What’s Driving Unprecedented Growth in Carbon Markets
By Oktay Kurbanov and Eron Bloomgarden
The concept of pricing carbon was introduced less than twenty years ago, when the first carbon allowance market launched in 2005 in Europe. Today, there are 68 carbon pricing initiatives across the globe, which is more than double of what it was ten years ago.[1] This growth reflects increasing regulatory support and political momentum for urgent action on climate change. Carbon pricing is often the central mechanism policymakers use to address climate change. With a combination of carbon taxes and Emissions Trading Systems (ETS) increasingly covering a large portion of global emitters, carbon pricing initiatives now cover 23% of global greenhouse gas (GHG) emissions, as seen in Figure 1 below.
While tremendous progress has been made establishing and growing Emission Trading Systems, there is room for greater advancements and progress. According to the High-Level Commission on Carbon Prices, a UN and World Bank-backed initiative, "carbon prices encourage producers to decrease the carbon intensity of the energy and industrial sectors and manufactured products, and consumers to choose less carbon-intensive goods. By creating opportunities to increase profitability or lower operation costs by reducing greenhouse gas emissions, carbon pricing also promotes innovation and incentivizes the generation of new ideas and solutions." To achieve this objective, the International Monetary Fund (IMF) and Organization for Economic Cooperation and Development (OECD) report on tax policy and climate change has estimated that to limit global temperature increases to 1.5 degrees Celsius (as called for in the Paris Agreement), a carbon price of $144 is needed by 2030.[2] This is much higher than the average price of global emissions, $30.[3]
The target carbon price levels from the IMF/OECD report closely relate to the cost of abatement technologies in the marketplace. While carbon prices remain well below abatement levels for technologies such as those needed to transition to green hydrogen or carbon capture and sequestration, the switch to new technologies will be slower, leading to lower emission reductions by industrial polluters. This, in turn, will keep demand for carbon allowances high, while the supply will shrink as Emission Trading Systems reduce their caps every year, with more sectors potentially coming in scope and competing for allowances. This creates a supply/demand imbalance that puts upward pressure on prices to achieve equilibrium.
As geopolitical, inflation and economic uncertainty rattled global markets in 2022, carbon allowance markets have demonstrated their resiliency and diversifying value. The largest carbon allowance market, the European Union ETS, stayed nearly flat, while the EuroStoxx 50 index tracking Eurozone blue-chip companies was down close to 12%[4]. Globally, the IHS Markit Global Carbon Index, which tracks the futures of the four major global carbon markets to create a single global reference price for carbon, was down in single digits, 8.5%, outperforming the MSCI World index which declined by 17.7%[5]. This steady performance comes in the wake of a record year for carbon allowance markets in 2021, when all major carbon allowance markets, including the European Union ETS and the California’s Cap-and-Trade, experienced significant gains. The IHS Markit Global Carbon Index returned an extraordinary 107% annualized return in 2021[6].
As these markets become more established globally, carbon allowances have become an increasing area of focus for institutional investors. This white paper seeks to be a resource to help investors understand the dynamics of carbon allowance markets, the potential portfolio diversification benefit of a portfolio allocation, as well as the impact case for investment in carbon allowances.
I. Where are the largest tradable carbon allowance markets globally?
The four largest and most liquid carbon allowance markets are the European Union ETS, the United Kingdom ETS, the California Cap-and-Trade program, and the Regional Greenhouse Gas Initiative (RGGI) covering the Northeastern United States. These markets have had an aggregate traded volume of more than $700 billion in 2022, more than tripling in size over the last three years (Figure 2):
European Union Emissions Trading System (EU ETS)
The European Union Emissions Trading System is the oldest, largest, and most liquid carbon market globally. Launched in 2005, the EU ETS consists of the EU's 27 member states (and three European Economic Area states) and covers 40% of the region's GHG emissions. Over 12,000 entities participate in the ETS across power, industrial, agricultural, and aviation sectors. The price per ton of carbon has fluctuated over the past decade, with a significant increase in the last five years. Total EU ETS emissions have dropped by 762 million tCO2e (36%) since the program's inception. Figure 3 shows the declining cap in the EU market, the price impact on generally declining emissions, and the trajectory of the supply and demand.
