Last Updated on August 15, 2023
It’s been several decades since we received the first reports about the concerning and critical state of air pollution. As measuring equipment continues to become more sophisticated and increasingly larger quantities of raw data are amassed, it’s becoming increasingly obvious that emissions are on the rise. Although many still debate the extent of humans have on the changing climate, going by the Kyoto Protocol and Paris Agreement, there is some level of consensus across the world. This also raises some questions about the sustainability of global industrial and economic growth.
Radically reducing carbon emissions requires tremendous sacrifice, which would certainly take a toll on both the current economy and its potential future. That’s simply not a risk most heads of state were willing to take, leading to some loopholes being added to agreements mentioned earlier. Chief among them is the free distribution and trade of emission quotas.
These so-called carbon credits are distributed to various countries by international organizations based on estimates of the likely emissions for each respective country. Once the quotas are set, they can be further distributed domestically by each country. The basic idea is that environmentally minded businesses would lower their emissions, thus creating a surplus that they can re-sell to other companies. This would force companies that produce high amounts of pollution to have higher operating costs, forcing them into a competitive disadvantage.
Although it seems plausible in theory, in practice, these quota estimates ended up being overly generous, allowing most companies to meet their emission targets with relative ease.
Looking at this from a trader’s perspective, we can see that there’s a rising number of companies looking to sell their credits while the demand for them has plummeted. The result of these circumstances is that carbon credit prices also dropped sharply. It’s no surprise that when carbon credits are cheap, companies are willing to spend a little extra to keep up or even increase their emissions. The invisible hand of the market once again shows that it’s a force to be reckoned with. On some level, this policy failure can be traced back to the fundamental unworkability of planned economies. Trying to control economic outcomes top-down through careful calculation is the same pitfall the USSR and most other communist countries fell into.
Initially, these quotas were traded Over The Counter (OTC) outside of the regulated markets; however, in the span of a few years, they were already available on various quasi-exchanges until finally, the Intercontinental Exchange (ICE) released its own official carbon credit futures. Pinning a trackable price on it was the final nail in the coffin for the original plan. As countries started publicly coming out with the numbers on how much they’ve saved, it became obvious that there was an overwhelming seller surplus. The fact that everyone was trying to get rid of it made it impossible to sell, and the market had practically no liquidity. This caused speculators to flee en masse. Once they left, liquidity dried up completely, resulting in quota prices dropping even further, completely collapsing it as a tradeable asset.
That being said, the emissions market is about to go through some major changes in 2020 that could completely alter the way it’s traded. The addition of a linear reduction factor would mean that allowance caps would continually diminish at a fixed rate. Instead of statically holding their value, they would depreciate on a yearly basis. This could affect the market in a similar fashion to how central banks often regulate the supply of money. When they sense that inflation is accelerating, they tend to tighten their interest rate policies, which reduces the amount of money in circulation and pushes down inflation. This type of solution could bring speculators back to the emission market, but it may also be necessary to create a new institution to support it. In this particular case, that’s the Market Stability Reserve (MSR), whose purpose is to act as a sort of market maker by draining the surplus from the quota market. Purchasing excess emissions also helps inject liquidity into the market.
News of the MSR’s creation could fundamentally revolutionize this market, and the wheels for it are already in motion. The price of the European Union Emission Allowance (EUA) ranged approximately from 3 to 7 euros in the first month of its creation; however, following the European Parliament’s decision to create the MSR, these prices jumped above 25 euros in 2019. This was mainly due to companies who are major producers of carbon emissions hurrying to buy up these futures in large numbers before these changes go into effect in 2020, including those with expiries up to as late as 2025. The revived interest in the asset also puts even more pressure on other companies to join. Could this be the first market segment where top-down government meddling produces an efficient outcome? Time will tell.
