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EUA ong-term price drivers stem from regulatory supply decisions with a singular objective: meet the bloc’s climate objectives thanks to the EU Emissions Trading System (ETS). Short-term price dynamics, on the other hand, can be influenced by temporary supply adaptations, or by fluctuations in energy markets.
Carbon markets are not complicated to understand, yet EUAs are a complex asset class. They are influenced by multiple factors from different backgrounds. Long-term price drivers stem from regulatory supply decisions with a singular objective: meet the bloc’s climate objectives thanks to the EU Emissions Trading System (ETS). The gradual reduction in EUA supply consistently drives prices upward - they are an asset designed for price appreciation. On the demand side, scientific and technological advancements that enhance industrial efficiency can play a role in shaping long-term EUA demand. Short-term price dynamics, on the other hand, can be influenced by temporary supply adaptations, or by fluctuations in energy markets.
A cap-and-trade scheme is a policy tool designed to make polluters pay for their CO2 emissions. The aim is to incentivize companies to reduce their carbon output by making them adopt more sustainable technologies as carbon prices increase. As a regulatory tool, mechanisms like the EU ETS are constructed with the purpose to meet the climate goals set by policymakers. In Europe, this means achieving carbon neutrality by 2050 and reducing carbon emissions by 55% by 2030 (62% for installations covered by the EU Emissions Trading System).
In the long run, the driver for the appreciation of EU carbon prices is the supply schedule set by regulators. To meet climate objectives, regulators bring about a gradual reduction in carbon emissions, preventing sudden economic disruption from an abrupt cessation of carbon emissions. The European commission issues EU Allowances (EUAs) at predetermined yearly volumes, decreasing gradually each year. This controlled reduction in supply is a structural characteristic of the scheme, driving the long-term increase in carbon prices.
Between 2013 and 2020, regulators decreased the limit on carbon emissions by 1.74% annually, then increased the rate to 2.2% per year until 2023. As climate ambitions were increased, EU policymakers accelerated the reduction rate to 4.3% annually from 2024 to 2028 and committed to 4.4% annually until 2030. This faster reduction in supply levels drives EUA prices higher, following basic macroeconomic laws of supply and demand.
To simplify, in the long run, EUA demand corresponds to the total emissions in the EU economy. Therefore, long-term demand for EUAs in the EU ETS will depend on technological and scientific advancements. For the same level of industrial demand and output, fewer CO2 emissions will be released if machinery and production processes become more efficient, reducing carbon emissions without compromising production levels.
Long-term political and economic trends influencing the enhancement or structural decline of European industrialization as a macroeconomic model can impact EUA prices. However, such fundamental changes require changes across numerous processes - political shifts, new economic findings and theories… It is therefore challenging to observe or account for the impact of such broad changes in the short-term price movements of any single asset.
Temporary supply adaptations can drive EUA prices in the short term. If the gap between supply and demand of EUAs (the EU ETS market surplus) becomes too large, some EUAs are transferred to the Market Stability Reserve (MSR). However, market balance values are reported annually, so the information provided to EU ETS participants is very periodic. Also, mechanisms related to the MSR can engender the permanent cancellation of EUA volumes under specific conditions. Announcements of such short-term supply changes can push EUA prices higher when there is an anticipation for a tightening market.
Additionally, during critical situations in Europe or globally, regulators can introduce temporary changes to the EU ETS due to its massive scale and the importance of the revenues that it brings about. For example, the REPowerEU initiative saw politicians temporarily increase supply to help Europe address the energy crisis.
If there are extreme weather events or temperatures and there is a significant need for heating or cooling energy, industries can expect to release additional volumes of carbon, leading to an increase in EUA prices. As summers become increasingly warm in Europe and globally, air conditioning becomes a standard practice in more and more places, driving EUA demand and prices.
Energy markets are very important when it comes to determining EUA prices. Recently, there has been a near-perfect correlation between EUA prices and gas prices. This correlation can be explained as follows: as energy prices rise for polluting sources, industries shift towards less polluting alternatives. Consequently, this reduces their carbon emissions projections and decreases their demand for EUAs. Such relationships explain why EUA prices react closely to dynamics in energy markets.
Finally, trading deadlines such as options expiry dates or general trading behaviors can influence EUA prices. However, these influences are typically short-term because they result from heightened levels of buying or selling activity within the same day. Such trading behaviors only transiently affect carbon prices.
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