EU ETS Market Mechanics
The EU ETS has several mechanisms to control dramatic price volatility as carbon allowance supply is reduced. From 2021 to 2030, 57% of carbon allowances are intended to be auctioned at market price to compliance actors, determined by supply/demand dynamics, with the remaining allocated for free to the industrial sectors. The number of free allocations will be reduced over upcoming years: aviation will transition away from free allowances from 2024 through 2026, while industrial entities will phase out from 2026 through 2034. This will increase transaction volume and liquidity as companies will have to buy these allowances at auctions or secondary markets.
After a period of meager prices, the European Commission implemented the Market Stability Reserve (MSR) to help avoid extreme market volatility. The MSR holds allowances out of the auction when excess volumes are available on the market and reinjects them when there is low circulation. There is no predetermined price floor or ceiling; however, this mechanism creates stability in the market and improves resilience to future spikes in supply/demand. In December 2022, the European Union finalized a set of sweeping reforms (“Fit for 55”) to align the EU ETS with the goal of reducing the European Union’s emissions by 55% vs. 1990. This will be accomplished by reducing annual supply of auctioned allowances by one off reductions of 90Mt in 2024, 27Mt in 2026, acceleration of annual cap reduction schedule, and targeting a decrease of 62% of the annual emission cap in 2030 vs. 2005 (the first year of the ETS). The stricter emissions, reductions targets will drive a shortage of allowances in the market, theoretically driving up the price and making carbon emissions more expensive.
Since 2013, the EU ETS has raised over €100 billion, which accrues to EU member states – about 75% of which is used for climate and energy-related purposes[7]. Integration of this secondary revenue-generating benefit into long-term infrastructure development reduces short-term policy risk.
EU ETS Market Liquidity
The EU ETS is the most liquid carbon allowance futures market. This market has experienced total notional trading volumes of about $630 billion in 2022 and has grown exponentially in recent years, increasing by more than 4 times since 2018. As shown in Figure 4 below, the price of EU ETS carbon allowances has increased dramatically over the same period, which has amplified the program’s recognition among media outlets and commodity investors.
United Kingdom Emissions Trading System (UK ETS)
The United Kingdom Emissions Trading System is the newest national cap-and-trade market, which was established after the UK’s exit from the European Union. The market was designed to resemble the EU ETS in all its key parameters, including auctioning off a large share of allowances, a market stability mechanism, and a cost-containment mechanism. This is one of the reasons why the recent price trajectory of the UK ETS market has been similar to the EU ETS, as one can see on Figure 5:
Trading volume and liquidity are considerably less than in the EU ETS, which is not unusual given that the EU ETS is 10 times larger than the UK market. Nevertheless, the UK ETS had a strong start, with the trading volume almost doubling in 2022 vs. 2021, and UK carbon allowances rising from £45.00 at the market's opening in May 2021 to about £74/ton as of March 2023.[8] The UK ETS is currently undergoing a regulatory review to align it with the UK’s 2050 net zero target. It is expected that the emission budget for the 2021-2030 period will decrease by 30-35%, and the 2030 cap will be reduced to about 50Mt vs. the current level of 118Mt[9]. The tighter emissions budget will provide strong price support due to reduced supply of carbon allowances.
California Cap-and-Trade Program
California has always been at the forefront of climate policy. State goals have historically been higher than US Federal regulations in clean air, clean fuels, and environmental protection. Established in 2013, the California Cap-and-Trade Program is a key element of the state's climate plan, developed under the framework of the California Global Warming Solutions Act of 2006 (Assembly Bill 32).
