Supply and Demand Dynamics in Carbon Allowance Markets: The Inflection Point and Beyond

By Oktay Kurbanov, Partner at Climate Finance Partners (CLIFI)

Introduction

Supply and demand dynamics play a pivotal role in determining price direction in various markets, and carbon allowance markets, which are an integral part of the Emission Trading Systems (ETS), are no exception. However, there are specific elements of supply and demand that are unique to carbon markets, as we discuss in this paper:

- The supply side is controlled by the regulatory bodies that are subject to government policy goals such as climate goals, energy transition, and revenue generation.

- The initial phases of the ETS operation tend to be over-supplied to ensure adoption and avoid negative economic impact on the in-scope industries.

- As ETS markets mature, they reach an inflection point, evolving from an over-supplied to under-supplied market due to annual reductions of emission caps and regulatory reforms intended to further reduce supply.

The last point is particularly relevant to the carbon allowances markets today, as major carbon markets have witnessed a steady progression along this path, moving from the over-supplied to under-supplied phase. This trend is present in each of the most liquid, tradeable markets[1]: EU ETS, UK ETS, California ETS, and the Northeastern US Regional Greenhouse Gas Initiative (RGGI).[2] Driven by ambitious carbon neutrality goals, each of these regions has either recently undergone or is currently undergoing tightening regulatory reforms of the ETS that combine aggressive annual emission cap reductions and additional measures to reduce excess supply (“bank”).

We believe this supportive tightening supply-demand dynamics makes carbon allowance markets an attractive investment as prices need to increase significantly to balance the market with a decreasing net supply. We illustrate the points above in greater detail by focusing on two major markets: the European Union and California ETS. However, the analysis and conclusions in this paper also apply to the UK and RGGI ETS.

Supply as Expression of Policy Priorities

The supply side of the ETS is determined by the regulatory agencies and is set in advance many years ahead. Currently, all major carbon compliance markets have supply side trajectories approved through 2030.[3] The supply is expressed in the annual emission caps placed on a given ETS region (annual emissions “budget”). Additionally, there are regulations that specify how this annual budget is to be injected into the market:

1. Free allocations that award carbon allowances to certain industries to ease migration to explicit pricing of greenhouse gas (GHG) costs to avoid the risk of these industries fleeing to non-ETS regions (“leakage”), allow utilities to aid the ratepayers, or spend saved funds on energy transition.

2. Government auctions where emitters must buy any additional allowances to cover their emissions. These auctions occur on a quarterly basis in North America, bi-weekly in the UK, and daily in the EU. The auctions are open to all market participants, including compliance and financial players.

3. Additional regulations that affect auction amounts:

– Funding special-purpose programs, such as EU Innovation and Modernization funds, or the REPowerEU initiative to fund energy transition

– Reintroduction of previously unsold auction allowances

– Mechanisms to withdraw excess allowances from auctions

The above is a simplified view of the budgeting process, but it gives a sense that the government has many “levers” to manage the supply. These levers are subject to periodic review and revisions, and the governments use them to ensure that the ETS acts as a guiding mechanism to steer the economy toward carbon-neutrality by gradual and steady reduction of the supply. EU Commissioner for Climate Action, Wopke Hoekstra, called EU ETS the “crown jewel and the working horse” of EU climate policies and law, and an “extremely powerful” tool to achieve EU’s 90% emission cut by 2040 vs. 1990 levels.[4]

ETS are also a critical funding tool to support energy transition policies, supplement member state budgets, and assist low-income communities. ETS auctions raised more than $190 billion since inception, with the annual revenue reaching $55 billion in 2022[5]. To illustrate this point, the below chart shows the auction revenue use in California:

Figure 1. Auction Revenue Use in California Cap-and-trade System, $B

California Climate Investments program puts billions of dollars to work reducing GHG emissions, strengthening the economy, and improving public health and the environment, especially in disadvantaged communities. Ratepayer Protection includes such programs as climate credits for ratepayers, energy efficiency, renewable energy, building and transportation electrification, and building decarbonization. [6]

The above discussion illustrates a very important feature of the ETS: the governments have incentives and means (through the regulatory review process) to tighten the supply in the ETS as part of achieving their policy goals. They also have a vested interest in a gradual price appreciation to ensure steady revenue stream to fund energy transition and social programs. California’s Cap-and-trade system, for example, has been amended eight times. In the most recent update of the program, “2022 Scoping Plan”, California’s Air Resource Board (CARB) highlighted both the emission reduction and price appreciation elements of the ETS, envisioning it as “a well-designed system that continues to send a steadily increasing price signal, minimizes for leakage, reduces emissions in the covered sectors toward the state’s targets.”[7]

