Despite a disappointing COP27, national and regional carbon pricing schemes are helping to drive decarbonisation – and keeping emitters and traders closely watching the market, says Vertis Environmental Finance deputy CEO Gauthier Bily
Environmental Finance: COP27 has just ended with little progress in terms of increasing the global ambition to tackle emissions. How can emissions trading systems (ETSs) help unclog the global decarbonisation effort?
Gauthier Bily: COP27 certainly was not a great success in terms of new targets, but it did see some interesting developments regarding Article 6 of the Paris Agreement, which is the framework for carbon markets. Even once Article 6 is operational – which we don't expect to see before 2024-25 – it will only add another layer to carbon trading, that will coexist with the regional Compliance carbon markets that have expanded over the last years.
The reason for the success of these compliance markets is simple: they allow for higher targets to be reached at lower costs. They also introduce robust measurement and accounting systems and give companies a certain level of predictability. When companies address their emissions strategically, they look at the future emission reductions that both they and their sector can deliver, and they carry them out. This gives them a competitive advantage compared to everyone else.
EF: A number of jurisdictions are considering setting up emissions trading systems. Which are you watching most closely?
GB: The EU and the UK are clearly leading the way, but countries around the world are indeed considering local ETS markets, or they are developing existing ones: New Zealand, USA, Canada, Mexico, Kazakhstan, South Korea, Japan and, most importantly, China.
The Chinese market is already the world's largest ETS, with currently around 4.5 billion tonnes of carbon emissions covered, and it is set to expand to almost 8 billion tonnes by 2025, when it will capture 60-70% of China's total emissions.
Our role in these upcoming ETS markets is to use the expertise we have gained in the EU over the past 15 years and put it at the service of new obliged entities. When done right, everyone profits: our client, because they are able to hedge their exposure at a lower cost, governments, because they are able to raise resources to finance the energy transition, and last and most importantly, the climate – because carbon pricing is an effective incentive for decarbonisation.
EF: The EU ETS has had a volatile year –where do you see the market going?
GB: Back in March, we witnessed a sell-off that dragged the price down to around €58 per tonne of CO2. Many believed that this would turn out to be a bear market. It was easy to be drawn into short-term thinking and find similarities with the 2008 financial crisis.
The reality, however, is that rules around allocation, benchmarking and the Market Stability Reserve have led to a completely different scenario today. In 2009, the allocation of emissions allowances did not change even as production fell by 49% – that's not the case anymore.
Furthermore, industrial emissions in 2022 are expected to be as low as they were during 2020. However, power and aviation emissions are set to reach their 2019 and 2016 levels, respectively. This means that, overall, 2022 emissions are expected to reach around 1,430 million tonnes of CO2, or about 70 million or 5% above the 2021 level. This will have a significant impact on demand. Over the long term, the market is set to remain tight, with the EU's final ETS reform compromise likely to be adopted within a few weeks. Yet in the mid-term, there are indeed some potentially bearish factors to watch, like a possible recession and an increase in the speed in which the EU brings supply to the market in order to finance the energy transition – the so-called RePowerEU plan.
EF: What about the UK ETS?
GB: The way the system is set up and the prospects of it re-linking with the EU ETS have kept the spread between the two systems low so far. However, various changes have been made to the UK ETS that are due to come into effect by 2023, and some are expected in the coming weeks.
These include aligning the emissions cap with the UK's net-zero trajectory, with a revision to the free allocation methodology (which will have a bullish impact), extending the UK ETS aviation coverage to include flights from the UK to Switzerland (also bullish) and amending the activity level changes to exclude 2020 from the free allocation calculation (which will have a bearish impact).
In general terms, we currently see somewhat of a divergence of policies between the two systems which reduces the prospects of a future re-linking of the systems; until recently, this was widely seen as only a question of time. The more the two systems adopt different policies and pathways, the higher the chance that the spread between the two schemes widens.
For more information, see: vertis.com