The program started in 2013 and currently covers approximately 85% of the state's GHG emissions[10], with the emission cap decreasing from 307.5M in 2022 to 200Mt in 2030 as seen in Figure 6. There are approximately 450 covered entities across the sectors of large stationary sources, electricity generation (including imports), fuel distributors, and large industrial facilities.[11] Emissions covered under the Cap-and-Trade program fell in 2020 from the impact of the COVID-19 pandemic. 2020 covered emissions decreased from 311 MMTCO2e in 2019 to 278 MMTCO2e in 2020; however, the state recovered in 2021, with the economy growing 7.8% and covered emissions increasing 4.9% from the prior year[12]. As California’s economy is returning to growth, the Cap-and-Trade program is a key policy tool to ensure this growth occurs with low emissions intensity, consistent with its goal of net carbon neutrality by 2045. Figure 6 illustrates the trajectory of emissions, emission caps and prices in the Cap-and-Trade program:
California Cap-and-Trade Program Market Mechanics
The objective of the California Cap-and-Trade program is to provide a market-based price signal that drives the energy transition with innovation and with a mechanism that minimizes the risk of entities leaving the system.[13]
The California Cap-and-Trade program maintains a restrictive lower price floor that increases by 5% plus inflation year-over-year. The price floor ($22.21 in 2023) sets the minimum price for carbon allowances in the auctions. A percentage of reserve allowances, 3.7%, is set aside into two carbon allowance reserve tiers or Allowance Price Containment Reserves (APCR) for sale in reserve auctions. If a previous auction settlement price exceeds 60% of the reserve trigger price, they are offered. The APCR is designed to contain prices should the demand for carbon allowances exceed auction supply. The APCR tier prices also increase at the same annual rate as the price floor.
The emission cap shrinks by 4% annually, leading to a proportional shrinkage in free carbon allowance allocations. In the second half of this decade, free allocations to the industry will fall below 50-60% of entity annual emission obligations, increasing the auction and trading activity as companies will have to secure more allowances.
The auction mechanism acts as a righting mechanism for any reduced allowance demand. In 2020, the COVID-19 pandemic negatively impacted prices in the emissions market, and prices fell to a low of $12 on the ICE secondary market. The following two auctions of 2020 were undersubscribed, and carbon allowances from those auctions were withheld from the auction supply. Following two oversubscribed auctions, the withheld carbon allowances were re-introduced. By this time, CCA prices had recovered to above $20.
This price recovery, along with a diminishing free allocation and program cap, has attracted increasing financial participation with a "buy and hold" strategy, adding more upward price pressure. The market once traded within a dollar above the price floor, and it now sells over $5-7 dollars above[14].
The increasing value of carbon allowances has resulted in greater revenue to help the state achieve its climate goals. In FY 2021-2022, the auctions generated a record revenue of $4.5 billion, compared to the average of $2.7 billion in the prior four years[15]. This revenue is used by the California's Greenhouse Gas Reduction Fund which invests in low carbon transportation, infrastructure, and disadvantaged communities. Like the EU ETS, capital from California's Cap-and-Trade program is earmarked for long-term infrastructure development, reducing downside policy risk.[16]
The California Cap-and-Trade Program will be reviewed this year to make it consistent with the updated Scoping Plan that was approved in December 2022. The plan has increased California’s ambition for emission reductions from 40% to 48% by the year 2030 vs. 1990. The review is likely to lead to a tighter emissions budget starting in 2025.
California Cap-and-Trade Program Market Liquidity
The ICE CCA futures market saw trading volumes of ~44.5 billion in 2022. Market liquidity has improved dramatically post-2019 as market makers and hedge funds have moved into the market, signaling an increasing interest in carbon as an asset class. As seen on Figure 7, CCA futures prices have increased over the recent period, with the bulk of the gains concentrated in 2021, when increased financial participation turned the overall market sentiment bullish.
