Between 2018 and 2022, carbon prices increased significantly - a major turning point for the European Union Emissions Trading Scheme (EU ETS). This rise ended the era of persistently low European Union Allowances (EUA) prices that had been undermining the effectiveness of the EU ETS as a policy tool.
The Market Stability Reserve (MSR) implemented to reduce the structural oversupply
One of the key changes came with the European Union’s implementation of the Market Stability Reserve (MSR) in 2019. It is a tool designed to tackle the long-standing issue of oversupply in the EUA market. The MSR works by adjusting the number of allowances available based on market conditions. If the total number of allowances in circulation exceeds a certain level, the MSR withholds a portion of future auction supplies. This helps to remove excess allowances from the market, tightening supply and pushing prices higher. The anticipation of the MSR’s impact began to influence prices as early as 2018, leading to the important increase from €5 to around €32 by the end of that year.
EUAs as official financial instruments
EUAs fell under the scope of the MiFid II directive in 2018. Designating EUAs as official financial instruments under European law was another important factor in the rise of prices. This designation was crucial in driving up prices, as it opened the market to a broader range of participants, including financial institutions. With more actors in the market, trading became more active and efficient, leading to better price discovery. As a result, EUA prices got closer to accurately reflecting the “true” high cost of carbon emissions to society and the economy, which helped create stronger incentives for decarbonization.
Strengthened EU climate agenda bringing EU ETS optimism
As the European Union strengthened its climate agenda, renewed optimism was infused into the market. Major policy announcements like the European Green Deal and the Fit for 55 package, set more ambitious targets for reducing emissions by 2030 and 2050. The European Green Deal sets the goal of bringing the EU to climate-neutrality by 2050, and the Fit for 55 package includes a target to cut emissions by at least 55% by 2030 compared to 1990 levels. These announcements signaled strong political commitment to tackling climate change, which boosted confidence among EU ETS market participants and drove up EUA prices. Whenever there was an announcement related to these policies, carbon market participants anticipated tighter future supply and higher compliance costs.
Rising Industrial Production: Increased Demand for EUAs
Finally, the period after 2018 (and before the global pandemic) saw high industrial production levels across Europe. As industries ramped up production, their emissions reached higher levels, leading to higher demand for EUAs. This increased demand, coupled with the market balance constraints introduced by the MSR and the anticipation of stricter climate policies, contributed to the upward pressure on EUA prices.
Regulators respond and adapt to real market conditions to make the EU ETS the most effective decarbonization tool possible. This was evident in the years following 2018, when the structural oversupply issue was effectively addressed - prices moved closer to the levels needed to support extensive decarbonization efforts across Europe.
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