The time-value of carbon

Jean-Baptiste Vaujour is a Professor of Practice at emlyon business school where he teaches about consulting and green finance. He is an energy economist and a registered expert at the EU Commission and for the World Energy Council. He has recently published a book on the decarbonisation of the economy.

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The total value of carbon markets across the world has reached €881bn in 2023 ($948.75 bn) an historical high that is dominated at 87% by the European Emissions Trading System (EU-ETS). To put this in perspective, this is roughly 5% of EU GDP. These values are increasing and other international carbon markets are gaining traction. With the commitments of the Paris Agreement, carbon economics are set to become a pivotal part of the global economy.

This raises a number of questions about the way these markets operate and are embedded in our economies. In a series of articles we will be discussing the economic reasoning underlying carbon markets, the actual organisation of these markets, the way States are extracting and recycling revenues from these markets and finally the future perspectives for market carbon pricing. In this first entry we discuss the economics of carbon pricing.

Pricing something without value

Carbon emissions are a by-product of modern human activities. As such, they have long been left out of the economic value chain, as no one could control them and their damages to the environment were not directly obvious. Since the IPCC contributed to disseminate the scientific consensus on the related destruction to the environment, the link between emissions and welfare reduction has been widely accepted.

In economic terms, carbon emissions are externalities, i.e. they are outside of the scope of economic transactions. The negative effect they have on the environment is too widely diluted to spontaneously establish a link with the transaction price. For example, if a customer purchases a shirt online in Europe, the cost to the environment of its production and shipping from Bangladesh is not included in the price. Hence the consumption and investment decisions of people and companies are biased since they do not have the correct price signal to factor-in the environmental consequences of their decisions. Simply put, everyone benefits from the lower prices but no-one pays for the related destruction.

One solution to this problem is to coordinate actors so that they collectively agree to factor-in the price of environmental destruction. This can take a centralised form where the State puts in place a tax (a so-called Pigovian tax) that all actors on a market have to pay. This provides certainty on the price but little control over the emissions volume. It also raises the question of the actual level of the tax, that has to be estimated by the administration through complex econometric models.

Another option to this coordination is to put in place carbon markets. Their principle is rather straightforward. Industrial production sites are responsible for a significant share of emissions and it is easy feasible to monitor their actual emissions levels. A central authority (the EU in the case of the EU-ETS) then provides a reference trajectory for emissions reductions which translates into periodic emissions quotas for these sites. These are polluting rights. Each site receives a set amount of allowances. If the site reduces its emissions below the number of allowances it had, it can then sell these emissions on a market. At the other end of the spectrum, the sites that polluted more than what their quotas allowed have to purchase additional quotas on the market. At the end of the regulatory period, if the sites cannot present enough quotas for their measured emissions, they have to pay a fine to the regulator. This fine provides the incentive for trading and provides a ceiling to market carbon prices.

The drivers of carbon value

Without public intervention, carbon in itself would not have a price. Carbon markets and carbon prices are the result of a social construct and the value of the asset, i.e. the carbon allowance, is therefore heavily determined by a set of factors.

The first, and probably most important one, is the number of allowances that is attributed to polluters for the regulatory period – the so-called “cap”. If the number of allowances is the same as the pollution levels of the preceding period, the incentive to decarbonise is relatively limited as only economic growth and new entrants will be pushing demand. In this framework market prices remain relatively low. On the other hand, if the number of allowances is decreasing in accordance with an emissions reduction trajectory, then emitters will have to compete to obtain the allowances or they will have to reduce their emissions, whichever proves to be cheapest. The number of allowances is an exogenous variable, it is set by authorities outside of the market and market participants are fully dependent on the underlying political decisions. This creates long-term uncertainty as investors have to trust in the commitment of governments to their decarbonisation trajectories. In Europe, the regulatory cycle is of five years and one can see a sharp change in carbon prices at the beginning of new periods as rules are modified towards more stringency.

Source: Trading Econimics for the data, commentary by the author

The second factor that affects prices is the general economic activity. Rather intuitively, all things being equal, an increase in economic activity translates into increased output and hence more emissions. However, this not a one-for-one correlation as many factors come into play, notably technological change. A strong link between economic activity has long been the norm but recently some countries have managed to accomplish a strong form of decoupling. Decoupling refers to the decorrelation of emissions and production. In its weak form, emissions increase at a slower pace than growth and in its strong form they actually decrease while the economy expands. While a positive development, this introduces a source of uncertainty in the long-term valuation of carbon as it is difficult to anticipate the rate at which technological progress will allow for emissions reductions.

The third factor is the general energy mix on which the economic system is based. Energy generators and notably fossil-fuel based power plants are among the biggest carbon emitters and are included in carbon markets. They have a very strong incentive to decarbonize as they have to purchase significant amounts of allowance on a market where their numbers progressively dwindle. At the same time, renewable energies are expanding fast and benefit from significant public subsidies.

Source: International Energy Agency

This new decarbonised production capacity is having an effect on carbon prices. As they gain an increasing foothold in the energy mix, the demand for carbon allowances diminishes. Here again, this is a positive development, however it also affects negatively carbon prices, reducing the incentives for other sectors such as steel or automotive production to reduce their own emissions. This is the so-called “waterbed effect” and its exact impact on carbon value remains theoretically disputed. However, it illustrates the sensibility of carbon value to the energy mix. At the other end of the spectrum, when Russia invaded Ukraine, gas became quite expensive in Europe, forcing coal power plants to produce more and hence emit more. As a consequence, carbon prices increased dramatically, leading other sectors to request for public support as they could no longer afford to buy allowances.

Many other factors come into play to determine exact carbon prices, one could for example mention the weather in the short run.

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Understanding the long-term value of carbon is thus a complex exercise that requires the analyst to take views on a number of unrelated topics that are intrinsically difficult to forecast. This in turn leads to significant estimate discrepancies in terms of carbon prices and to a structural difficulty to making long-term investment decisions that would rely on carbon prices for their profitability.