Environmental policy in the European Union (EU) is becoming increasingly ambitious as the EU develops a roadmap to meet its obligations under the Paris Agreement.
As a near-term goal, the European Commission aims to reduce greenhouse gas emissions by 55% by 2030 from 1990 levels. By 2050 the EU aims to be carbon neutral.
The European Union Emissions Trading Scheme (EU ETS) is the world’s biggest carbon market and the foundation of EU’s policy to mitigate climate change and reduce greenhouse gas emissions. The scheme is intended to support the EU in achieving carbon neutrality in the region by 2050. Under the EU ETS, a cap exists which limits the amount of greenhouse gases that can be emitted by companies each year.
A fixed number of carbon emission allowances are issued each year, with companies required to hold enough allowances to cover their emissions and ensure they fall under the cap. Price increases in carbon emission allowances means it gets more expensive for companies to cover their carbon footprint with the allowances and incentivises them to invest in pollution abatement technology which could help drive change faster.
In July 2021, the European Commission released its ‘Fit for 55’ legislation package, supporting its commitment to reduce net greenhouse gas emissions by at least 55% by 2030. A central pillar in this package is the enhancement of the EU ETS. The legislative changes are likely to:
- Increase the scope of the European carbon emission allowances market to a larger number of industry sectors
- Reduce the supply of allowances to emit carbon
- Raise the price of allowances and thus help policy makers deliver on their promises to decarbonise and become emissions net neutral by 2050
Investors in carbon emission allowances futures can benefit from these trends and inject further liquidity in these trading instruments. In 2020 the EU ETS accounted for 88% of the total value of all carbon emission allowances trading systems globally with 8bn emission allowances changing hands and a market value of €201bn. Trading in European Union Allowances (EUAs) futures is unrivalled in terms of liquidity.
The benefit of higher liquidity is a better price discovery process. The social cost of an under-priced carbon emission allowances futures contract is the overproduction of carbon. Therefore, avoiding an under-priced carbon market with an improved price discovery process is a welcome development.
Carbon as an emerging asset class, therefore, presents a unique proposition given its supply is expected to be tightened by design to reduce emissions. Investors in the asset class not only gain exposure to carbon’s promising fundamentals, but also contribute towards helping achieve environmental goals.