Why the European carbon price can no longer be ignored
The EU carbon market was reformed in 2017, meaning the price of carbon permits has soared over the past year. We look at the industrial impact and what this could mean for climate change.
The EU carbon market was reformed in 2017, with the objective of reducing oversupply. That reform certainly succeeded. The price of EU carbon emission permits has quadrupled in 12 months, to a much more impactful level. After years of not having to worry about the price of carbon, industries included in the scheme are facing a completely new environment.
The most obvious initial effect has been on wholesale power prices. Coal and gas plants have to pay the higher carbon costs, so this gets built into their pricing. As a result, power prices have risen across the continent.
Chart 1: European CO2 emissions price versus the German power price
Source: Bloomberg: ELGBYR1 Index, EECXSYR1 Index
Chart 2: German power price built up for coal based plants (Eur/MWh)
Source: HSBC, TR Datastream
The second major effect of high carbon prices is that demand for coal and gas shifts. This is of course, intentional. Coal releases double the amount of CO2 as burning gas. The economics of burning each fuel therefore change dynamically with the price of carbon.
A third, and much less appreciated effect, is that operators of heavy industries such as steel, cement, and chemicals, face higher costs for inefficient business practices. A high cost of carbon creates a shift in profitability towards the most efficient operators in each industry, and incentivises investment in upgrades or more efficient new plants.
As businesses’ conviction in the sustainability of high carbon prices grows, they are increasingly likely to invest in emission-reducing equipment. The cement industry is a good example of this dynamic.
Because of a (largely justified) fear of import substitution by overseas producers with no carbon costs, the cement industry received free allocation of carbon permits for their entire European production volumes when the emissions trading system (ETS) was initiated. This allocation turned into a surplus of permits after the financial crisis, when production declined, and so the industry has been sitting on a pile of surplus permits that they can either hold or sell to realise a windfall profit. However in 2021 a new phase of ETS permit allocation begins, and the EU sector will lose approximately 25% of its free allowances. At spot carbon prices, this represents 12-13% of industry profits. The charts below illustrate the period of excess emission permit allocation, and the emerging deficit even before the permit allocation is cut by 25% in 2021.
Chart 3: Cement sector carbon emissions and free allowances (mt CO2)
Source: Redburn, EU compliance log
Chart 4: Yearly and cumulative value of cement sector carbon surplus/deficit at average prices (Em)
Source: Redburn, EU compliance log
The cement sector therefore appears set to become a significant net buyer of carbon emission permits. The implications of all this for the industry are likely to be inefficient capacity rationalisation, higher prices, more capital investment, and higher carbon prices.
To find out more about how company profits and investor returns could be at risk from tougher climate policies and higher carbon prices, read about our “Carbon Value at Risk” (Carbon VaR) framework here.
To find out more about our Climate Progress Dashboard - which monitors progress being made towards decarbonising the global economy - click here.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.