Putting a price on Carbon: Market-based solutions to decarbonisation

Carbon pricing – achieved through carbon taxes or carbon Emissions Trading Systems (ETS) - is a valuable instrument in the policy toolkit to promote clean energy transitions. By internalising the societal cost of green-house-gases (GHG¹) emissions, carbon pricing can stimulate investments in low-carbon technological innovations, foster multilateral co-operation and create synergies between energy and climate policies. Emissions Trading Systems offer one possible design for carbon pricing schemes. Where emissions are capped, trading systems create certainty about the allowed emissions trajectory, while allowing carbon prices to fluctuate. Carbon taxes are an alternative, but do not provide a cap on overall emissions (see table below).

Carbon pricing policies are implemented alongside a wide mix of other policies that promote clean energy transitions, such as air pollution control, renewable energy deployment, energy conservation, economic restructuring, and energy sector and power market reforms. It is important to understand the interaction of an Emissions Trading System with these other policies because it can accelerate or hinder clean energy transitions.

1 Market convention is to refer to all GHGs as carbon (but to adjust each gas to carbon equivalent terms). Therefore, the terms carbon markets, carbon pricing, decarbonising all refer to a broader scope than carbon itself, but in keeping with market terminology we use these terms and associated GHG terms interchangeably.

The origins of Emissions Trading Systems can be traced to an academic essay published by John Dales in 1968. What is now considered to be a centrepiece of modern carbon policy rests on the idea that if policymakers decide on the appropriate level of GHG emissions acceptable, then a market-based system to trade allowances ensures emissions are cut where it costs least to do so.

1. Policy makers decide on a cap on emissions.
2. Greenhouse gas emitters must acquire allowances to emit a certain unit of GHG. These can be given to them, or they can be sold to them, depending on the design of the system. The key thing is that the quantity of permits must be limited and linked to the cap set.
3. GHG emitters can then trade their allowances. If the cost, for a company, to reduce GHG emissions (e.g. by using newer technology) is less than the market price for the allowances, they have a strong incentive to sell their allowances and reduce their emission levels by investing in technology. If the cost, for a company, to reduce GHG emissions is higher than the market price for carbon allowances, and the company does not have enough allowances already to cover their GHG emissions, they are likely to buy allowances from those selling.
4. At the end of a compliance period, the GHG emitter needs to verify how much GHG they produced and surrender the appropriate number of allowances.

There are many different ETS markets across the world. The largest, by far, is the European Union’s (EU) Emissions Trading System, where EU Allowances (EUAs) are traded, and represent 87% of global emissions traded, in value terms. Dating back to 2005 it is the oldest and most established system and sits at the centre of the EU’s climate strategy. Each time the EU tightens climate policy, the supply of EUAs declines, aiding the price incentive for European emitters to decarbonise.

The second largest ETS market in the world is the Western Climate Initiative (WCI) where California Carbon Allowances represent the lion’s-share of traded instruments. It accounts for close to 6% of global emissions traded, in value terms. While California does not place as much prominence on Emissions Trading Systems in its policy delivery solutions as the European Union (i.e. it leans more on other tools to deliver decarbonisation), in the next leg of its decarbonisation journey, it will need to utilise this tool more heavily. California aims to reduce GHG emissions by 85 percent below 1990 levels no later than 2045 and by 48% by 2030 as an intermediate step. That will be tough without using all its policy levers.

a Volume and value of EUAs include spot, auctions and futures but excludes option positions

b Western Climate Initiative (California and Quebec)

c Regional Greenhouse Gas Initiative. The units traded in the Regional Greenhouse Gas Initiative are short tons, which are 0.907 metric tonnes. For unit consistency, we have converted RGGI’s total volume figures to metric tonnes.

d The value for Chinese market includes allowance units for pilot ETS, national ETS (for 2021), and CCER transactions. Value includes only allowances.

e Certified Emission Reductions. These are voluntary market instruments, whereas others in the table are compliance market instruments.

All non-European transactions are priced in local currencies, for the sake of consistency we have converted values into euros. Source: Refinitiv Carbon Market Year in Review 2022 published February 2023.

Historical performance is not an indication of future performance and any investments may go down in value.

2 Quebec participates in a linked-programme but more of the issuance and allowances in circulation are from California

EU Allowances (EUAs) and California Carbon Allowances (CCAs) have active futures markets. Unlike the underlying spot market where liquidity can be low and where holding limits or threat of a financial player censure makes investors feel unwelcome, the futures markets are open to investors. Like most futures markets, transacting directly in futures requires rolling contracts and the need to have a credit line with an exchange; posing a potential hurdle to investors. Fortunately, WisdomTree has developed Exchange-Traded Products (ETPs) that track a rolling futures price on both EUAs and CCAs, democratising access to this asset class. Using robust structures involving swap counterparties that have been applied by WisdomTree for over a decade in commodity markets, they provide superior credit protection to investors.

The swap counterparties who provide the underlying exposure need to hedge themselves using the futures market, and so investors in these ETPs ultimately boost liquidity in the futures market. That aids the price-discovery process and creates a more stable basis for commercial players (entities with compliance obligations) to use the futures market to hedge themselves. This virtuous circle is important for the continued development of carbon markets. The European Securities and Markets Authority (ESMA) conducted a thorough investigation of the EUA market and published its findings in March 2022³. They demonstrated that financial players are a significant source of market liquidity and concluded that price volatility in EUAs followed market fundamentals and were not “abnormally impacted” by the increasing number of financial institutions trading.

3 Final Report Emission allowances and associated derivatives, ESMA 28 March 2022

Both EUAs and CCAs have a very low correlation with other assets. That makes them an option worth considering for portfolio diversification. They also have a very low correlation between each other, and so can complement rather compete within an investor’s portfolio.

Each number above represents the correlation between two assets (read the column/row intersection). A perfect positive correlation is 1 and a perfect negative correlation is -1.

CCA = Solactive California Carbon Rolling Futures TR Index
EUA = Solactive Carbon Emission Allowances Rolling Futures TR Index;
S&P = S&P 500 Total Return Index;
MSCI ACWI = MSCI All Country World Index (includes developed and developing countries)
Commodity = Bloomberg Commodity Total Return index;
Precious metals = Bloomberg Precious Metals Subindex Total Return;
Global Aggregate Bond = Bloomberg Global Aggregate Index TR Index
Daily returns from 17/02/2021 to 17/02/2023, based in unhedged dollar terms

Source: WisdomTree, Bloomberg, Includes backtested data. Solactive California Carbon Rolling Futures TR Index live date is 14/12/2022 and backtest is available to 31/12/2020. Solactive Carbon Emission Allowances Rolling Futures TR Index live date is 03/08/2021.

You cannot invest directly in an index. Historical performance is not an indication of future performance and any investments may go down in value.