Benjamin Graham famously said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

The EU carbon market will work the same: in the short term, prices will gyrate, and movements may be hard to explain. Over longer time horizons the price will be determined by rational players making decisions to maximize their profits. In this set of upcoming posts (subscribe here) I’ll explore the key forces that will move the price of carbon.

Let’s dive in.

‍

A single-supplier market

The ETS is a market created by government policies. Any changes to these rules will impact carbon prices. A decrease in supply of allowances will drive up prices, and vice versa. The chart below shows the impact of the “Fit-for-55 package” that was adopted in 2023. The linear reduction factor (LRF) - i.e. by how much allowances are reduced each year - was increased from 2.2% to 4.3% which accelerates the path to a zero cap from 2058 to 2039. The red line charts the path to a zero-carbon cap economy. The carbon price will be the arbiter to keep us on track. If we’re behind, prices will increase to incentivize investment in decarbonization efforts. If we’re on track or ahead of the curve, prices will move sideways or decrease.

(Source: The Emerging Endgame: The EU ETS on the Road Towards Climate Neutrality)

‍

The single-supplier nature of this market is worth highlighting further. The supply side is purely determined by policies and known by all market participants. In most other markets, participants can decide to increase supply by e.g. increasing production. As such, the European ETS market is more akin to a currency market where the supply is determined by a central governing body - in that case a central bank.

Having a predictable, fixed supply is a cornerstone of a cap-and-trade system. With that knowledge, each market participant can plan their actions. Emitters can abate emissions or buy and sell credits. Their actions will determine the demand side of the market which we’ll cover in the next post.

‍

The role of the Market Stability Reserve (MSR)

The MSR is a fairly complex, but critical mechanism that allows the EU to react more flexibly to market shocks. In a nutshell, 24% of all ETS allowances are placed into the MSR each year. Depending on the total allowances in circulation, the mechanism then removes allowances from the market or distributes them by adjusting the auction volume in subsequent years.

The MSR is a regulatory innovation born out of the oversupply of allowances in the first phases of the ETS that nearly killed the market’s credibility. In the early years, many companies built up allowance reserves which led to a glut of allowances and was a big factor why the carbon price was irrelevantly low for many years. When the MSR was introduced in 2018/2019, it had the intended impact on the carbon price lifting it from ~€5/ to ~€20/t. After its introduction, someone said: “The MSR was politically important to demonstrate that the doctor had not given up on the patient.”

Interestingly, the MSR release mechanics are not directly linked to the carbon price but to the number of permits “banked” by participants, i.e. the permits held by companies for future use at the end of each year. Given the novelty of the MSR - and the ETS market as a whole - the impact of the MSR on prices is not well understood yet. Some researchers believe it will indeed increase allowance scarcity in the long run as designed but at an uncertain scale. They believe, however, it may, in fact, increase, not decrease, price volatility and increase the market’s vulnerability to speculation and manipulation.

The MSR’s impact on the ETS is still unknown and will continue to be a hotly debated topic. As we learn more about the overall impact of the MSR on prices and market stability, I would not be surprised if we see changes made to the MSR over time.

‍

Subscribe here for Part 2 which explores the demand side of the market and how emitters will decide whether to abate or buy credits.

‍