This article is part of our special report EU carbon market reform and price stability.
Some form of price regulation, like a price collar or position limits on market players, could address worries about high prices on the EU’s Emissions Trading Scheme (EU ETS) and help prevent “a political backlash”, climate and energy expert Michael Pahle told EURACTIV in an interview.
Dr Michael Pahle is a working group leader at the Potsdam Institute for Climate Impact Research in Germany.
- There is “no hard evidence” about speculation on the ETS which has a significant effect on the price of CO2 allowances.
- The notion that there are bad and good traders “is dangerously misguided” because speculation is also done by compliance traders acting on behalf of the regulated industry.
- That being said, allowing financials to operate without sufficient controls is “a recipe for turmoil and serious market disruption”.
- This is why indicators and thresholds are needed to measure trading patterns – to avoid a liquidity crunch for the regulated industries covered by the EU ETS.
- Carbon price volatility is also driven by a “monopoly on information” held by a handful of traders who can anticipate price movements. Greater transparency and information sharing would help prevent this.
- Other potential solutions include imposing “position limits” on market players or introducing a “price collar” to ensure price stability, like the US state of California has done with its own ETS.
How much speculation is there on the ETS? Are the volumes significant? And what kind of problems can this generate?
The main problem, I believe, is actually “speculation about speculation”. We can neither directly measure the volume of speculation, nor rigorously quantify its impact on prices so far. So if observers are stating with high confidence that speculation is a big problem or no problem at all in the ETS, they are in fact making claims for which there is no hard evidence.
There are two main challenges when it comes to assessing speculation: First, it can be both beneficial and detrimental to market functioning. It is beneficial when it helps compliance traders to hedge, provides liquidity that reduces volatility, or supports price discovery when fundamentals change. If it does the opposite, it has a detrimental effect and is deemed excessive.
This is why I say speculation can only be meaningfully assessed with regard to its effects on prices, not with regard to the volumes held by, say, financials.
Second, speculation is not necessarily exclusive to financials – as our research suggests, compliance traders also engage in trading that goes beyond hedging purposes. To measure the effects of non-compliance traders like investment funds, one would therefore need to filter out their effects on the market and establish a counterfactual benchmark of how prices would have looked like without them.
In fact, there is a large body of literature on the financialisation of commodity markets, which has tried measuring the impact of so-called non-compliance traders. But the development of suitable scientific methods is still ongoing, and data availability and quality still need to be improved, as shown in ESMA’s report as well as ours.
Sorry for the lecture, but as an academic, I think it is important to clarify that hard evidence is still lacking, and proposals for how to deal – or not deal – with this topic should take this into account.
So, to summarise the key distinction is between traders who are compliance players from the regulated industries, or those operating on their behalf, and traders who are not from regulated industries. Is this correct?
How big is trading coming from non-compliance industries? Are the volumes significant and have they changed over time?
Looking at the data in the ESMA report on the EU carbon market and in our own work, you can see that the lion’s share of trading volumes is by investment firms and credit institutions.
Mostly, these are banks acting on behalf of compliance traders who do so-called ‘carry trades’ – buying allowances on their behalf and selling them back to them – which is a very common form of trade for hedging.
Then, in much smaller volumes, there are trades by investment funds and other unclassified financials.
These are the new players, right? These are the financials that have only been interested in the ETS until recently and are not acting on behalf of the regulated industries?
Are these people the speculators then?
This is where terminology is important. Some would call them speculators because they solely trade to make money, while others would call them investors because they buy and hold allowances – in contrast to speculation, which is typically thought of as more short term, meaning profits are made within timescales ranging from seconds to months.
More interesting than wording though is what brought these firms into the market a few years ago. Until 2018, the EU’s climate targets were less stringent, there was an oversupply of emission allowances and CO2 prices were relatively low. And then, the ETS reform for phase IV was implemented to remove oversupply.
That made investment and hedge funds realise that the EU was being serious about climate change. Correspondingly, this was when these traders first started appearing, and as things stand they have come to stay.
Ok, so there is more speculation than before. Can you now explain what kinds of problems this can generate? Is it just pushing up the price or are there other problems as well?
Apparently, it affects the price of CO2 allowances, and it is important to understand how this happens. These traders can both consume and provide liquidity to the market. But it’s not really clear when they buy or sell allowances, or how long they hold them. This very much depends on their trading strategies, which are hard to predict. In case they consume liquidity for a prolonged time, they may push prices up persistently above their fundamental value.
Related to this, the investment decision of retail investors may mostly be driven by the market and, in the case of impact investment, environmental sentiment. They may just buy allowances and decide to sell all of a sudden irrespective of market conditions, or even cancel to put price pressure on emitters.
This means you have higher uncertainty in terms of what drives trading, which generates noise in the market and impairs the environmental cost-effectiveness of the ETS.
So it’s really hard to tell because financial players follow other trading logic than compliance traders who need to buy allowance depending on their production.
In a recent paper, you warned about the participation of financial actors in the ETS, saying they risk triggering “excessive speculation” on the market. How is the behaviour of financial actors different from other players?
It is different in the way I just described, namely the trading strategies and the risk of a persistent reduction in liquidity.
However, we made clear that the potential negative effects of trading by new financials are more of a looming than a present threat. But as allowance supply is set to shrink over time and the ecosystem of market actors widens, allowing financials to operate without sufficient monitoring controls is a recipe for turmoil and serious market disruption.
Our conclusion, therefore, was that we need a way to measure investment flows and allowance holdings, and define a point above which they can be considered excessive.