Regional Greenhouse Gas Initiative (RGGI)
Established in 2005, the Regional Greenhouse Gas Initiative (RGGI) was the first ETS in the US, as an agreement between seven states in the Northeast. The initiative has since grown to eleven states (Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, Vermont, and Virginia). In the absence of a mandatory federal carbon market, RGGI was created as an alternative to allow state governments to take climate action. It was predicted that member states would increasingly use the market-based RGGI framework to meet climate objectives. The framework is built for regional expansion, broader industry coverage, the creation of more stringent targets, and increased demand for carbon allowances, ultimately contributing to the rise of prices over the next several years.
RGGI covers the state's power sector emissions from generators larger than 25MW, which make up approximately 19% of the region's total GHG emissions from 217 fossil fuel generators.[17] Currently, RGGI emission caps are reduced by about 4% each year. Below, Figure 8 displays RGGI's actual emissions through 2022, the base carbon allowance budget, and the carbon allowance prices. The step-up in emissions caps in 2020 and 2021 is driven by expansion of the ETS to include New Jersey and Virginia, respectively.
RGGI Market Mechanics
RGGI employs internal mechanisms to control price volatility and limit supply, including such mechanisms as the auction price floor, Emissions Containment Reserve (ECR) which acts as a soft floor, and Cost Containment Reserve (CCR) which acts as a soft ceiling. The auction price floor for 2023 was set to $2.50 and is set to increase by about 2.5% every year. A more relevant price support feature is the ECR price level, set higher than the auction floor. The supply of allowances will automatically be reduced by 10% if prices fall below the ECR trigger price, which was set to $6.87 for 2023 rising at 7% per year. The CCR mechanism acts as a damper on prices and releases additional carbon allowances to the market when predefined price ceilings (trigger prices) are hit. A CCR trigger price was set to $14.88 in 2023, increasing by 7% per year.[18]
The generous 7% annual increase allowance for the CCR level reflects a desire by states to see a steady carbon price appreciation to incentivize energy transition and generate a consistent revenue stream. Since the program's inception, $4.8 billion in revenues have been collected and returned to RGGI states. The revenue is used for funding consumer benefit programs: energy efficiency, renewable energy, direct energy bill assistance, and other greenhouse gas reduction programs.[19]
The RGGI market continues to expand. The potential addition of Pennsylvania and North Carolina will bring traditional fossil fuel giants under the ETS framework. RGGI is a multi-state program and tends to be less aggressive in pricing carbon emissions. The rate of GHG emissions in RGGI has decreased faster than that of the cap. Significant investments into offshore wind, battery technology, and ambitious electricity sector net-zero goals by RGGI states will boost renewable energy and further reduce carbon emissions. Acknowledging this trend, RGGI has taken measures to ensure a proper balance of supply and demand in the market by introducing three adjustments to decrease supply of allowances. Combined, these adjustments reduced supply by 235Mt or by 20% of the original emissions budget in the 2014-2025 period[20]. Further tightening measures are expected as RGGI launched its third Model Rule review to be finalized by the end of 2023. These developments should continue to be a supporting factor for RGGI prices.
