Is Carbon Poised for a Breakout Year in 2023?
By Eron Bloomgarden, Jeffrey Berman and Oktay Kurbanov
The year 2022 was the fifth hottest year on record according to the EU's earth observation program, Copernicus, with Europe and Asia exhibiting their second warmest year and Europeans living through the hottest summer yet. 2022 was marked by extreme weather events across the globe, including floods, wildfires, and droughts. As these events continue to take a heavy human and economic toll, increasing public awareness of the risks of climate change helps solidify political will to implement climate-related legislation that is supportive of carbon markets, as discussed in this paper.
At the same time, the 2022 global energy crisis has led to an increased focus on affordable and secure energy, with some investors staying on the sidelines as high energy costs combined with wider inflation suppressed economic output. While acknowledging these concerns, we believe the case for carbon remains as strong as ever. Fundamental factors that have supported the 30%+ annualized return of global carbon markets over the last 5 years have been reinforced by recent policy and market developments. If anything, the current environment provides a unique opportunity to enter carbon markets at attractive levels, positioning for upside potential and years of strong performance as the supportive policies start working their way through emission trading systems (ETS) and as the global economy returns to its full capacity.
⦁ Increasing climate ambition is translating to tighter emissions caps creating tighter markets, i.e., supply scarcity.
Despite the energy crisis and economic pressures, policymakers on both sides of the Atlantic reconfirmed and increased their ambition to cut emissions and achieve net zero goals. European policymakers recently agreed to lower upcoming annual EU ETS emission caps in line with a more ambitious 2030 climate target, reducing the 2024-2030 supply available to market participants by 14%. Policymakers in California, the UK, and the RGGI region are expected to begin similar efforts later this year.
⦁ Energy security concerns are leading to increased emissions in the short term and supply pressure in the medium term.
Europe's power sector must rely on coal in the short term as it works to wean itself off Russian gas. This has slowed down the pace of power sector decarbonization and led to an increased EU ETS compliance demand. Additionally, policymakers recently increased the EU ETS supply to help fund energy transition efforts to end Russian fossil fuel imports by 2027, termed the REPowerEU initiative. However, they are doing so by "borrowing" supply earmarked for future years – thereby creating a supply shortage further down the road. While the current extra supply creates downward pressure on short-term prices, it also supports steeper future structural price appreciation.
⦁ Increasing demand is expected as emissions rebound with the end of the economic downturn.
While recessionary concerns may persist, we think 2023 will provide more certainty on the timing of the economic recovery. Without taking a strong view on the exact timing, we expect 2024-2025 as the likely period of economic recovery based on the forecast data available. As the global economy rebounds, we expect that emissions will subsequently increase as production ramps up, as was the case in 2021 after the pandemic-impacted 2020. This creates yet another attractive appreciation possibility in carbon markets from current levels. Acknowledging the possibility of near-term macroeconomic weakness and geopolitical risks, we feel the current environment provides an attractive entry point, positioning for the expected economic recovery.
⦁ Lack of cost-effective abatement technologies is creating persistent demand pressure in compliance markets.
Meeting more ambitious climate targets will also require more substantive emissions reductions from harder-to-abate sectors like heavy industry and transportation. Yet there are few readily available solutions to substantially reduce industrial and transport emissions by 2030. However, European and UK industrial emissions, which represent about half of the total emissions for those regions, remain heavily tied to production levels. Current European carbon prices remain too low versus the abatement costs for industrial sectors, which are often estimated at several hundred euros per ton of CO2. Technologies such as green hydrogen, carbon capture and storage (CCS), and sustainable aviation fuel are considered critical for the decarbonization of industrial sectors and transportation; however, they face significant economic viability challenges.
EU ETS: Increased climate ambition as emissions rise post-pandemic
Tighter caps coming from Fit for 55's increased climate ambition
Stronger climate ambition is leading to lower supply in the EU ETS – the world's largest carbon market – through 2030. Policymakers from the EU Commission, the EU Parliament, and the EU Council (representing member state governments) in December finalized a number of EU ETS market reforms that were originally proposed in the July 2021 Fit for 55 package. These reforms are intended to bring the EU ETS in line with the EU's stronger emissions reduction target: a 55% cut in economy-wide Greenhouse Gases (GHGs) by 2030 vs. 1990 levels, rather than a 40% cut that was previously on the books. As a result, fewer EU Carbon Allowances (EUA) will be available to market participants.