Supply Evolution: EU ETS

EU ETS started its first compliance phase in 2008, marking the launch of the largest Cap-and-trade system in the world, now covering about 38% of the EU economy. [8] In its early stages, through 2013, it went through a consistent period of oversupply driven by two major causes. The 2008 financial crisis knocked the European economy off-course, suppressing industrial output and, therefore, the demand for emission allowances. Another contributor to oversupply was lenient regulation on the usage of offsets to reduce compliance obligations. The offsets included both Clean Development Mechanism and Joint Implementation Credits, both of which were in great supply and priced very low, incentivizing their use. As a result, the combined effect was 2 billion tons of oversupply accumulating in the EU ETS system by the end of 2013, representing about one year’s worth of annual emissions cap.

Generally, regulators welcome some oversupply in the early stages of the ETS to ease the transition of the power and industrial sectors toward a carbon-pricing economy. However, the regulators observed a concerning correlation between the EUA price decline and the increase in oversupply in the system – something that started to threaten the effectiveness of the ETS. As one can see from Figure 2 (top chart), EUA auction prices declined from about €22 at the beginning of the first compliance period in 2008 to €6.5 at the end of the period in 2012, depreciating 70%. The drop in prices was matched by an increase in excess supply over the same period, as illustrated in the bottom part of Figure 2. The white bars on the lower chart show the reduction of demand for allowances due to offsets each year, as emitters used them to reduce their compliance obligations (orange bars, shown as emissions net of offsets). For example, in 2012, offsets reduced emissions-related obligations by a stunning 25%.

Figure 2. EUA auction prices (top) vs. supply-demand dynamics (bottom) in EU ETS, 2008-2016

Sources: CLIFI, ICIS, ICAP

As the regulators recognized the need to address the oversupply to ensure the ETS effectiveness, they introduced restrictions on the offsets, which included quality controls and limits on their use. Additionally, the regulators removed 900 million tons (Mt) from the auction supply in the years 2014-2016. As one can see in the graph above, these steps stabilized the prices during the period from 2013 to 2016, with the year 2013 becoming an inflection point in the supply-demand dynamics as the oversupply started its steady decrease in subsequent years.

In the subsequent years, the EU ETS continued introducing further measures to tighten the supply:

- Decision to fully disallow the use of offsets in the EU ETS in the Compliance Phase 2021-2030 (“Trading Phase 4”, or “TP4”)

- Establishment of a Market Stability Reserve (MSR) that absorbed the above-mentioned 900M allowances and, from 2019 onward, removed 12% of excess allowances from the supply each year, which later was amended to the 24% level up until 2023.

- “Fit for 55”, a comprehensive set of regulations accelerating EU-wide emission reductions in 2030 vs. 1990 from 40% to 55%, including more aggressive annual emission cap reductions combined with one-off cap reductions by 90Mt in 2024 and by 27Mt in 2026, and an extension of the aggressive 24% withdrawal of excess allowances into MSR through 2030.

The EUA market responded positively to these measures, as one can see from Figure 3 below:

Figure 3. EUA auction prices, 2017-2023

From 2017 through 2023, EUA auction prices appreciated at an annualized rate of 40%, lifting the EU ETS market from the extended period of low single-digit prices to the levels that started to create real incentives for the power and industrial emitters to decarbonize, thus addressing the policy goals. With these measures implemented, the EU ETS excess supply (“cumulative surplus”) is projected to continue its downward trend through 2030, as seen in Figure 4:

Figure 4. EU ETS Supply / Demand Balance of Allowances

Outlook: EU ETS

As the projections in Figure 4 show, the EU ETS market is expected to run into significant supply shortages closer to the end of the decade. This will bring forth the natural evolution of the EU ETS market from over-supply earlier in its operation to a tightly balanced market by the end of the decade. The decreasing over-supply is the net result of two counter-acting forces. On one side, the European Union is aggressively moving toward greener energy sources. To facilitate this transition, the EU launched the REPowerEU initiative to raise €20 billion by bringing forward sales of allowances slated for future years, with about 250 million of extra allowances auctioned in years 2023-2026 in addition to the regular auction volume.[9] Additionally, Europe has been going through an economic downturn, with gross domestic product (GDP)[10] declining to 0.7% in 2023.[11] Combined, these recent developments have placed downward pressure on demand, causing weak price performance in 2023-2024.

