the EU ETS, California, RGGI and other more nascent compliance carbon markets are very different: market size, coverage (power, industry, etc.), the carbon intensity of the sectors covered, the degree to which emitters have already decarbonised and the options available (fuels, technology, etc.), whether there is a floor and ceiling price or not, the use of free allowances, allowance over-supply and mechanisms to reduce it, the rate at which the emissions cap declines, different compliance periods and penalties for non-compliance, whether other decarbonisation policies are being used alongside the ETS, and last but not least, political pressure.
From the perspective of a coal plant manager in Poland, the owner of a cement factory in California or the person in charge of compliance at a gas fired generator in New England, there really isn’t any reason why different compliance markets for carbon should be correlated. Why, they might ask should my decision to abate the emissions from my facility have any bearing on obligated emitters anywhere else in the world?
Carbon markets remain a nascent asset class, a patchwork of compliance trading schemes, albeit one dominated by the EU ETS. In this article I argue that there are two reasons why disparate carbon markets will converge and become increasingly correlated over time. That will frustrate analysts and traders of physical carbon allowances that have grown used to gauging the fundamentals of their carbon market in isolation. It will also be an opportunity for longer term investors who are able to see through the short term macro/technical noise.
The financialization of carbon markets
In the first decade of this century, disparate commodity markets became increasingly correlated, both with each other and compared with other assets. The argument in the mid-2000’s was that strong economic growth in China and elsewhere in Asia and their burgeoning demand for commodities was behind this co-movement.
What appears more likely based on the evidence is that it was driven by increased appetite from investors for commodities and commodity linked investments. For example, at least until 2011, those commodities that form part of commodity investment indices show even greater degrees of cross-commodity correlation than those commodities that are not included in the indices.1
Increased demand for commodities by investors was driven by the argument that they offered diversification benefits based on the historically low correlation between returns from commodities and other financial assets, strong risk-adjusted returns versus equities, as well as being a strong hedge against inflation.
Over the past year, the same uncorrelated returns argument is being made for carbon markets. But, as we’re seeing already, carbon markets are increasingly connected with broader macro trends affecting other asset markets. For example, the correlation between EU carbon prices and equities rose from 32% in the period January 2019 to mid-March 2020, to 42% during the subsequent 20 months to October 2021. Equity returns became the single most important determinant of daily price movements in carbon, more important than energy prices.
The emergence of global carbon funds such as KRBN is also likely to mean that disparate carbon markets follow the path previously trod by commodities. Investors chasing higher EU carbon prices via a global carbon fund will naturally also result in a surge in buying pressure for other carbon markets held within the fund - irrespective of the fundamentals supporting those markets.
Indeed, speculators may not even care what basket of carbon markets is in these funds, and trade them on the basis of technical indicators. There is already evidence of this happening. This mirrors the growth in commodity index speculation where despite the basket of commodity futures held within an index being rebalanced annually the price of the index is what is traded.
The demand for carbon will not only be driven by compliance entities and investors. Carbon markets (both compliance and voluntary) will also be used by investment institutions seeking to offset the carbon risk embedded in their portfolios (increasingly a feature of green bonds). The price of carbon, the markets reputation for genuine carbon abatement and the size of the market will all be factors that institutions take account of when deciding which carbon market they should use to hedge the carbon exposure within their portfolios. This arbitrage across carbon markets will drive carbon prices closer over time, reflecting the above factors on a risk adjusted basis.
Zero carbon competition
As I have discussed before, the carbon price is the currency of decarbonisation. A strong carbon price is a signal that investors, businesspeople and citizens trust their government’s commitment to combat climate change. A weak carbon price suggests they do not.
Much as some policymakers and their leaders loath the influence of investors, they play a crucial role in driving price discovery. Investors will reward those strong carbon markets with stretching decarbonisation targets and which leave little room for meddling by politicians. Investors will also punish those markets that fail to do those things.
The strength of an individual trading area, country or state’s carbon market will increasingly become an indicator of a strong economy. One where governments are serious about attracting decarbonisation investment, recognise the benefits of offsetting carbon risk for businesses and investors, and providing a foundation for more sustainable long term economic growth.
The introduction of the EU’s Carbon Border Adjustment Mechanism (CBAM), currently scheduled to come into force in 2026, will accelerate the convergence of carbon market pricing by incentivising governments to introduce ETS rules as stringent as the EU’s. Should they fall short then the difference between the price of the CBAM certificate and the domestic carbon price of the country of origin will be paid to the EU by importers of carbon intensive products.
What does this mean for carbon prices?
A patchwork of carbon markets and carbon taxes dot the Earth and currently account for around one-quarter of global emissions. The wide variation in carbon prices creates unintended consequences that slow efforts to meet net-zero targets.
A recent paper by Luc Laeven and Alexander Popov of the European Central Bank (ECB), and published by the Centre for Economic Policy Research (CEPR), analyses data on cross-border lending between 1988 and 2021, during which time many countries imposed carbon pricing.
The authors find a game of ‘Whack-A-Mole’ in which domestic carbon taxes resulted in banks cutting lending to domestic fossil fuel companies, but also had the perverse consequence of causing them to increase such lending abroad, particularly to firms located in countries lacking a carbon price or tax.
The sooner a global carbon price is established, the more likely it is that capital can be allocated more efficiently and the required innovation can be accelerated as economies of scale kick in. Estimates from industry and consultants typically suggest that carbon prices need to rise to somewhere in the range of €120-€230 per tonne in order to achieve industrial decarbonisation, depending on the industry and the nature of the technology required.
The twin forces of financialization and competition between countries and jurisdictions will mean compliance carbon markets are likely to evolve into a global market. This will happen much quicker than we saw with commodity markets, , despite the current political headwinds.
Ultimately, a global carbon price will reduce the peak carbon price required to clear the decarbonisation bottleneck. Carbon investors will need to be ever nimble to decipher the often conflicting forces at play.
For example, the S&P GSCI and the Bloomberg Commodity Index.