Crucially, this included reducing the annual emissions caps that determine EU ETS market supply, which will be 14% lower in the impacted years 2024-2030 than what would have been the case, as shown in Figure 1. We expect entities with compliance obligations to maintain stronger allowance purchases ahead of supply crunches resulting from annual supply-demand deficits.
REPowerEU will increase near-term market supply creating a long-term supply shortage
Policymakers in December also reached an agreement on the May 2022 REPowerEU proposal to end dependence on Russian fossil fuels. The proposal includes an initiative to raise €20B via additional EUA sales from two sources: the EU ETS Innovation Fund, which is intended to support new low-carbon technologies, and EUA auction volumes. In both cases, these volumes will be "frontloaded," or borrowed, from volumes earmarked for the 2026-2030 period. While the exact increase in supply will depend on the market price of additional allowance volumes sold, the extra supply creates downward pressure on short-term prices - already priced in. However, frontloading auction sales will also lead to about 4.5% tighter supply in 2026-2030, supporting future price appreciation on a steeper supply curve. Furthermore, by increasing supply in earlier years, REPowerEU will cause a greater net intake of excess allowances into the MSR, with about 145M allowances additionally removed from the supply through the year 2030, representing 1.7% of the total remaining supply from 2023 through 2030. Ultimately, the frontloading of allowances, which will be taken from future auctions, creates a bullish outlook for EUA prices in the future when the supply constraints are realized.
Europe wants to increase climate ambition while coal-fired generation is rebounding
Europe's power sector must rely on coal in the short term as it works to wean itself off Russian gas, leading to stronger near-term emissions. EU ETS stationary emissions fell by an average of 3-4% annually from 2013-2019 (and by over 11% in pandemic-impacted 2020), primarily because of power sector fuel switching from coal to gas. However, stationary emissions rose 6.8% in 2021 following the pandemic recovery. Coal-fired generation rose to multi-year highs in 2022 as generators switched from gas to coal because of record-high natural gas prices. This has slowed down the pace of power sector decarbonization and supported real-time EU ETS compliance demand. Though gas prices have come down in recent weeks, we expect power sector emissions to remain elevated in the near term.
Industrial emissions are likely to grow with the end of the economic downturn, with emissions reductions still expensive and difficult to achieve
Meeting more ambitious climate targets will also require the EU to achieve more substantive emissions reductions from its industrial sectors like steel, cement, and refining, which currently make up about half of EU ETS-covered emissions. However, industrial emissions remain heavily tied to production levels. While EU ETS emissions from industry likely declined in 2022 on lower production, we expect these emissions to increase again as the European economy rebounds. For reference, the World Bank, IMF, and the European Commission forecast real EU GDP growth of 0-0.7% in 2023 but stronger growth of 1.6-2.1% in 2024. Though we recognize the possibility of near-term macroeconomic weakness and geopolitical risks, we also feel that the current environment provides an attractive entry point and a good position for the expected economic recovery. Indeed, the tightening of markets further insulates carbon from the economic cycle.
Another reason that we believe industrial emissions will recover is the lack of readily available solutions to reduce them by 2030 substantially. Despite a tripling of their price in the last few years, current European carbon prices remain too low to encourage the wide-scale implementation of new technologies to reduce industrial emissions, like CCS or green hydrogen. According to Morgan Stanley research, most abatement across different industry sectors has a cost averaging around €130/ton of CO2, reaching €180/t for areas like industrial furnace CCS. Technologies involving green hydrogen, air capture CCS, and synthetic fuels carry a cost well over €180 per abated ton of CO2 on top of significant fixed costs and time required to build the necessary infrastructure. At the current price of €85, we believe there is significant near-term upside.
UK ETS: Net zero alignment by the end of the year
UK ETS caps to be lowered in line with net-zero targets by next year
The UK left the EU ETS at the end of 2020 and replaced those obligations with the domestic-only UK ETS at the start of 2021. CLIFI expects that the caps in the UK ETS will soon be lowered despite the relative tightness that currently exists in the market, which will further support market prices. Policymakers originally set the UK ETS caps based on the UK's share of allowances in the EU ETS. However, in a 2022 public consultation, policymakers committed to aligning the emission caps with the 2050 net zero target. The consultation document proposed a decrease of 30-35% of the total emission budget in Phase 1 (2021-2030), with an expected one-off decrease of the cap in 2024 by about 40%. Climate action is relatively popular across the British political spectrum, and the timeline for passing and implementing new policies is quicker in the UK than in the EU. As such, it will be possible for the UK to begin the legislative process this year and still revise caps in time for the 2024 compliance year.
