Carbon compliance markets: Why volatility is here to stay

Carbon certificates are a key tool in the drive to reduce GHG emissions. Emitters subject to a compliance scheme aim to cover their annual emissions with certificates, while over the longer- term reducing their real emissions in line with targets. Prices for both compliance and voluntary certificates are at record levels and there is huge volatility in the market, which I believe will stay for the foreseeable future.

In June 2021 the European Commission released their “Fit for 55” plan, to deliver on their 2030 target to reduce emissions by 55% yet, uncertainties in the future form of the EU Emission Trading System (ETS) are in my view compounding, rather than reducing, market volatility for carbon certificates.

Why uncertainty is leading to market volatility

Firstly, there is the potential for further changes in regulation to reduce perceived market speculation which could disrupt markets further.

Trading of certificates between market participants, some of whom are not regulated emitters, is increasingly widespread. In light of record energy prices, there is a feeling that this may be caused by increased speculation. An initial investigation by the European Securities and Markets Authority in late 2021 suggested the market was broadly operating in line with expectations. However, their more in-depth study due for release shortly might find differently.

Secondly, market liquidity and standardisation is restricted by the limited linkages between the various compliance schemes globally.

Agreement at COP 26 paved the way for a more global carbon market, but until this is realised demand for national/regional carbon certificates will, in my view, remain distorted. The most likely linkage may come from the UK and EU who are giving ‘serious consideration’ to link their respective schemes. A large majority (89%) of respondents to the 2021 IETA-PwC GHG sentiment survey are expecting this.

Thirdly, proposed regulation to counter ‘carbon leakage’ will likely increase the demand for carbon certificates at least in the short-term.

Until compliance schemes are widespread and linked, there is a strong risk of ‘carbon leakage’ as companies in regions with stringent carbon standards move carbon-intensive production abroad, to take advantage of weaker regulations. To counter this, the proposed EU carbon border adjustment mechanism (CBAM) is planned for 2026, under which importers of carbon-intensive goods will pay a financial adjustment.

The compliance carbon markets are evolving fast. While price increases suggest market participants have built in the release of the “Fit for 55” plan, until the areas above are resolved, I believe emitters should plan for continued volatility, high prices and increasing numbers of market participants.

Carbon emitters will need to develop strategies and processes to ensure they obtain the carbon certificates they require at the right price at the right time to comply with the regulation and not incur a significant fine.