RGGI Market Liquidity
The RGGI futures market has had total notional trading volumes of roughly $5.8 billion in 2022. In 2022, non-compliance investors bought 32% of auctioned carbon allowances, while the total number of participants increased by 10% in 2022 vs. 2021. The potential addition of Pennsylvania[21] and North Carolina[22] will include more participants under the ETS framework, further increasing market liquidity. Active interest in RGGI market provided support to prices in the volatile 2022 year, as June 2022 auction price settled at $13.90, just below the CCR level of $13.91. Figure 9 shows recent performance of RGGI futures:
II. Portfolio Diversification
Given the growth and liquidity in the largest markets, many investors are now considering the potential portfolio implications of an investment in carbon allowances. As a newer area of focus from the investment community, carbon allowances stand out for their continued growth potential and low correlation to major asset classes. Let us look at how carbon prices performed versus traditional asset classes since the inception of the IHS Markit Global Carbon Index, from August 2014 through March 2023. Table 1 shows return and risk statistics for carbon allowances and other key asset classes over the period, while Table 2 shows correlations:
Over the past 8.5 years, global carbon allowance prices have returned over 25% annually with a realized volatility of around 30%. While delivering higher Sharpe Ratio than equity markets, carbon allowances also exhibit 2x volatility risk compared to equities. Market dynamics partially explain the high volatility in response to supply-demand factors, making carbon allowances behave similarly to commodity markets, which exhibit significantly higher volatility than equity markets. The amplified market response to new information may also be a factor due to the low penetration of financial actors, who typically bring stabilizing effects in commodity-like markets. The latter point may indicate that fundamental signals are primary drivers in these markets. The comforting factor is that carbon allowance futures have exhibited a low correlation to other asset classes: 0.32 to equities, 0.05 to bonds and 0.31 to commodities (Table 2). Consequently, the diversification benefits of carbon allowance exposure can more than compensate for the commodity-like volatility in a portfolio context. To demonstrate that, let us see what happens to a traditional equity portfolio represented by the S&P 500 if one allocates 5% to carbon allowance futures, using the same historical data as above. Table 3 presents the results, where the first column shows the original equities portfolio, the second column shows this portfolio with a 5% allocation to carbon allowance futures, and the third column displays the percent change in performance statistics:
One can see that due to the low correlation of carbon allowances with equities, the combined portfolio decreases its volatility by 1.6%, while the expected percent change in the annualized return is increasing by 7.9%, with the Sharpe Ratio increasing by 8.7%.
Similarly, let us see what happens to a more conservative portfolio with 60% in equities represented by the S&P 500 and 40% in bonds represented by the Bloomberg Barclays US Aggregate Bond Index ("The Agg"). Table 4 presents the results, where the first column shows the original 60/40 portfolio, the second column shows this portfolio with a 5% allocation to carbon allowances, and the third column displays the percent change in performance statistics.
While the risk to the portfolio stays at nearly the same level, both the annualized return and the Sharpe ratio increase by a significant percentage change of 13.9%.
Another angle to the diversification benefit is that the world is recognizing increased social costs of GHG emissions and climate change. The investment in carbon allowances may act as a hedge for the portfolios of companies exposed to the increases in the cost of emissions. Companies that pay a low price at present may face much higher costs in the future, with their profitability exposed to carbon price increases. At the same time, the rise in costs of carbon emissions is expected to drive up carbon allowance prices, providing hedging benefits to the portfolio.
One should note that the above examples were deliberately simplified for illustrative purposes, while the real-life allocation decisions may be more involved and complex. Nevertheless, they indicate the potential benefits of carbon allowances as an asset class that provides an attractive proposition for portfolio diversification.
III. Impact Investing: The Case for One Ton of Carbon Emissions and Investment in Carbon Allowance Futures
On top of being a potential portfolio diversifier, it is also worth examining investment in carbon allowance futures from an impact investment lens. Investing in carbon allowance futures supports liquidity and efficiency in the largest and most heavily traded emissions markets. Additional financial participants buying and selling increases the market's efficiency in doing what it does best: effectively allocating resources. These markets have a significant impact on reducing CO2 emissions.
The emission trading systems discussed in this paper have been instrumental in enacting positive climatic change - namely, reducing GHG emissions - in their respective regions. To view a summary of emissions reductions, please reference Table 5 below.
On a macro basis, establishing a carbon allowance price provides a valuable benchmark that will raise awareness and, in due course, cause a change in planning and behavior at all levels of society, business, government, and individuals (carbon footprint pricing). On a micro basis, an investment in carbon allowance futures will contribute to reducing carbon emissions by providing capital and liquidity to the underlying system designed to reduce carbon emissions efficiently.
