For companies that fail to accumulate enough allowances or reduce their emissions as a result, they face a fine of around 100 euros per excess tonne of carbon emitted, as well as the obligation to accumulate quotas in the coming years to cover those not covered in previous years. The system is structured such that there are significant penalties for participants who fail to meet emissions targets.
The benefits of using a ‘cap and trade’ system as a means of achieving carbon emissions targets are that it allows the market to determine how emissions can be reduced at the lowest cost to consumers. consumers and the economy. This means that the price of carbon is effectively set by the market through the supply and demand of allowances. Compared to more traditional methods of simply taxing carbon emitters, a “ cap and trade ” system offers much more flexibility and efficiency, resulting in reduced carbon emissions by businesses and operators. industries that will bear the least cost to do so.
First launched in 2005 as a pilot program, the Emissions Trading System is now in its fourth stage and has undergone several changes throughout its history. Phase 1 (2005-2007) was the test phase in which too many allowances were issued, which caused the price to drop to zero. This oversupply is in part due to the fact that companies themselves voluntarily overestimate their carbon emissions, thus allowing them to access a greater number of allowances.
Phase 2 (2008-2012) was also motivated by an oversupply of Phase 1 allowances and coincided with the Great Financial Crisis, both aimed at keeping prices low. On the other hand, phase 3 (2012-2020) made it possible to reduce the offer and increase the number of participants. Phase 3 was successful and established the EU ETS as one of the most effective measures in the world to tackle carbon emissions. The system is expected to further reduce supply and increase participants throughout Phase 4 (2021 and beyond).
What is important to note with regard to phases 3 and 4 is that the number of available quotas has decreased, the number of participants who were previously entitled to free credits is decreasing, and finally, the number of industries and countries included under the scheme is increasing. As it stands, 27 European Union countries are part of the program, as well as non-EU countries, Norway, Liechtenstein and Iceland. As I will discuss in the next section, the dynamics of supply and demand for the scheme indicate that the prices of these allowances are strongly biased upwards.
Dynamics of supply and demand
The current supply of allowances is what is known as the total number of allowances in circulation, or TNACs. This figure is currently set at around 1.4 billion tonnes of carbon emissions per year. The system’s emissions targets are a 43% reduction in emissions from 2005 levels when the system was launched. This implies a linear reduction in emissions of 2.2% per year from 2020 to 2030. TNAC will reduce accordingly in accordance with the emission reduction target. Simply put, the supply of allowances will decrease every year.
This creates a simple dynamic within the diagram; a reduction in supply coupled with an increase in demand. The system is biased towards higher prices. The advantage of the system is that it creates incentives to increase the prices of allowances for almost everyone involved. The higher the price (i.e. the higher the cost of carbon emission), the more companies have an incentive to hold credits and therefore less greenhouse gases are emitted. In addition, governments not only have an environmental incentive for higher prices, but because the sovereign governments of the many countries involved in the program are the ones who actually distribute allowances to participating companies, they receive revenue directly through the auction. to do this. Again, higher prices equate to higher incomes.
To some extent, the quotas themselves are viewed by participants as a store of value. They are aware that prices will increase, they are aware that the supply of allowances will continue to decline and they are all required to hold enough allowances to carry out their activities as they are. There is little incentive to sell. Analyzing this supply and demand dynamics from a stock-flow perspective as one would for gold, bitcoin or other scarce assets again presents a favorable outlook for price. Also, unlike gold or bitcoin, it is in the interest of governments to see prices rise. The system is defended by government policy rather than an alternative to government policy.
To give an idea of how the supply and demand dynamics of the system will work in the years to come, Lawson Steele of Berenberg Bank, one of the world’s leading experts on the EU ETS, is projecting a cumulative supply deficit of about 99% in 2024! If such projections were modestly true, there would be a huge increase in the price of allowances in the years to come.
However, it should be noted that the EU is somewhat wary of a too rapid rise in prices and has put in place measures to combat such a rapid rise in prices if it were to be too damaging for the companies involved in the process. ‘ETS. If necessary, policy makers (will attempt) to intervene through what is known as the Market Stability Reserve (MSR), as well as the possibility of modifying the supply of allowances as defined by the Article 29a of the ETS.
The MSR is essentially a feature of the system that controls an over or under supply of allowances. Introduced in 2019, the MSR strives to reduce supply (i.e. TNAC) when there is an abundance of allowances, and increase TNAC when there is a potentially shortfall in allowances. detrimental. The idea behind the MSR is to allow prices to rise smoothly with minimal volatility.
Likewise, Article 29 bis of the scheme directive obliges decision-makers to monitor the dynamics of supply and demand and to intervene by reducing or increasing supply if deemed necessary. While the purpose of Article 29 bis is again to try to get prices to rise in an orderly fashion, the actual rules it contains are murky in nature and very open to interpretation. In addition, the many sovereigns concerned will want different prices depending on their industries included in the ETS, thus creating in some way a potential conflict of interest between the participants and thus increasing the difficulty of intervention via Article 29 bis. .
While the most important risk is an excessive rise in prices to the point that policymakers deem it appropriate to intervene, such a risk could be considered insignificant given that prices must go up first to justify such intervention. To be clear, policymakers most certainly want higher prices. These measures are more aimed at achieving these higher prices in an orderly manner. Ultimately, the priority of the program is to reduce GHG emissions, and if the price has to go up to achieve that, so be it.
Techniques and means of negotiating
To top it off for EU carbon allowances, it’s the technical aspects. The allowances themselves can be traded on the futures market. This US futures market has a market capitalization of nearly $ 300 billion with a significant level of liquidity.
From a long-term technical standpoint, the recent breakout of the decade and the base model remain immensely optimistic.