The prior post covered the unique supply-side dynamics of the carbon markets in Europe. The more dynamic and complex aspects of the market will play out on the demand side:

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Difficult decisions

Demand for carbon credits will be driven by emitters who own factories operating in energy intensive sectors covered by the ETS and CBAM (e.g. power plants, steel, cement, aluminum, pulp and paper, fertilizer, shipping, aviation - and at a later point road transport and buildings)

Companies in these industries will make profit maximizing decisions to reduce their carbon costs - they can either reduce their emissions or buy allowances. The basic optimization function looks something like this:

If the net present value (NPV) of the marginal abatement project < price of carbon, invest in abatement project. Otherwise buy allowances in the open market.

Each company will have to stack-rank possible abatement projects by their NPV. Each project’s NPV calculation will take into account a long list of risks and costs:

• Technology risks
• Project delays
• Financing costs
• Disruptions to existing operations
• Opportunity costs of working on something else with higher ROI
• Expertise in implementing a new technology
• Risk of a leapfrogging technology coming along in a few years

To make matters even more complex, abatement projects usually take years to deploy which means companies have to develop a view of the future carbon price to decide if the risks and costs are worth taking on. Let’s run through an example for a cement plant:

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While hypothetical, these scenarios illustrate that an abatement decision today, can have enormous impact on plant profitability in the future. This shouldn’t come as a surprise to anyone tracking Tesla, which has been making billions from selling emission credits.

If a single player’s decision depends on future carbon prices, which in turn is influenced by other players' cost optimizing decisions, it becomes obvious that an emitter's abatement decision is quite complex. For now, most emitters are in a “wait and see” pattern. They might be experimenting with different technologies but not yet deploying solutions at scale.

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The role of new technologies

The elegance of a unified carbon market is that the carbon price serves as the yardstick to measure all technologies against each other and across industries. Economic theory tells us that those technologies with the lowest cost of abatement will be implemented first as it creates the highest returns for the emitter. Any technologies that have a negative NPV compared to the price of carbon will not be implemented since buying allowances will be cheaper.

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Startups selling abatement solutions need to be aware that their product competes not only in their specific segment, but against all other abatement technologies and across industrial sectors. Let’s say your product is the lowest cost technology to make green cement at €50 per tCO2. But the cheapest way to abate carbon is building solar projects at the equivalent of €20 per tCO2. The electricity sector will build those projects as fast as possibly to capture the NPV surplus against the prevailing carbon price. They can then sell their allocated allowances into the open market keeping the price below €50 and therefore making it uneconomical for cement makers to adopt your new technology.

Startups and investors need to look beyond their immediate competitors and build a view of what the marginal abatement cost is across the entire ETS economy. Over time the marginal cost of abatement will go up as supply is decreased, the cheapest projects get realized and, as a result, more expensive technologies become economical.

Getting the timing right for startups is a matter of survival. You can be right in the long-run but too early and not find any buyers for your technology before running out of cash. Operators and investors need to plan accordingly by keeping an eye on what is going on in other sectors that will influence the price of carbon in the future.

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