On the other side, as these themes play out in the short term, they expect to revert, leading to tighter supply-demand dynamics. Starting from 2027, the auctions will be deprived of those 250Mt allowances sold in the 2023-2026 period as part of REPowerEU. The economy is expected to start getting back to the trend growth of about 2% from 2025 onward. Additionally, the introduction of the Carbon Border Adjustment Mechanism (CBAM), which essentially exports the European cost of carbon by levying a carbon tariff equivalent to what the manufacturer would pay if regulated under an ETS, is expected to increase hedging demand, which may total up to 90Mt by the end of the decade. [12] Combined with Fit-for-55-related supply decreases, these developments are expected to turn around the EUA price performance and lead to significant price appreciation, as shown in Figure 5 below:

Figure 5. EUA Price Forecasts

Sources: CLIFI, BloombergNEF, Energy Aspects, ICIS, Macquarie, Morgan Stanley

Considering current weakness of demand, EUAs are expected to end 2024 in the €60 to €75 range, down from €80 at the end of 2023. However, after two years of weak performance, EUAs are expected to appreciate significantly through the end of the decade, rising to the €120-140 range, with an expected annual return of around 12.5%. This trajectory will be in line with the gradual elimination of excess supply and the policy objective of steady price appreciation.

Supply Evolution: California ETS

The California ETS (“CA ETS,” a.k.a. “Cap-and-trade”) is a key element of the state’s climate ambition, covering 75% of its emissions. It is the second-largest carbon allowance market, with its first auction held in 2012. As is the case with the EU ETS, the CA ETS excess supply evolved over an arched trajectory since the launch of the program. There are a couple of key differences that changed the shape of this arch for California. First, learning lessons from its European counterpart, the California Air Resource Board (CARB) put strict limits on offsets use from the start. In the first three compliance periods, 2013-2020, offsets use was limited to a maximum of 8% of the emitter’s total compliance obligation. This limit was decreased further down to 4-6% in the 2021-2030 period. Secondly, the Cap-and-trade introduced an explicit floor on auction settlement prices (“auction reserve price”). This price floor was initially set at $10 with an aggressive annual increase of 5% plus inflation (as measured by the Consumer Price Index).[13] While the system experienced an increase in excess supply in its early years, the combination of these two measures ensured the stability of the prices and a minimum level of price increases year-on-year. One can see this dynamic in Figure 6 below:

Figure 6. CCA auction prices (top) vs. supply-demand dynamics (bottom) in CA ETS, 2013-2020

Sources: CLIFI, ICAP, CARB, Clear Blue Markets

The Cap-and-trade has been accumulating excess supply since inception, which reached 275Mt in 2020. In the subsequent period, California’s legislature started its work to increase emissions reductions in the ETS to align it with the updated 2022 Scoping Plan that outlines specific steps to achieve the state’s carbon neutrality by 2045:

- The 2022 Scoping Plan set an accelerated emissions reduction target of 48% in 2030 versus 1990 levels compared to the prior target of 40%. The ETS system is expected to tighten its emission budget to match this goal. This updated target will translate into an additional 150Mt removal from the emissions budget.

- CARB started to consider ways to remove excess supply in the Cap-and-trade. The removal of excess supply would happen through a combination of reducing price ceiling reserve accounts, auction amounts, or free allocations.

- Emissions measurements using updated 2022 methodology for prior periods resulted in lower emissions numbers, leading CARB to further reduce supply by an additional 115Mt to account for this adjustment.

These measures are expected to come into effect starting in 2025, after the completion of the legislative process in 2024. Collectively, these measures would remove about 20% from the 2025-2030 emissions budget, and with a potential introduction of an explicit excess removal mechanism like the MSR in the EU ETS, this number could reach 30%.[14]

As the supply reduction measures are expected to be implemented, the Cap-and-trade’s excess supply will go through the inflection point, tilting back toward zero starting in 2024 and beyond:

Figure 7. CA ETS Supply / Demand Balance of Allowances

Outlook: California ETS

As seen in Figure 7 above, California’s ETS is expected to run into a deficit by the end of the decade, which will prompt prices to increase to balance supply and demand. To analyze the impact of ETS tightening on prices, CARB contracted UC Davis to evaluate scenarios with emission reduction targets of 40%, 48%, and 55% by 2030. The results were presented at the November 16, 2023 webinar, where, for all scenarios, the conclusion was that the prices are expected to break the price containment levels and potentially the price ceiling level by 2030 – depending on the speed of depletion of the excess supply, as market participants are expected to tap into price containment and price ceiling reserves by the end of the decade.[15] For more background, California has implemented the Allowance Price Containment Reserve (APCR) designed to help prevent price spikes by unlocking allowance reserves at set tier price levels set at $56.20 for Tier 1 and $72.21 for Tier 2 in 2024. If the two reserve tiers are depleted, entities can then buy allowances at the price ceiling to fulfill their emissions obligations (set at $88.22 in 2024). Similar to the floor price, the tier levels and price ceiling increase by 5% plus the inflation rate. Market analysts share conclusion of UC Davis researchers and predict the CCA prices to reach the Tier 1 level and potentially above by the end of the decade, as seen in Figure 8 below.

