Carbon Markets: Trading to Stop Climate Change

By Elizabeth (Lisa) Zelljadt, Senior Analyst, Point Carbon

Every morning Mike walks into his London office and logs on to the Intercontinental Exchange, where he and most of his colleagues do all their work. He surveys the news for major political developments related to greenhouse gas emissions, then checks current and forward prices of fuels, and throws an eye on the weather. Finally, he sells or buys a few hundred thousand tons…of carbon.

Mike is a carbon trader, one of many financial sector workers who specialize in a commodity that is like pork bellies, scrap metal, or crude oil contracts—but was created entirely by an environmental policy called cap-and-trade.

With all the hype in the news, most people know how cap-and-trade works: regulators set a tonnage limit on the amount of pollution—a cap—that declines over time, and then allocate enough permits to equal the cap. Each permit is worth one metric ton of carbon dioxide equivalent (tCO2e). Emissions from all the entities covered by this cap cannot exceed that limit collectively, but on an individual basis, each can cut its carbon output in whatever way works best.

Making the right to emit a ton of CO2e into a tradable commodity puts a price on emissions. To avoid paying that price, everyone tries to avoid emitting—by becoming more efficient, investing in renewable energy, switching to lower-carbon fuels, etc.

While we are still discussing whether and how to do this here in the US, Europe has had an active carbon market for five years. That’s where Mike comes in. Mike’s daily routine shows that, just like any other commodity, carbon is subject to fundamental price drivers:

He checks out the weather because if there’s a cold spell, power plants will be generating more electricity for heating. This creates more emissions, which increases demand for permits to cover those emissions, which in turn raises their price. He looks at the relative prices of coal and natural gas because if the latter is cheaper, power companies are able run cleaner gas-burning plants more often and coal-fired plants less, causing fewer overall emissions and thus lower demand for permits, which lowers their price. Policy is one of the biggest price drivers, which is why Mike keeps up with the trade press. If someone from the European Commission hints that the next phase of the EU’s trading program will be really strict, you can bet the carbon price will go up.

Is it working?
While cap-and-trade aims to cut emissions at the lowest overall cost to society, the environmental goal is of course to cut the most possible emissions. The key there is getting that overall cap tight enough – make it too loose, and emitters won’t have an incentive to reduce. If the cap is even higher than business-as-usual emissions, the system is called “overallocated,” meaning there are more permits than emissions. That’s what happened in the pilot phase of the EU Emissions Trading System (EU ETS) in 2005-2007: regulators set what seemed like a reasonably strict cap, but then it turned out emissions levels were a lot lower than assumed, so the program offered more permits than needed. This graph shows how the market reflected that reality: the price of a permit (a European Union Allowance or EUA) went down to zero.

Figure 1. Prices in the EU ETS, 2004-present
Front year contracts for phase 1 and 2

(Source: Point Carbon)

But the graph also shows that regulators learned from this pilot phase – they made the caps tighter in the current phase of the trading program, which started in 2008 and goes through 2012. Permits were not bankable between phases. Prices have dropped because the recession inherently cut emissions, but they are not going to zero.

The recession illustrates how hard it is to know whether the EU ETS is “working.” While Europe’s emissions have definitely been decreasing, it’s hard to determine how much of that is due specifically to the carbon market; the ETS covers only power and industry, not other greenhouse gas sources like agriculture or vehicles. Nonetheless, covered entities increasingly say the EU ETS has caused them to cut emissions. Results of a survey released at our 7th annual Carbon Market Insights conference last week shows most participants in the EU ETS have cut carbon in their company, especially the larger emitters.

EU ETS and internal abatement
Companies covered by the EU ETS. N=368 (2010)

(Source: Point Carbon)

Whether the US will follow suit in this endeavor remains to be seen. There are already several traders like Mike in North America dealing with emission reduction credits. Although establishing a similar program on this side of the Atlantic would take carbon trading to a new level, it would not be reinventing the wheel or plunging into unknown territory—especially in the power sector, the players would not be entirely new to the game. Stay tuned for our next posting about the potential for such a US carbon market and the politics around it.

Elizabeth (Lisa) Zelljadt is a senior analyst in Point Carbon’s Trading Analytics and Research division, where she focuses on North American federal and regional climate policy as well as international negotiations. She also coordinates Point Carbon’s educational programs in North America.

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5 responses

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  2. Very well written and interesting post! It really will be transformational once carbon is traded here in the US under a federally mandated system. Despite the legislation taking way too long, the opportunity to learn from how the Europeans set up their ETS will pay off big time when the political climate is finally warm enough for us to jump into the game. Let's just hope that the actual climate isn't overheated by that time! I'll be right there with you following the unfolding carbon regimes at and on twitter @CarbonCapitalst. Keep up the good work!

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