SustainaWeekly - What is driving carbon prices?
In this edition of the SustainaWeekly, our first note examines the drivers behind recent moves in carbon prices. The EU’s carbon price climbed through the EUR 100 tonne mark last month for the first time. However, the price of allowances has subsequently fallen back, with the upward trend struggling to maintain momentum. We go on to assess why the UK government’s Boiler Upgrade Scheme – which provides subsidies to home owners for a new heat pump – has failed to achieve its objectives, and what would be necessary for success. Furthermore, we follow up our decoupling of GDP and emissions analysis of last week on the main global economic regions by applying the framework to the sectors of the Dutch economy.
Economist: Europe’s carbon price breached EUR 100 a tonne, but has since struggled to maintain momentum. Continued weakness in industry has played a role, while power sector emissions have been falling. The agreement on ETS reform at the turn of the year – making the scheme more stringent - has been a supportive factor for prices. Carbon prices are not too far off levels that would be meaningful for the energy transition.
Policy: The UK launched an attractive subsidy scheme to encourage homeowners to switch to heat pumps. The take-up rate is low in spite of the grant. Installation and running costs are an important barrier but not the only reason for the low rollout rate. Heat pumps use electricity and electricity is a lot more expensive than gas in the UK. The gap between electricity and gas will have to narrow to improve the cost benefit ratio of heat pumps.
Sector: The influence of sector trends on the trend of total emissions in the Dutch economy is large. We mostly see weak to strong decoupling between the trend in emissions and sector GDP. Strong decoupling - where emissions shrink and value added grows - occurs almost in one-third of all cases. Strong negative decoupling between the two occurs only in 12% of cases among sectors.
ESG in figures: In a regular section of our weekly, we present a chart book on some of the key indicators for ESG financing and the energy transition.
Carbon prices struggle to maintain momentum
Europe’s carbon price breached EUR 100 a tonne, but has since struggled to maintain momentum
Continued weakness in industry has played a role, pouring cold water on market optimism
While power sector emissions have been falling, following the decline in share of fossil fuels
The agreement on ETS reform at the turn of the year has been a supportive factor for prices
The changes will make the ETS more stringent, reducing the supply of permits
Carbon prices are not too far off levels that would be meaningful for the energy transition
The EU’s carbon price climbed through the EUR 100 tonne mark last month for the first time. However, the price of allowances traded under the Emissions Trading System (ETS), has subsequently fallen back, with the upward trend struggling to maintain momentum. Unlike a carbon tax, the price of carbon under the ETS is set by market forces, though the EU sets and limits supply, and the market determines demand. The ETS supports the transition by directly reducing the amount of emissions for sectors (energy-intensive industry and power) covered by the scheme. In addition, indirectly, if the carbon price is high enough some companies would find it cheaper to implement energy efficiency measures or switch to lower emission fuels. In this note, we take a brief look at the drivers of the recent developments in carbon prices and whether current levels are meaningful in terms of encouraging the energy transition.
Industrial sector still in recession
Although over the last few months, equity market optimism about a European industrial recovery rose (see chart on the left), recent data have remained rather weak, with manufacturing orders still at levels consistent with a recession. For instance, the PMI survey, shows these indicators under the 50-mark consistent with contraction (see chart on the right).
Power sector emissions have been falling
Carbon emissions from Europe’s power sector fell sharply at the end of last year and start of this year. For instance, in January, emissions are estimated to have fallen by close to 15% compared to last year, which would be a serious drag on the demand for permits. Behind this trend look to be too factors. First, overall electricity generation is down, likely reflecting steps in energy efficiency that have reduced consumption as well as mild weather. Second, the share of fossil fuels in the power mix has declined rapidly, completely reversing an upward trend seen during the course of last year.
Of course, the energy crisis in Europe played a big role in all these trends. The surge in electricity prices during the course of last year triggered falls in consumption. Over the last few months we have seen a recovery in generation from hydro (following shortfalls for much of last year due to drought) and nuclear (numerous plants had gone offline). The share of coal in generation rose during the first nine months of last year, but has subsequently fallen back. The share of wind and solar rose significantly last year compared to 2021 (and together were the EU’s top power source for the first time ever). Overall, demand from both industrial and power sectors has been lacklustre reflecting a combination of fundamentally positive (energy efficiency, increased use of cleaner fuels) and other (cyclical weakness, mild weather) factors.
Progress on ETS reform
As part of the Fit-55 package first set out in 2021, the European Commission set out a proposal to reform the ETS to be consistent with a more ambitious emission reduction target for 2030. The Council and the European Parliament reached a provisional political agreement on ETS reform in December of last year, which will reduce the supply of emission permits. The agreement may have added support to carbon prices, and more broadly, will be a structural supportive factor for carbon prices in the coming years, though the extent will depend on the pace of transition. Under the reform: (a) the target annual reduction in emissions will be doubled (see chart on the left), (b) free allowances for certain sectors will be phased out - in parallel with the introduction of the carbon border adjustment mechanism (c) two one-off ‘rebasings’ of the cap, reducing it by 90 million allowances in 2024 and an additional 27 million in 2026.
Carbon prices and the transition
Carbon prices are not too far off levels that would be meaningful for the energy transition. For instance, the NGFS estimates that carbon prices for industry would be just over EUR 100 in a net zero scenario in 2025, though they rise sharply thereafter. Arguably, under an ETS rather than a carbon tax, a fast orderly transition with rapid technological development, could see demand for permits falling just as quickly as the reduced supply, keeping the price rise constrained. However, the NGFS and other transition scenarios, take the view that high carbon prices would be needed to make such a fast orderly transition possible in the first place. For instance, a number of emission reduction solutions would require carbon prices sustaining at around USD 100 as a necessary (but not sufficient) condition to become economical (see for instance).