Figure 8. CCA Price Forecasts

Sources: CLIFI, IMF, BloombergNEF, Clear Blue Markets, Macquarie

This conclusion is not a surprise given the aggressive measures to decrease excess supply. As the changes to the program are finalized and made into law in 2024, analysts expect a significant price appreciation through the end of the decade as CCAs trend upwards toward the Tier 1 price containment reserve level (green line, increased by 5% + inflation each year). This convergence is expected to deliver about 12% of annual price appreciation from 2024 onward based on the median forecast scenario, with CCA prices rising to the $85-95 range by the year 2030, or double the expected 2024 levels. This dynamic is another example of the natural evolution of supply and demand, leading to the tightening in the later stages of the ETS and to price appreciation.

Conclusion

Our analysis of EU and CA ETS showed that both markets have undergone evolution from excess surplus in the early years of the program to the inflection point where this accumulated excess starts its gradual decrease. This inflection point happened in 2013 for the EU ETS, and since then, EU ETS has faced consistent annual shortages in supply versus demand, a trend that is projected to nearly eliminate the surplus by 2030. The CA ETS is going through this inflection point right now, with annual deficits expected to start in 2024, increasing in magnitude by 2030 as the Cap-and-trade reforms are implemented. This type of supply-demand dynamics is typical and is present in the UK and RGGI ETS as well from the inception through the end of this decade:

Figure 9. UK and RGGI ETS Supply / Demand Dynamics

Sources: CLIFI, ICIS, Clear Blue Markets

Similar its European Union counterpart, the UK ETS has recently revised its regulation to tighten supply. As part of its plan to achieve net zero emissions by 2050, the UK government reduced the 2021-2030 ETS emissions budget by 30%, with the 2030 emission cap decreasing by 58%.[16] Additionally, the government stated its intent to develop a UK equivalent of the Carbon Border Adjustment Mechanism (CBAM) by 2027, which will further support tightening of the market due to increased hedging demand. On the RGGI side, the ETS is undergoing its Third Program Review, with the discussion focusing on various scenarios to achieve carbon neutrality post-2030, considering scenarios of net zero by 2035 and 2040 through more ambitious emission budget cuts.[17] This is expected to tighten the remaining 2024-2030 ETS emissions budget by 4-10%, with the 2030 emission cap decrease of 10-30% depending on the adopted scenario.

These observations across major markets illustrate the natural evolution of the supply-demand dynamics in the ETS systems, where the excess supply tends to go through an arched trajectory: increasing in the early stages of the ETS operation, reaching an inflection point, and decreasing steadily afterward as respective jurisdictions introduce tightening reforms. The tightening trajectories of the four major compliance markets present a particularly attractive investment opportunity. As the cumulative excess supply shrinks and gets closer to zero and into deficit, the prices of carbon allowances are expected to rise significantly to avoid an imbalance. We believe these supply and demand dynamics have the potential to deliver rewarding returns to investors.

[1] Source: Bloomberg, data as of 3/31/2024. Measured by daily futures volume.

[2] As of 3/7/2024, RGGI includes 10 participating Northeast and Mid-Atlantic states: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont.

[3] With a caveat that these supply-defining regulations are subject to periodic revisions as discussed below

[4] Bruegel, Conversation with Commissioner for Climate Action, Wopke Hoekstra, on 2040 EU climate target, 2/13/2024

[5] See Oktay Kurbanov, “Carbon Pricing: Investing in Climate Action”, Table 2, for greater detail

[6] Source: CARB, “Auction Proceeds by Fiscal Year or Auction Quarter”

[7] Source: CARB, “2022 Scoping Plan for Achieving Carbon Neutrality”

[8] Source: ICAP, data as of 2021

[9] European Commission

[10]GDP: measures the monetary value of final goods and services produced in a country in a given period of time.

[11] Bloomberg, “Euro Zone Unexpectedly Avoids Downturn But Struggles Persist,” 1/30/ 2024

[12] Source: CBAM, ICIS

[13] Consumer Price Index (CPI): used as a metric for inflation, as it measures of the average change overtime in the prices paid by consumers for a basket of consumer goods and services.

[14] Sources: CLIFI, CARB, “Cap-and-tradeCap-and-trade Program Workshop”, 7/27/2023

[15] CARB, Joint Cap-and-Trade Program Workshop, 11/16/2023

[16] UK Government, “Developing the UK Emissions Trading Scheme: Main Response”, June 2023

[17] RGGI, “Regional Greenhouse Gas Initiative Program Review”, 9/26/2023