• The European carbon quota market is the main instrument of the European climate change mitigation strategy, according to our partner The Conversation.
  • As the price of the quota has risen in recent months, carbon-free electricity is becoming very profitable compared to electricity produced from gas or coal.
  • This analysis was conducted by Christian de Perthuis, professor of economics at Paris Dauphine University – PSL.

When Russia invaded Ukraine in February 2022, energy prices soared. That of the CO₂ allowance on the European carbon market has lost a good third of its value. Some believed that the system would not withstand the soaring energy prices.

One year later, the quota price is doing well. Since the beginning of 2023, it has gained more than 15%. On February 27, the price of the one-year futures contract reached the symbolic bar of €100/t. The spot price, settled in cash, reached an all-time high of €97.

To understand these price movements, it is necessary to recall the principles on which the European carbon quota market, the main instrument of the European climate change mitigation strategy, is based.

A flexible rationing mechanism

Complex in its implementation, the basic principle of the CO₂ Trading System is in fact very simple. This is a flexible rationing mechanism.

Rationing is imposed on industrialists subject to the system by setting an overall emission ceiling not to be exceeded. If this cap is binding, it creates scarcity on the market, which drives up the price of the quota. If it is lax, the price will tend to fall. If there are no more constraints, the price will tend towards zero.

Flexibility results from the possibility for industrialists subject to the system to trade allowances which are all rights to emit one tonne of CO₂. Each year, these manufacturers must surrender as many allowances as they have emitted CO₂. If they default, they pay a deterrent penalty. The higher the price of the allowance, the more expensive it becomes to emit one tonne of CO₂. The actors of the system are then encouraged to reduce their emissions.

Quota price and climate targets

During the 2010s, the system was not binding for a substantive reason. The European Union's climate target – a 20% reduction in greenhouse gas emissions between 1990 and 2020 – was not binding. The best proof: the objective was achieved in 2013 as indicated by the European emissions inventory which serves as a justice of the peace in this area. No need for a quota system to aim for a goal that has already been achieved!

Faced with this situation, the Commission managed to patch up the system by setting up a "stability reserve" from 2018. This reserve removed allowances from the market, which pushed the price up to around €20/t.

The situation changed completely in December 2021 when European heads of state raised the emission reduction target to 55% by 2030, from 40% previously. The commitment has been deposited with the United Nations as part of the European Union's contribution to the achievement of the Paris Agreement. It is therefore set in stone.

The market did not take long to react. The price of the quota rose in a few months above 80 € / tonne. At this price, carbon-free electricity becomes very profitable compared to electricity produced from gas or coal.

The increase in the price of the quota also increases the cost of producing steel in blast furnaces where coal is used both as fuel and as a reducing agent for iron ore. In France, the two most CO₂-emitting facilities are Arcelor Mittal's two blast furnaces based in Foss and Dunkirk. As soon as the price of the CO₂ quota exceeded €80, the manufacturer took out of its boxes investment projects to convert these two industrial complexes to low carbon.

The impacts of the war in Ukraine

Then comes the war in Ukraine. Prices for coal and gas used in Europe are soaring, due to the EU's heavy dependence on Russian supplies. Oil prices are also rising, but to a lesser extent. This surge in prices clouds the macroeconomic outlook and encourages a decline in gas and coal consumption.

These two economic variables logically lead to a downward correction in the price of the quota. There is also a political factor. Faced with soaring energy prices, European governments are competing in inventiveness to set up tariff shields to protect citizens and industrialists in the face of soaring prices.

Among the panoply of measures, some countries want to suspend the quota system that increases the cost of fossil fuels. This is particularly the case for Poland, which officially calls for it at the European Energy Council in August 2022.

These attempts were unsuccessful. Not only is the system not suspended, but the Parliament and the European Council reach a political agreement on 17 December 2022 to implement the reform proposals prepared by the Commission. This strengthens the political credibility of the CO2 allowance market.

The rise in the price of quota: an anti-coal weapon

In addition to strengthening political credibility, the sharp rise in the price of the allowance in January and February 2023 also responds to the simultaneous fall in the price of coal observed on the energy market.

The easing of coal prices became apparent as soon as the risks of supply disruptions to the electricity system, which were high as winter approached, eased. It was strong and rapid, because the industry had built up precautionary stocks in northern Europe that were not used.

In an economy without carbon regulation, a falling coal price means more consumption and therefore more greenhouse gas emissions. Especially when there are possible substitutions between fuels, which is the case on a fairly large scale in Europe between coal and gas.

OUR "COAL" DOSSIER

With the emissions trading system, the European Union will largely escape this perverse chain. The fall in the price of coal is indeed thwarted by the increase in CO₂ quotas. The quota trading system thus acts as an anti-coal weapon. This is valuable at a time when we need to accelerate the energy transition to achieve a -55% reduction in net greenhouse gas emissions by 2030.

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This article is produced by The Conversation and hosted by 20 Minutes.

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