IV. Conclusion
Carbon markets have come a long way over the last twenty years, and we expect to see these markets continue to grow and develop. 2022 was a test year for carbon markets, as governments’ commitment to decarbonization was tested by geopolitical turmoil, energy concerns and economic pressures. Looking back one can say with confidence that carbon markets passed this test with flying colors, as we witnessed several significant achievements reflecting increasing regulatory support and political momentum. Highlights from the last year included Europe strengthening and tightening its compliance market with the final agreement on the "Fit for 55" package in December, a commitment of the UK ETS to significantly tighten its emission caps, California’s 20% increase of its emission reduction ambition and its commitment to leverage its Cap-and-Trade program as a major policy tool. In addition to the continued policy support behind them, carbon markets proved once again their resilience and diversifying value in a difficult year by outperforming equity markets, with the IHS Global Carbon Index outperforming MSCI World by 9.2% in 2022. We also observe continued expansion of carbon markets. In North America, the state of Washington held its first carbon allowance auction in January 2023, and in February 2023 New York state announced its intention to launch an economy-wide cap-and-invest program[24] to help achieve its goal of 40% emission reductions by 2030 vs. 1990. As part of the EU ETS reforms finalized in December 2022, the maritime shipping sector emissions will be included starting in 2024, and a new ETS for transport and buildings was set to start in 2027. Similarly, in March 2023 the UK government stated that it is exploring adding new ETS sectors such as waste and maritime shipping to achieve its carbon neutrality goals[25]. As carbon programs mature and expand, carbon allowances are emerging as a unique and investible asset class with significant growth potential, diversification benefits, and a positive impact story.
[1] World Bank State and Trends of Carbon Pricing 2022
[2] IMF/OECD (2021), Tax Policy and Climate Change: IMF/OECD Report for the G20 Finance Ministers and Central Bank Governors, April 2021, Italy, https://www.oecd.org/tax/tax-policy/tax-policy-and-climate-change-imf-oecd-g20-report-april-2021.pdf. EUR/USD FX rate used for the USD target carbon price is from Investing.com as of 4/30/2021, the report issue date.
[3] The World Bank, Carbon Pricing Dashboard, https://carbonpricingdashboard.worldbank.org/map_data, 2022
[4] Source: Investing.com
[5] Source: SP Global, MSCI
[6] Source: SP Global, Global Carbon Index
[7] European Commission, “EU Climate Action Progress Report 2022”, 10/26/2022
[8] Source: ICE
[9] HM Government, “Developing the UK Emissions Trading Scheme (UK ETS)”, March 2022
[10] https://ww2.arb.ca.gov/sites/default/files/cap-and trade/guidance/cap_trade_overview.pdf
[11] https://icapcarbonaction.com/en/?option=com_etsmap&task=export&format=pdf&layout=list&systems[]=45
[12] CARB Cap-and-Trade Program Data: https://ww2.arb.ca.gov/our-work/programs/cap-and-trade-program/cap-and-trade-program-data, Bureau of Economic Analysis
[13] https://ww2.arb.ca.gov/our-work/programs/ab-32-climate-change-scoping-plan/about
[14] Source: CARB auction data, ICE carbon allowances prices
[15] Source: CARB, “Auction Proceeds by Fiscal Year or Auction Quarter”, California Climate Investments
[16] https://lao.ca.gov/Publications/Report/4480
[17] https://sgp.fas.org/crs/misc/R41836.pdf
[18] https://www.rggi.org/program-overview-and-design/elements
[19] https://www.rggi.org/investments/proceeds-investments, CLIFI
[20] https://www.rggi.org/program-overview-and-design/elements
[21] https://www.dep.pa.gov/Citizens/climate/Pages/RGGI.aspx
[22] https://www.nrdc.org/experts/luis-martinez/north-carolina-moving-forward-climate-regulations
[23] UK was part of EU ETS from 2005 through 2020. For historical purposes, the table uses EU ETS emissions attributable to UK.
[24] https://www.nyserda.ny.gov/About/Newsroom/2023-Announcements/2023-1-10-Governor-Hochul-Unveils-Cap-and-Invest-Program
[25] HM Government, “Carbon Budget Delivery Plan”, March 2023