No easy abatement options in UK ETS
With nearly no coal-fired generation left in the UK and limited electricity interconnection with continental Europe, there are few opportunities for inexpensive emissions reductions via coal-to-gas switching. At the same time, the net zero pathway presented to the UK parliament in 2021 expects emissions to fall by 71-76% by 2030 compared to 2019 levels. To help achieve these highly aggressive targets, prices will need to rise to much higher levels to incentivize abatement, as discussed above. These considerations will ensure strong policy support for higher UK ETS levels to achieve ambitious goals.
California: Greater ambition in a hard-to-abate market
While the California cap-and-trade market, also referred to as Western Climate Initiative (WCI) ETS (a joint marketplace that includes Quebec), is smaller than the EU ETS, it also has a broader scope – as it covers not just large stationary emissions but also emissions from supplied transportation and heating fuels. Similar to Europe in 2021-2022, CLIFI expects that California policymakers will soon begin new efforts to increase the ambition of the California market, which implies upward price pressure for California Carbon Allowances (CCAs). The effect of more ambitious policy will be compounded by the difficulty California entities have had in reducing covered emissions to date. With the particularly hard-to-abate transport and residential/commercial heating sectors accounting for about 66% of covered emissions in 2022, CCA prices will likely have to move higher to achieve California's emissions reduction goals.
California policymakers expected to reduce emission caps in line with stronger climate ambition
In the wake of the legislative developments in 2022, we expect that steps will be taken during 2023 to tighten California's annual emissions caps, providing support for CCAs. Last summer, California's legislature passed a bill that set a 2045 climate neutrality target, as well as an explicit 85% emissions reduction target for that year (California Assembly Bill AB 1279). In November last year, the California Air Resources Board (CARB) completed a review of the state's 2022 Scoping Plan, a legislatively mandated document that outlines how the state will meet its carbon neutrality goal and must be updated every five years. The updated 2022 Scoping Plan calls for a 48% emission reduction target for the year 2030 vs.1990, which is significantly higher than the minimum mandated level of 40%. As cap-and-trade covers 80% of California emissions, it is a major policy mechanism to meet the state's increased ambition to reduce emissions. We expect that emission caps will be revised downward to help meet the new target. As shown in Figure 2, CLIFI expects that California's caps will be tightened starting in 2025 to line up with the new 48% target. This reduction will lower supply by about 8.7% in the impacted years 2025-2030 and will lead to meaningful annual net deficits, putting upward pressure on prices in the WCI ETS, where CCAs are trading.
California-covered emissions have exhibited slow declines that are not enough to meet the goals, with no low-hanging fruits remaining in power generation
While reduced caps will add upward price pressure to the market from the supply side, considerable pressure also exists on the demand side in California. Unlike Europe, where covered emissions can shift substantially from one year to another (whether upwards or downwards), California-covered emissions tend not to move very much. In the three years prior to the pandemic, total covered emissions moved by no more than 1% year-on-year, and we expect a similarly small decline in 2022 vs. 2021.
A major reason for this is that emissions from supplied transport fuels dominate the California market, making up about half of all covered emissions, and the progress towards emissions abatement in this sector is not easy. While California targets zero-emitting vehicles making up 100% of sales by 2035 to reduce transport emissions, consumers typically purchase new vehicles to replace older ones. Vehicles tend to last around 12 years, so even with ambitious sales targets, zero-emitting vehicles will make up a much smaller share of the fleet, estimated to be less than 20% of the light-duty fleet in 2030. Indeed, the emissions reduction included in California's Scoping Plan was driven by an assumed decline in overall transport activity, with a 25% reduction in miles traveled by light-duty vehicles by 2030 and no significant changes to the fleet. We see no evidence of such an ambitious change in lifestyle to occur. While electrification is a strong trend in California, we do not expect its impact to be material through 2030.
