This article is part of our special report EU carbon market reform and price stability.
The European Union’s flagship climate policy instrument, the Emissions Trading Scheme (ETS), needs more monitoring and transparency in order to prevent “speculation about speculation” and restore political confidence in the market, analysts have said.
Carbon prices rose sharply last year, hitting €50 per tonne for the first time in May after languishing below €20 for more than a decade.
An all-time high of nearly €100 was reached in February this year on the back of new EU targets to halve emissions by 2030 and a gas supply crisis fuelled by Russia’s war in Ukraine.
This has sent alarm bells ringing in EU capitals, with Madrid calling for trading limits to be placed on the ETS in order to prevent CO2 prices from pushing up the cost of energy.
Those calls were later amplified by Polish Prime Minister Mateusz Morawiecki, who warned that carbon prices were “out of control” and needed to be contained in order to prevent “a drastic increase in energy bills” for ordinary households.
“We must cut through the speculative bubble that has built up around ETS trade,” Morawiecki wrote in an opinion piece published on EURACTIV in January.
ESMA calls for more transparency and monitoring
The European Commission has so far rejected suggestions that speculation was driving up the price of CO2, and referred to a March report by the European Securities and Markets Authority (ESMA) which concluded that the EU carbon market was functioning normally.
“Price movement and volatility are mainly driven by supply and demand dynamics, the structural decline in allowances and the rising in energy prices,” said Fabrizio Planta, head of markets and data reporting at ESMA.
And although investment funds have increased their presence on the EU carbon market, “traded volumes are still relatively small in comparison to other market participants,” he told a recent EURACTIV event, dismissing the notion that speculators had become dominant players on the ETS.
The official did acknowledge however that “transparency and monitoring” could be improved, and pointed to suggestions in the ESMA report for how this could be done.
This includes, for example, extending controls to emission allowance derivatives, amending positions reporting on emission allowances, improving the information content of weekly position reports, and improving transparency and reporting of Over-The-Counter (OTC) transactions, Planta said.
“So a lot of work in terms of transparency and monitoring is necessary,” he said.
Calls to increase transparency on the EU ETS are supported by Michael Pahle, a leading academic at the Potsdam Institute for Climate Research in Germany.
“The main problem, I believe, is actually ‘speculation about speculation’,” Pahle told EURACTIV in an interview, saying there is currently “no evidence” about speculation leading to an increase of the carbon price on the ETS.
That said, he agreed with Planta that stronger controls are needed 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,” he said, adding that this requires new methods to measure the impact of trading as well as improving data along the lines ESMA suggested in its report.
More fundamentally, Pahle also pointed to a “monopoly on information” held by a handful of traders who have a disproportionate influence on the market. For instance, he pointed to a situation last year when prices rose sharply after an influential London-based hedge fund made vocal declarations about future ETS prices.
“This certainly received a lot of attention from other, likely less informed traders, who may have followed suit,” Pahle explained, saying this underlines that information can play an important role in driving prices on the market.
To address this, Pahle recommends improving information-sharing and transparency among all market participants. “We need a better explanation of what actually drives prices,” he said. “And I think this is really the root problem of the current debate” on price stability, he told the EURACTIV event.
“In a politically-created market, we want a clear answer to this question” because everyone needs to be able to trust the market to deliver the political objectives for which it was created, he said. “So trust needs to come into the equation. And I think this is really what we should make a centrepiece of new proposals.”
Some European politicians are receptive to calls for greater transparency.
Peter Liese, a German MEP leading the ETS reform in the European Parliament, mentioned a recent example where carbon prices rose by 10% on the back of an article published by financial news agency Bloomberg.
For Liese, “that means there is speculation” happening on the ETS. That “nothing should happen is not a satisfactory answer to me,” he said.
Complaints about volatility
PGE, Poland’s largest energy utility, has complained loudly about volatility on the EU carbon market.
“The situation is absolutely unpredictable from our perspective,” said Wanda Buk, vice-president for regulatory affairs at PGE. “One day EU ETS allowances cost €90 per tonne, the next day it’s €60,” she told the EURACTIV event, recalling that the cost of CO2 had previously stayed at around €5 per tonne for many years.
“We are in a very, very difficult situation,” she said, complaining that the current high price of carbon credits “affects our daily liquidity” as a company. “In 2021 alone, we paid €2 billion” in EU ETS allowances, a sum equal to PGE’s earnings (EBITDA) for that year, she pointed out.
To investigate the impact of financial actors on the EU carbon market, PGE commissioned a study from a consultancy, Compass Lexecon, which published its report in April.
Fabien Roques, the consultant who oversaw the study, came to the same conclusion as ESMA and found “no hard evidence” that carbon price volatility can be attributed to financial players like investment funds.
However, he said, “some characteristics of the market itself can potentially favour speculation and have harmful consequences on price stability.”
For instance, even though a Market Stability Reserve (MSR) was introduced to prevent wild fluctuations in carbon prices, “there is in the short term an inelastic supply, and that obviously can increase price volatility”.
Roques also flagged “concerns” about the volume-based thresholds in the MSR, saying “this mechanism could actually have, in some circumstances, a destabilising effect on the market and actually favour speculation”.
More fundamentally, Roques said the ETS was “politically-driven” and based on the “credibility” of EU climate policies and commitments to reduce emissions. This long-term policy uncertainty, “in itself can enhance speculation on the market,” he pointed out.
In his view, it is essential to review the market design of the ETS and consider “some additional measures to enhance price predictability and stability” of carbon prices. Those include better monitoring and market oversight, as outlined by ESMA in a recent report.
“And we think that this is a no-regret option”.
[Edited by Zoran Radosavljevic]