Carbon trading: A young and exciting market
By Dan Atkinson
15:02, 10 May 2019
Legend has it that a very bright student was once asked to write an essay on “the future of coal”, with the expectation being that he would produce an erudite argument on the prospects for this important fuel source.
Instead, he wrote just one word: “Smoke.”
Decades later, it is precisely the fact that coal and other fossil fuels produce smoke and other fumes – carbon emissions, in the jargon – that has so alarmed policymakers and led to a series of agreements to try to reduce the rate at which these “greenhouse gases” are being pumped into the atmosphere and contributing to climate change.
Science knowledge not required
One such agreement was the 1997 Kyoto Protocol which, alongside containing commitments for industrial countries to reduce their greenhouse-gas emissions, provided the opportunity for countries to trade among themselves any “spare” permitted carbon emissions. Countries with a surplus of these carbon permits could sell them to those who needed more.
In due course, as governments distributed these permits – also known as credits – among companies whose greenhouse-gas generation meant they would need them, a secondary market in carbon trading sprang up as surplus companies sold on credits to firms needing to cover excess emissions.
In short, carbon credits have become a commodity, little different from any other. But even some experienced traders have difficulty accepting this, given that – looked at one way – the permits are simply state-manufactured pieces of paper relating to the exhaust of factory chimneys far away.
But there was a time when the notion of, for example, a financial services “industry” grated on the ear. No more.
For the novice trader, the first fact to appreciate is that carbon emissions trading requires precisely no knowledge of climate science or the technicalities of environmental pollution, any more than gold trading calls for a degree in mine engineering.
Carbon credits comprise a market that is driven, in the main, by the same factors as any other market – supply and demand. Yes, there are one or two ways in which it departs from this norm, of which more in a moment.
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Growth is a key
So, what are the pros and cons of carbon trading? First, the basics. Carbon emissions, essentially the “right to pollute”, are traded in blocks of 25 tonnes of carbon emission. That may sound a lot but is very broadly the annual output of the average household.
Emissions trading has grown rapidly for a market that is just over 20 years old. From $47 billion in 2008, the carbon market is now worth more than $80 billion. Carbon credits are traded both on established markets, such as the Chicago Mercantile Exchange, and newer forums, such as London’s Carbon Trade Exchange.
Regardless of the carbon trade exchange, big investment banks have become involved in carbon trading.
As with many, if not all, commodities, the price of carbon-emission credits is driven in large part by the outlook for economic growth. An upbeat mood in terms of likely economic expansion is likely to lift the demand for carbon permits as businesses need to cover the extra emissions likely to be generated when factories, vehicles and other carbon-intensive facilities step up the pace.
With surplus credits being eagerly bought by businesses in need, the price will rise.
A reverse effect goes into operation when economic growth either slows or is thought likely to do so. As industry battens down the hatches, its emissions are likely either to stabilise or fall of their own accord. The result is that those with surplus credits may find far fewer takers, and the price is likely to decline.
Where are we now? Take a look at our carbon trading graph:
In short, like it or not, economic growth pollutes the environment. A recession, however, has the benign side-effect that the air is, for a while at least, cleaner than it would otherwise have been.
The price has surged
In this regard, the price of carbon permits rises and falls in much the same way as that of copper or oil. But there is a very big difference.
Copper, oil, coal or anything else are “natural” markets in that there is an unforced demand for the commodities in question. People and businesses need them regardless of official attitudes.
But the carbon-emission market is an artificial construct based on government-issued permits. This has a number of consequences for those trading carbon credits.
The first is that, should the scheme work as intended, then, over the long term, the permits ought to become steadily less valuable, as businesses become cleaner and need fewer carbon credits. Thus, there could be seen to be a steady downward bias in the market.
Second, the European market operates within an overall “cap” on carbon emissions set by the European Union, setting a ceiling on greenhouse-gas emissions. But key to EU carbon trading is that, over time, this cap is being reduced in order to bring down total emissions.
In other words, the workings of the market contain inbuilt official interference, albeit prompted by the highest motives in terms of environmental protection. All things being equal, this ought to make permits increasingly expensive, as the right to pollute will become more valuable, in part compensating for the downward bias mentioned above.
Third, political intervention does not end here. For the scheme to work as intended, carbon credits need to be relatively costly, in order to dissuade companies from emitting carbon and to prod them into seeking new, low-carbon methods of operation.
But the financial crisis and subsequent Great Recession acted, as we mentioned earlier, to reduce growth and so the need for carbon credits. With a large number of surplus permits sitting on the market, the European Commission announced that, as of this year, a large number would be removed.
The effect on the price was notable. From about €4.50 a tonne in the spring of 2017, the carbon trading graph shows the price, spurred also by energy demand during last summer’s heatwave, is currently over €25 a tonne.
So, carbon trading is a hybrid market, partly driven by supply and demand and partly by political objectives. But this ought not to deter the novice trader. After all, much the same could be said about the currency markets.
Trading carbon credits is best approached by focussing on the prospects for growth, the key influence on short-term movements, while keeping a weather eye on any new pronouncements or proposals from the European Commission or elsewhere.
This is a huge and exciting market. Good luck!