The final post in this 3-part series covers important macro forces market participants should take into account when trying to anticipate future carbon prices. In prior posts I wrote about the policy-driven supply side and the complex build vs buy decision companies are facing and the role of new technologies. Let’s jump in.

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Macro economic cycles

The price of carbon will be linked to macroeconomic cycles. In a down-cycle, carbon emission may drop as economic output decreases. The covid dip you can see in the data below is an example of this. We expect carbon prices to decrease as economic output decreases and with it the demand for carbon credit decreases.

As economies decrease their dependence on fossil fuels, the relationship between GDP and CO2 emissions will weaken over time. You can already see it happening:

The weaker the relationship between GDP and emissions, the lower the impact of changes in GDP on the price of carbon.

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Interest rates

Like all infrastructure investments, decarbonization projects require upfront capital. The prevailing interest rate environment impacts the financing costs of any capital intensive project. Let’s look at a simple example to get a sense of the magnitude.

Let’s say it costs €1M in capital to replace an industrial natural gas boiler with a clean energy alternative (e.g. a heat pump or battery). The simple calculator below shows the impact of different interest rate environments on the cost of abatement. A drop of interest rates from 6% to 3% would mean a decrease in the cost of abatement of 7%.

Given the capital intensity of many abatement solutions, we should expect carbon prices to match interest rate movement - if interest rates go up, so do carbon prices. The higher the capital intensity of a technology, the more it is exposed to interest rate changes.

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Fossil fuel prices

The higher fossil fuel prices are, the more profitable investments in low-carbon alternatives will be. Europe pays 3-4x per MBtu in normal times - and is exposed to enormous geopolitical price risk being a net importer of oil and gas:

We saw the consequences of Europe’s energy dependence on Russian oil and gas at the start of the Ukraine war when gas prices jumped to over $70/MBtu.

Higher fossil fuel prices make investments in clean energy alternatives more attractive: clean energy investments will have faster payback and higher ROI profiles. The combination of higher oil and gas prices and a healthy cap-and-trade carbon market will make Europe the primary proving ground for climate tech startups. 

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Financial instruments

The ETS is the world’s biggest carbon market by traded volume, worth about $800B in 2023. An ecosystem of financial players is developing that will sell financial instruments on top of the carbon credit market. Market participants can use those instruments to hedge their future price exposure and speculate on the price movement. Or they can hedge by buying excess allowances in the open market and banking them if they expect prices will rise.

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Bringing it all together

We’re at the beginning of the most important economic experiment of our lifetimes: the emergence of a $6 trillion carbon economy. Europe is leading the way with the most robust carbon market today, but the implications are relevant beyond its borders. The world will watching how Europe is transforming into a low-carbon economy. Many doubt it’s possible. Others are concerned it will cost too much and tank the economy. Doubters aside, using a market-based approach will chart the most efficient way to get there. As with any market reshuffle of this magnitude, it’s an opening for startups to build massively successful companies and define the shape of low-carbon economies.

I write about startups and low-carbon economies. Follow along here.