Author Details

Hitendra D Varsani

Hitendra D Varsani

Executive Director, MSCI Research

Rohit Gupta

Rohit Gupta

Senior Associate, MSCI Research

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Introducing the Carbon Market Age

  • The carbon market can play a significant role in the decarbonization of the global economy by putting a price on carbon and giving polluters an incentive to reduce their emissions.
  • Carbon markets have grown to a market value of USD 270 billion, placing it on the radar of institutional investors as an investable asset class.
  • Global macroeconomic forces have impacted carbon prices in the short run, but the long-term outlook for carbon markets and their contribution toward the net-zero transition remains constructive.

Financial markets continue to be influenced by investors, companies and governments striving to limit the effects of climate change. Consequently, the carbon market — where emission credits are purchased and sold, and derivatives are traded — has been rapidly expanding. The carbon market is now tracked and traded like any other commodity, with the market’s potential being an important driver of global economic decarbonization by pricing carbon and incentivizing polluters to reduce their emissions.

 

Carbon markets for a net-zero transition

Carbon markets are categorized as either voluntary carbon markets (VCMs) or compliance carbon markets (CCMs), which are significantly different to each other in terms of regulations, impact and market size, among other factors.

VCMs are unregulated markets that enable individuals, firms, governments and nongovernmental organizations to buy carbon offsets from project developers on a voluntary basis to achieve carbon compensation and neutralization. Compensation includes environmentally and socially useful projects to avoid further carbon emissions and support new technologies, resulting in less carbon emissions. Neutralization includes carbon-emission-reduction projects using natural (e.g., reforestation) and technology-based carbon-capture and -storage techniques. Companies can voluntarily purchase carbon offsets, certified by private standards, as part of their sustainability strategy. The size of VCMs is still relatively small, with approximately USD 1 billion of carbon offsets traded in 2021,1 currently lacking scale for institutional investors. Also, a lack of high quality (environmental and social integrity of projects) carbon offsets have held back the growth of this market.2

CCMs are also referred to as emissions-trading systems (ETS) or cap-and-trade programs. They are marketplace mechanisms where regulators auction off, or distribute for free, a limited number of carbon allowances to various regulated companies. Each carbon allowance typically allows its owner to emit one ton of a pollutant such as CO2. Firms that are more efficient in their emission reductions can sell unused allowances to companies that need to purchase allowances for excess emissions. The idea behind carbon markets is that once the price of carbon has been internalized efficiently, the regulators allow the market to optimally decide the usage of their resources (buy credits vs. reducing emissions) with a lever to reduce the overall supply of emission allowances gradually.3

There are approximately 30 ETS implemented globally, covering 38 national jurisdictions4 with a market value of approximately USD 270 billion.5 Some of the biggest such systems are EU ETS, North America (WCI and RGGI) and U.K. ETS. The market value of global compliance carbon credits traded in 2021, which was approximately EUR 760 billion, or USD 851 billion, up 164% from 2020 on higher carbon prices and a modest surge in volumes.6 Interestingly, EU ETS comprised approximately 90% of the entire global carbon credits turnover in 2021, making it the most liquid and developed ETS systems in the world. Shown below is the timeline of EU ETS carbon prices presented in four phases of market development.

 

Timeline of EU ETS carbon price

A timeline of the EU Emissions Trading Systems price changes since 2011.

Sample period: Jan. 18, 2011, to May 31, 2022. EU ETS carbon price is based on 12-month constant-maturity futures prices.

 

Different phases of EU ETS

Phases Overarching Theme
Phase 1 (2005-07) Phase 1 was a three-year pilot phase aimed to create an infrastructure for the free trade of carbon and establish its pricing mechanism. This phase was marked with lower carbon prices as supply exceeded demand in the absence of reliable emissions data.
Phase 2 (2008-12) The pilot phase (Phase 1) served to create headways in recording verified direct emissions data which proved to be useful in phase 2. Using the emissions data, regulators created an emissions cap for various firms and reduced the carbon allowances supply. However, 2008 global financial crisis resulted in dampened economic activities leading to lower demand for carbon allowances driving carbon prices down.
Phase 3 (2013-2020) The oversupply of carbon allowances in phase 1 and 2 laid the foundation of this phase which mainly focused on regulating the excess supply. This phase experienced an increase in carbon prices on the back of reforms such as "backloading", Market Stability Reserve, annual reduction of carbon allowance cap etc.
Phase 4 (2021-2030) The fourth phase introduced more stringent policy measures to reduce the carbon emissions for e.g. the allowances supply cap will reduce at a higher rate of 2.22% every year, compared to 1.74% earlier. This phase also focused on providing funding mechanisms for low carbon innovations to help energy-intensive sectors in their transition to low carbon economy.

