• Alessandro Vitelli

Europe's Big Choke

It’s all gone rather quiet on carbon lately. Daily trading volume is down, intraday volatility has come right off and some traders are even taking holiday breaks.

Obviously the main reason for this is that carbon prices are now in a sort of vacuum, where they’re not high enough to trigger fuel switching from coal back to gas, but nobody seems to want to drive them significantly lower, because there’s still a long-term upward trend in place that’s a function of political ambition.

Some cracks are starting to appear in that ambition, though. This week European energy ministers met in Luxembourg to worry about rising energy costs and how to deal with them. It seems no decisions were made, but once again carbon prices came in for some abuse.

I’ve lost count of the number of times that people have pointed out that the current energy price “crisis” has nothing to do with the price of carbon. Just look at the price evolution!

Carbon is currently up by 77% on the year. Coal is 68% higher, electricity is up by 142% and natural gas has jumped by 245% over the course of the year. Even crude oil is up by 69% in 2021.

And you’re telling me that EUAs are the culprit for everyone’s rising energy bills?

There’s plenty of writing out there about the reasons behind current energy prices, and none of them point to carbon as a contributing factor. This is a natural gas story, pure and simple.

Yes, you could argue that it’s also an energy transition story, and that we’re in a stage of this revolution where coal is being forced off the grid and we are for the moment unusually dependent on gas. But carbon pricing is a symptom of this, not the cause.

However, politicians don’t seem to want to let the facts get in the way of a knee-jerk reaction. We’ve heard calls to “do something” about the high price of EUAs from Bulgaria, Poland, Czechia, France, Spain and Hungary, to name a few.

It feels as though the political leadership is choking, panicking even, and looking for any excuse in a scenario when there is in fact a very clear trail of accountability.

At the energy ministers’ meeting this week, Spain presented a “non-paper” (shared by Politico) that paid out a number of different ways to deal with the energy cost crisis. A lot of it was devoted to the gas market, but a significant portion at the end dealt with potential ways to “prevent financial speculation in EU ETS markets”.

(I’ll just add here that according to data from ICE Futures, investment funds – the most obvious candidates for the role of “speculator” – hold around 5% of all long positions in EUAs in Europe. “Commercial enterprises” – interpret that how you will – hold around 73% of all length.)

Spain’s non-paper reminds us that there exists a mechanism to manage extraordinary price volatility. It’s called Article 29a of the EU ETS Directive, and it sets out a vaguely-defined formula that defines when the market has risen too sharply.

I won’t go into the formula here; suffice it to say that nobody is absolutely certain how it works. But Spain thinks one option could be to “modify” the formula.

The non-paper also lists four other possible ways to intervene in the EU ETS.

Firstly, “limiting the number of excess emission allowances that can be purchased, as done in the Swiss and Californian Emission Trading System.”

California’s market does impose holding limits on physical allowances, but the limit is adjusted according to an installation’s emissions. As I’ve suggested before, though, this might not act as a deterrent to investors, who typically wouldn’t want to hold physical EUAs.

It might affect some large trading companies who happen to own physical assets in Europe, such a refineries, and who may use that compliance status to trade on their own account. But I’m not convinced that’s who Spain is really targeting.

To wit: the second option is “excluding speculative players from participating in the EU ETS market.” This appears to be fairly simple, but exactly who it would apply to is a matter of interpretation. As I just mentioned, quite a few “trading houses” also own installations that are covered by the EU ETS. How do you limit their participation, except by applying the Californian rule above?

Third, “limiting the validity period of emission allowances purchased, to avoid their use for

speculative reasons.”

When I’ve mentioned this to some stakeholders, their reactions have been the written or verbal equivalent of burying their head in their hands and groaning loudly.

If the EU hands out EUAs to industry, with a fixed term of eligibility, where is the incentive to reduce emissions? If you know that you have to use up all your EUAs by a certain date, surely your choices are either to use them or sell them. How long would the eligibility need to be to allow for an investment cycle to start to produce results, thereby freeing up more of these limited-lifespan EUAs to sell?

Anyway, how exactly does limiting the eligibility of physical EUAs prevent speculation in a futures market? And since when did the number of physical allowances distributed in any given year govern the actions of the futures market? Let’s just compare some fun numbers:


EUA Supply (mil)

Total trade volume in ICE front-Dec futures (mil)













The EU ETS already has mechanisms to deal with surplus allowances. They’re called the Linear Reduction Factor and the Market Stability Reserve. The first reduces the number of allowances handed out each year, in accordance with the ultimate emissions target set by the European Union. The MSR acts as a kind of janitor, sweeping up any surplus that might have been generated by unexpectedly rapid reductions, or changes in economic conditions.

Limiting the validity of EUAs effectively removes the long-term price signal from the market. Yes, it would deal with the issue of oversupply by periodically flushing the market of any remaining unused EUAs, but it would mean the market can’t set a 10 to 15-year horizon for planning, for investments.

Finally, Spain suggests “reinforcing the existing mechanisms to build a swifter adjustment to price fluctuations. This price target/range could be modified gradually and predictably over time, following a trajectory that is compatible with the EU’s emission reduction objectives.”

That’s beginning to sound dangerously like a price corridor. The European Commission has always steered very clear of anything like a price floor, ceiling or corridor, preferring to let the market do its work. Why change course now, now that the EU ETS has arguably actually started to work?

A price corridor would essentially act like a tax. You’d know – roughly – what your maximum liability would be in any given year, so there’d be no real incentive to hedge your compliance exposure or invest in reductions, since you’d know how much cost you’ll be passing through.

Next week more than 190 nations assemble in Glasgow for COP26, where they have to come up with ambitious new pledges to cut emissions, agree to fill the Green Climate Fund to its required size and, hopefully, carve out an agreement on how international carbon markets will work.

This isn't the most auspicious moment for Europe to lose its nerve and target the EU ETS as a convenient scapegoat. It’s no time to choke!

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