On the electricity generation side, California no longer has any coal-fired generation left in its system – thus, no low-hanging fruit for reducing emissions. New renewable builds are only moderately impacting gas-fired generation at this stage. In their latest long-term forecast, the US Energy Information Administration forecasted a roughly 1% average annual decline in gas-fired generation during 2023-2030 for the Pacific region, which also implies continued CCA demand. Similar to Europe, California's industrial emissions move with production, and CCA prices will need to rise to encourage new technologies to abate emissions.
There are new markets on the horizon that may join California and Quebec in the WCI framework. Washington's cap-and-trade program officially launched at the start of 2023, with negotiations to join the WCI set to start once CARB finishes its program review by year end. Washington will add about 50Mt to the WCI, sending a positive signal for the marketplace and providing a pathway for states like Oregon to join the joint emission exchange system.
RGGI: Market reforms and potential expansion during 2023
Upcoming RGGI market tightening expected
CLIFI expects the existing 11 RGGI states to take concrete steps to review and tighten the market as part of their Third Program Review later this year. The prior Program Reviews (in 2013 and 2017) saw the states lower annual emission caps, eliminate the oversupply that built up in the market's early years, and increase the market's auction price floors. We expect these issues to be addressed again in the upcoming program review, and based on our model, we expect the emission budget to tighten by 17% in the years 2026-2030 (through the 4th bank adjustment mechanism). This tightening is expected to add positive sentiment to market prices – even if the reforms themselves do not actually take effect for several years.
Positive demand signals from new market participants
The potential expansion of the RGGI market into new states is also supportive for prices. Prior market expansions, including when New Jersey re-entered the market in 2020 and Virginia entered the market in 2021, coincided with strong demand as entities in those states began purchasing a bank of allowances for both compliance and hedging. There is a high possibility that this fundamental demand will continue with the possible addition of Pennsylvania, which has been facing legal hurdles to finalize its program entrance for the last couple of years. Pennsylvania would increase the size of RGGI by 65% on an emissions basis, largely because its power generation fleet is very coal-heavy. However, the final certainty on Pennsylvania as well as legal challenges to Virginia's RGGI membership will be settled in courts later this year. North Carolina, sized at about 40% greater than Virginia in terms of emissions, is also taking steps to join RGGI.
The possible additions to RGGI (Pennsylvania and North Carolina) are more significant than a possible departure of Virginia, which looks increasingly like it will stay in RGGI after the Virginia Senate committee voted down the governor's exit proposal. As such, we see uncertainty in the RGGI market skewed more toward the upside.
2023 is a unique time to enter the carbon markets
Carbon markets remain poised for growth, despite geopolitical and macroeconomic factors. We reiterate our view that the current environment provides a great entry point into the compliance carbon markets. Crucially, each of the four major markets has either recently increased its climate ambition or is expected to do so soon. As we have seen, these ambitions face challenges and do not always align with projected emissions trajectories, making past decarbonizing trends harder to maintain or accelerate. As emissions caps tighten in the future, this disconnect is expected to create greater demand in the future from the emitting industries.
Meeting more ambitious climate targets will require more substantive emissions reductions from harder-to-abate sectors like heavy industry and transportation, though there are few readily available solutions. Traded carbon prices remain too low versus the cost of abatement technologies such as green hydrogen, CCS, and new biofuels and below most estimates of marginal abatement costs. Ultimately, prices will need to rise to reduce emissions and encourage the deployment of these technologies. Another fundamental factor, the production-driven demand, has been suppressed over the last year due to the global economic downturn. The macro-environment placed a damper on carbon prices across all regions, creating a unique opportunity to enter the markets at attractive levels. Since emissions across the regions are linked closely to the production levels, as the economies rebound in the next few years, we expect increasing demand pressure to provide additional steady support to carbon market.
Disclaimer:
The opinions expressed herein are those of Climate Finance Partners, LLC (CLIFI) and are subject to change without notice. Material within this article is not financial advice or an offer to purchase or sell any product. Past performance is not indicative of future results. Therefore, it should not be assumed that any specific investment or investment strategy made reference to directly or indirectly by CLIFI herein, will be profitable. CLIFI is an investment adviser registered under the Investment Advisers Act of 1940, as amended. Additional information about CLIFI is also available on the SEC’s Investment Adviser Public Disclosure website.
—Eron Bloomgarden, Oktay Kurbanov and Jeffrey Berman
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