 

Carbon allowances traded in primary and secondary markets

Carbon allowances are traded in both primary and secondary markets. Regulators typically auction, or distribute for no cost, allowances to regulated entities through primary markets to comply with their emission limits. Once regulated companies are allotted an allowance, they can trade it in secondary markets (in line with their emission requirements) using both spot or derivatives contracts such as futures, options and swaps. A view of the various stakeholders involved in compliance carbon markets is shown below.

 

Compliance carbon markets’ trading flow

A chart that details the four phases of EU ETS including themes.

 

Short-term turbulence in carbon prices

Amid various uncertainties in the current global macroeconomic environment — characterized by high inflation, concerns over economic growth and surges in energy prices — one thing that may have gone unnoticed is the recent volatility in global carbon prices and its breakdown in correlation with the price of oil. Following the Russian invasion of Ukraine and subsequent international sanctions on Russia, carbon prices in the EU ETS7 witnessed a steep decline of ~40% from EUR 97 to EUR 58 during the first quarter, before recovering during the latter half of March. The correlation between carbon and oil, which is typically positive, turned to -0.27, as detailed below.

 

Rolling 3-month correlation between returns of Brent crude oil and EU ETS carbon price

The correlation between brent crude oil and EU ETS carbon price returns.

Jan. 18, 2011, to May 31, 2022. EU ETS carbon price and Brent crude-oil price are based on constant-maturity futures prices.

 

Europe is dependent on Russian fossil fuels, in particular gas, and given uncertainties around various economic sanctions on Russia and their impacts, carbon markets got shocked due to the increased volatility in energy prices. As various European countries started exploring a transition back to coal-based power plants to meet their energy requirements, many would have expected higher carbon prices due to increased demand for carbon allowances. However, EU carbon prices pulled back sharply for a brief period in March 2022, potentially due to the following reasons:

  • Liquidity: A broad market sell-off across various asset classes during the Russia-Ukraine war may have triggered some investors to liquidate carbon positions. The open interest for the EU carbon futures contracts (expiring Dec. 22 and 23) trading on the Intercontinental Exchange did come down to ~545,000 contracts as of March 7, 2022, from its year-to-date peak of ~567,000 contracts as of Jan. 18, 2022.8
  • Economic headwinds: Concerns around a potential recession and lower economic activity may have resulted in decreased demand for carbon allowances resulting in lower prices.
  • Supply: Distribution of 2022 free allocations.

Despite the recent carbon-price volatility, the EU regulators are committed to the full implementation of “Fit for 55” proposals, under which it aims to reduce the net greenhouse-gas emissions by at least 55% by 2030 compared to 1990 levels.9

 

Zero to hero

The idea behind carbon markets is that once the price of carbon has been internalized efficiently, regulators allow the market to optimally decide the usage of resources through buying credits or reducing emissions. Key to this rapidly growing market is its link to global warming and the attainment of net-zero emissions. In an ensuing blog, we will discuss the applications and use cases of carbon derivatives as an emerging asset class in portfolios.

 

 

 

1“Carbon Markets Year in Review 2021.” Refinitiv.

2"Phase II Report Summary." Taskforce on Scaling Voluntary Carbon Markets, July 8, 2021.

3As of 2020, EU ETS emissions were reduced by 43% from their 2005 levels. For more details, please see: Nissen, Christian, et al. “

4According to World Bank data, as of April 1, 2021.

5Jiang, Betty, et al. "Carbon Markets: The Beginning of the Big Carbon Age." Credit Suisse.

6Carbon Markets Year in Review 2021.” Refinitiv.

7The EU ETS is the world's first major carbon market and remains the largest one.

8“Carbon Markets Year in Review 2021.” Refinitiv.

9“REPowerEU: Joint European action for more affordable, secure and sustainable energy.” European Commission, March 8, 2022.

 

 

Further Reading

Foundations of Climate Investing

Low Carbon 𝙖𝙣𝙙 High Liquidity for Bond Investors?

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