One indicator is to measure how much liquidity is consumed – how many allowances are taken off the market that are not available to regulated entities anymore. If it’s just a very small share of overall market liquidity – currently a few million allowances – nobody will have to bother. But if at some point, it becomes a larger phenomenon, it risks distorting the market.
So we need to have a proper indicator and a threshold to determine when this becomes critical. This is about finding new methods to measure the impact, but also about improving data along the lines ESMA suggested in its report.
Your paper recommends establishing a warning mechanism to guard against excessive speculation. How would this work? And where would you place the threshold?
The approach ESMA took to assess if the market is properly functioning is to look at ‘disorderly behaviour’. But it doesn’t provide a definition of it, it’s more an implicit notion based on volumes and aggregate market indicators, which are put in relation to what is deemed normal market behaviour.
What we suggested in the paper is to explicitly establish trading patterns that could reveal speculation. For instance, a substantial increase in front-year contracts’ open interest within a year, which would not be the case if trading in the futures market would be solely for hedging purposes.
This is not a bullet-proof approach, it is still more an informed heuristic. But it would be a major step forward to establish such trading patterns that are normal in the sense that they are characteristic of functioning compliance trading.
Then detecting a deviation from these patterns could be a clear warning signal that the market isn’t functioning correctly.
What about super-fast automated electronic trades, so-called high-frequency trades which are taking place in milliseconds? Could that be used as a metric as well?
You can indeed develop different metrics for trading on different time scales, such as high-frequency trading, measured in seconds or milliseconds. And you can also look at longer time scales, like years.
The latter is much more challenging because information and anticipation play a decisive role. For instance, at the beginning of 2021, a London hedge fund stated very vocally that the price of an allowance may well be around $100 per ton at the end of the year. This certainly received a lot of attention from other, likely less informed traders who may have followed suit – at least prices increased discernibly in the wake of this news.
This underlines that information can play an important role, not only in market uptake but also in market creation by key actors.
That’s more like market manipulation, then.
Not really. Market manipulation is when you squeeze the market by withholding allowances to push prices up – it’s physical in the sense that the actual scarcity of the asset is increased.
In the case above, I would say this is more like creating contagious information. That is why our recommendations are actually aimed to improve information sharing and transparency among all actors in the market. It is to prevent a kind of monopoly on information that a handful of traders could capitalise on by anticipating price movements on the market and timing it to the disadvantage in particular of compliance traders.
This aligns well with the growing demand to improve transparency about market movements and make them understandable to a wider public.
Some lawmakers in the European Parliament have tabled an amendment to the ETS directive (Amendment 405) with the aim of limiting trading on the ETS to “operators with compliance obligations” or to financial intermediaries acting on behalf of them. What are your thoughts on this, would this help resolve the issue?
In general, I think it is very important to be clear about the role of financials in and for the market, and limit participation when it becomes detrimental.
But the notion that there are bad traders and good traders, and the latter can be excluded and all is well, is dangerously misguided. Doing so would be a substantial risk for market functioning in many ways.
First of all, the market could experience substantial liquidity problems, like it happened in South Korea, where financials were not allowed to participate until recently. This implies that the price signal becomes informationally inefficient. Furthermore, big compliance companies not excluded from trading could also engage in speculative trading, and likely already do so to some extent. Finally, there are also co-movements of financial products that mimic the ETS or are linked to it. So, there’s a number of good reasons not to exclude them.
A less intrusive option by far is to introduce position limits. I am generally supportive of this, also because it has a signalling function. We know this from the carbon market in California, where such limits are already implemented: market players know they are under surveillance, which can automatically contain potential disorderly behaviour.
But it is absolutely crucial to calibrate those position limits well, which is an issue both we and ESMA flagged in our respective reports. There are already position limits for agricultural commodity derivatives for example. But you can’t simply do the same with the carbon market – set a fixed level practically forever – since supply of carbon allowances is going down structurally. So, the limits need to be constantly adjusted to current market conditions, which makes it particularly tricky.
Generally speaking, carbon prices on the ETS have risen to almost €100 per tonne over the past months, levels that were not expected to be reached before 2030. Do you believe measures need to be taken to limit price volatility or levels on the ETS? For example, are you in favour of a price ceiling?
To begin with, at least in hindsight we shouldn’t be very surprised about high carbon prices: we have a European Green Deal ongoing, and a proposal on the table to substantially tighten the cap on emissions under the ETS.
According to the analysis we did at PIK one year ago looking at the ETS proposal, the price of carbon would reach €130 per tonne by 2030 under optimistic abatement costs assumptions. The pace at which prices rose may have been surprising, but certainly not the direction – it would have happened sooner or later.
In light of that, what financial players did was to actively anticipate this future. They were taking risks in doing so, not knowing how prices would actually develop. Sometimes, you are rewarded by taking risks and anticipating what the market will do next. And at other times you will get punished because you failed to make the right predictions. This is part of normal market functioning – price discovery during a transition to a new equilibrium.
However, we need to acknowledge the ETS is a politically created market, and there are arguably price levels that may trigger a political backlash when they hit regulated firms or countries too hard. To some extent, we are experiencing this at the moment in my view.
In order to safeguard political stability, a price collar would be very helpful to prevent discretionary intervention and clarify beforehand and for all stakeholders which range of price is politically acceptable. And we have a good example from which we could learn how to put this into action: the cap-and-trade program in California.
[Edited by Zoran Radosavljevic]