We are on the cusp of creating a new economy. And it is the most important economic experiment of our lifetimes.

Humans are emitting 60Gt of CO2-equivalent each year - that's 60 billion tons. Let’s say we put a price of $100 on each ton of CO2, the GDP of the carbon economy would be $6 trillion making it the third largest economy in the world. For a long time, economists have proposed pricing emissions into our economic activities to fairly capture the damage they cause to others. The time might have finally come. Over the past 20 years the EU has slowly built the largest carbon market in the world. At first it was irrelevant and mostly ignored because the price was laughably low. The latest regulatory tweaks in 2023 tightened supply sufficiently that it's now being taken seriously. And it will impact most industries in Europe and countries doing business in Europe. 

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William Gibson said “The future is here, it's just not evenly distributed.” What's happening in Europe might just be the way we'll get a handle on carbon emission everywhere. I'll explore the European Carbon Economy and its implications beyond Europe. To follow along subscribe here. 

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This time will be different

It's a bit of a joke among venture capitalists to proclaim that "This time will be different!". It usually isn’t. So feel free to take the other side of this argument. And I totally get the skepticism: we've been talking about a price on carbon, cap-and-trade, carbon tax, and similar ideas for FOREVER. Economists have been lecturing about emissions being a negative externality for decades; in fact they’ve used it as the canonical example of failed markets: if emissions aren’t priced into our economic activities they will therefore be ignored by rational market participants. In theory, they told us, all we need to do is create a pricing mechanism for emissions.  But it's been just that - a theory taught to bright-eyed and bushy-tailed undergrads that has never made it out of textbooks into the real world.

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Until now. This time will be different. Here is why:

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1. The ETS is tightening supply

The European Union Emission Trading System (EU ETS) has been around for almost 20 years, but has been largely irrelevant until now. Changes in 2021 and 2023 significantly tightened the available allowances, creating scarcity of emission credits and therefore establishing the largest market for emissions in the world. What is the ETS, you might wonder? The details are complicated, but in a nutshell, it’s a cap-and-trade system in which emission allowances decrease annually until they hit zero by 2039. The idea is to price-in emissions and let the market figure out the most efficient approach to reduce them over time and get to a net zero economy.

Until recently, the ETS didn’t matter much. Emitters were given more than enough free allowances to go about their day. The first 16 years of the ETS were like playing musical chairs with more chairs than kids. Now we've gone past the point of equilibrium and there are not enough allowances for all the emissions in the EU. You can see it in the ETS price development in the last few years below...the cost of emission permits has surged from a stagnant €5 for over a decade to fluctuating between €60-100 in recent years. 

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2. CBAM will stop leakage

In 2023 the EU added another lovely-named regulation called the Carbon Border Adjustment Mechanism (CBAM), an important complement to the ETS. Without it, the risk - and likely outcome - of the ETS is that carbon-intensive industries will relocate outside Europe to avoid the ETS and then import their goods back into the EU. The CBAM is plugging that hole by requiring a border tax on carbon-intensive imports covered under the ETS. The price of that tax is linked to the ETS to create a unified market for carbon abatement.

The CBAM is going through a transitional phase until 2026 at which point the importers of all those energy-intensive products will start paying the import tax to level the playing field with the ETS. By 2030 all sectors under the ETS will be covered by CBAM. No more carbon import loophole - at least that's the theory.

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‍There you have it - the EU will have created the largest Carbon Economy in the world. Pretty incredible if you think about it. We've talked about it for decades and it might finally be happening.

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A word on regulations

I can already hear the free-market aficionados shouting, "We don't need more regulations!" Sure, if you’re of the mindset that carbon emissions don’t cause harm, these blog posts are not trying to convince you otherwise. However, if you think we need to reduce emissions and believe in free market solutions, a well-functioning Carbon Economy is the most efficient way to get there. Far better than having government officials deciding how to spend billions (or trillions!) in subsidies on an arbitrary set of initiatives. Programs like the IRA (just like the American Recovery and Reinvestment Act from before it) all fizzle out at some point. Without a long-term, market-based approach to find the lowest-cost carbon reduction solutions, we'll waste a bunch of private and public money.

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Final thoughts

A well-functioning carbon market creates predictable incentives for the best technologies and companies to emerge and thrive. The ETS has profound implications on nearly all industries in Europe. And it goes well beyond Europe: any company selling into Europe should know its impact. The implications are fascinating and complex which I’ll explore in future posts. My goal is to keep the boring policy and regulation minutiae to a minimum - instead I’ll focus on what the ETS means for startups, investors and industry incumbents and how they can best position themselves in this new carbon economy.

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Follow along and subscribe here.

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