Carbon to Rise Past Record on Tighter EU Climate Goals

The cost of carbon emissions is likely to rise further past the record it broke Friday after European Union leaders endorsed their most ambitious proposal yet for slashing pollution.

Leaders of the 27-nation bloc backed a more aggressive 2030 emissions-reduction target and approved a $2.2 trillion stimulus package, almost a third of which will be spent on climate-related projects.

The message from policy makers to several thousand companies in the EU Emissions Trading System is clear -- switch from fossil fuels to cleaner energy because the pollution limits are only set to get more strict. That’s likely to boost the cost of carbon allowances past the record of 31.30 euros a ton reached on Friday after the deal was agreed.

“We are bullish for 2021,” said Trevor Sikorski, head of natural gas and carbon research at Energy Aspects in London. “We expect price rises to head up to 40 euros by the end of the year.”

BloombergNEF analysts said 40 euros is achievable by the mid-2020s. Carbon permits fell 1.2% to 30.53 euros on Friday.

Carbon to Rise Past Record on Tighter EU Climate Goals

EU will propose detailed measures on how to align the carbon market with the European Green Deal next year. They will come shortly after the program enters a new trading phase in January, marked by already tighter supply of permits.

The 15-year-old EU ETS is the region’s flagship climate policy tool, covering emissions by power producers and manufacturers from Renault SA to ThyssenKrupp AG. It ensures emissions are being reduced by controlling the number of allowances, which are predominantly sold to companies at auctions. Those who emit less can sell their unused permits to those who need more providing a financial incentive to cut pollution faster.

Pollution caps shrink every year, forcing emitters to invest in renewable energy sources and cleaner technologies. Under the Green Deal, the shift away from fossil fuels will need to accelerate significantly for Europe to meets its goal of reaching climate neutrality by the middle of the century.

By 2030, EU leaders want the region to step up carbon reductions to at least 55%, compared with the current goal of 40%.

The EU carbon market has already driven significant emissions cuts in the power sector. CO2 pollution fell 15% last year as renewables displaced fossil fuels from the energy mix. Now the challenge will be to decarbonize heavy industry, a more complex task requiring significant investment in new and unproven technologies.

That will also affect the market structure and pricing in the EU program. With a shrinking amount of free permits given to manufacturers, companies will need to decide if they want to invest in abatement measures or buy allowances, according to Ingo Ramming, head of corporate and investor solutions at Commerzbank AG.

Carbon to Rise Past Record on Tighter EU Climate Goals

Emitters will get more clarity on how the policy makers intend to bolster the EU ETS in June, when the European Commission plans to unveil a package of draft regulations to reach the stricter 2030 target under the Green Deal.

The EU regulatory arm is considering several options, including a one-off reduction in the pollution cap and increasing the pace at which emission limits shrink every year. The annual decline is 1.74% in the current trading phase until the end of this year and 2.2% from 2021.

Another possibility is strengthening a special reserve that automatically controls the supply of permits bringing in a tighter emissions cap earlier. The Market Stability Reserve, which absorbs excess allowances from the market, was agreed in 2017 to revive a floundering carbon market after a glut of permits kept prices at a low level for much of the last decade.

Over the past three years, the price more than quadrupled. The upcoming revamp of the market could even push the cost of pollution to as high as 80 euros by 2024 should the EU opt for the most aggressive set of measures to tighten the market, BNEF said.

While such a scenario is not feasible politically, prices are still likely to rise to around 40 euros by the middle of the next decade, said Jahn Olsen, head of EU carbon at BNEF.

Short-term

Beyond the broader policy picture, there are short-term changes in the market that will keep boosting the cost of pollution. From Monday there isn’t likely to be an auction of permits until late January or early February, restricting supply. Free allowances will also be distributed to companies later than the end-February deadline to as late as the second half of 2021.

Europe’s growing climate ambition and the rising cost of pollution is also spurring a discussion about the entry into the market of long-term institutional investors. The Green Deal will overhaul the region’s entire economy, from agriculture to transport and the design of cities. The commission wants to extend the market into shipping and is thinking about the inclusion of road transport and the building sector.

“Increasing CO2 costs across society is very inflationary and high inflation risks need to be hedged,” said Ariel Perez, at Hartree Solutions. “This is ultimately what will bring big, long only investors to the market like pension funds or insurance companies.”

©2020 Bloomberg L.P.

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