Carbon market collapse?

Tom Arnold | May 9, 2006

The recent 65% drop in the trading value of carbon on the European exchange (EU ETS) has Martin Tobias predicting “end of a commercial carbon market as we know it.”

Phooey.

Let’s review how the European market works. To achieve the Kyoto targets, the EU places caps on the emissions of companies in member countries. These companies are required either to reduce their own emissions, or to purchase carbon offsets from other companies who reduce emissions by more than the necessary amount. This trading system ensures emissions reductions are achieved at the lowest economic cost, as shown in numerous academic studies of the theory and practice of cap-and-trade markets.

Policymakers control these markets by adjusting the carbon caps to meet their objectives. For example, a policymaker may attempt to limit the supply of carbon allowances so that producing energy from more carbon-efficient natural gas is as economically attractive as producing energy from more carbon-intensive coal.

The drop in carbon prices is part of a natural process playing out in the political economy of Europe. Companies and countries have sandbagged their emission reduction goals, and the system therefore has more allowances than were expected just a few weeks ago. Naturally, when the supply increases, the price drops.

But let’s put this in perspective. The price today is around 14 Euros, which is up substantially from the market open of 6 Euros in January, 2005. More generally, the price is higher than zero, which is what carbon allowances would be worth if the market truly had collapsed.

But a 65% drop is substantial. Why did it happen? Well, the first round of the game of establishing a price signal in the European market for allowances reached a critical information juncture. The cards were shown from the member companies — and countries — and it became clear that many countries were in need of a lot less allowances than they claimed at the start of the process.

Further evidence that the carbon market is alive and well is provided by the companies providing carbon finance in Europe. These companies expect to make money by trading clean energy credits. Their stock chart is below. Clearly they’ve taken a hit, but carbon trading and the carbon market are here to stay.

< Previous: How a Suburban gets 30 mpg (at least in CAFE) Next: New electric car film is…electric >

Comments

1. By Tao on May 10, 2006 10:48 AM

Seems like people are missing the point if they think that the purpose of the carbon offset market is to make money by driving the prices up. Political policies changing the caps will always have a bigger influence on price than economic effects. If people are speculating on the whims of politicians they're either insider trading or they deserve to lose money. These are probably the same people who thought that DARPA terrorism futures market a few years back was a good idea.

And in an ideal world where the major factors influencing the price are economic instead of political, wouldn't the price naturally trend lower as companies managed to ever more efficiently reduce emissions on their own instead of having to buy allowances?

Reply
2. By Adam on May 10, 2006 3:40 PM

Not necessarily. It's true that supply will drive the price for allowances, but the number of allowances is determined by more than just companies' skill at reducing emissions. The price of oil and coal, caps on emissions set by policymakers, and other factors all play a role in the supply of allowances. So the market should evolve in unpredictable ways.

Regarding carbon-market speculators, more likely than not these people play a positive role in the market. This is not an area of deep expertise for me, but in most markets speculators are thought to provide liquidity and help set prices. There may also be downsides to speculation, but in general speculators are not the spoilers they are sometimes caricatured as.

Reply
3. By Anonymous on February 22, 2007 2:03 PM

So, how's that market looking now?

Reply
4. By Windowdog on May 22, 2007 11:20 AM

Speaking of the carbon market I'd really like the Terrapass folks give their take on this article http://www.msnbc.msn.com/id/18659716/

Overall it's pretty harsh in respect to the carbon offset industry.

Reply
5. By Adam Stein on May 22, 2007 12:41 PM

The article doesn't seem especially harsh to me, but I guess we see a lot of press on the carbon industry, positive and negative, so we're pretty accustomed to it. This article trots out most of the standard criticisms, but mixes them with measured praise. It's not worth dissecting the article line by line, but two general thoughts:

1) The list of quality criteria at the end of the article is pretty solid, and TerraPass scores well on all of them. We're independently verified, we identify all of our projects specifically, no tree-planting projects, etc.

2) The only major criticism I have of the article is that the author got spun really hard by Clean Air-Cool Planet. I got a chuckle out the line, "Some offset retailers did not even return the study's questionnaire." That's not quite true. Most retailers didn't return the questionnaire, both because it was generally perceived to have a flawed design and because it was commissioned by a competing offset retailer. The reaction was not so much "startling" as "entirely predictable."

Otherwise, the article was pretty standard.

Reply