I Won't Back Down - European Carbon Trade Drives Up Global Gas Prices, By Design

Global gas and LNG prices are currently at record high levels. If we sound like a broken record, it’s because this epic bull run that started in the spring, has been roaring in recent weeks and showing little sign of slowing down. European prices have hit new post-2008 or all-time highs more than 25 times since late June, and prices in Asia, which had been at seasonal all-time highs for most of the spring and summer, finally last week also topped its previous all-time record from last January. A confluence of bullish factors, including high global demand, low storage inventories, weather events, and supply outages, have all contributed to the surge in gas prices. While many of these are near-term drivers and will eventually flip in the other direction, there is one bullish driver of global gas demand — European carbon prices — that will remain a constant in the years to come. That is by design because the carbon market is meant to serve as an incentive for the industry to seek greener solutions over fossil fuels. In today’s RBN blog, we look at the European Union’s Emission Trading System (EU ETS) and how it interacts with the global gas market.

Europe has the world’s oldest and largest carbon trading system. We’ll start with its origins to get a better understanding of how it works. The market, which now covers all the countries in the EU as well as Iceland, Liechtenstein and Norway, was established in 2005 to regulate emissions from power generation, manufacturing and some airline operations. Together, the sectors that fall under the ETS regulations account for about 40% of the EU’s total greenhouse gas (GHG) emissions. The EU ETS is a cap-and-trade system, meaning that there is an annual limit or “cap” on the total allowable GHG emissions from each of the roughly 10,000 installations covered by the ETS regulations. Each of the installations (say, a power plant or factory) receives a certain number of emissions allowances for a year. If an installation emits its exact allowance, then it is all set, but if it has extra allowances or needs more, that’s where the “trade” portion of cap-and-trade comes in. If an installation has extra allowances, it can bank them for the following year or sell them using the ETS and, if it needs more allowances, it has to purchase them. The open trading of emissions allowances provides a financial incentive for participants to go green and does it in a least-cost-first way. Basically, those who can reduce emissions cheaply, do so and then sell credits, and those who can’t, buy them. Either way, the overall market is capped, guaranteeing that the emissions don’t go over that level even though individual participants may emit more or less than what they were allotted.

The system began with a three-year pilot program, phase 1, which ran from 2005-07. During this time, the emissions caps were based on estimates since reliable data around emissions was not yet available, and it covered only carbon dioxide (CO2) emissions for a subset of the industries and installments that are covered today. Phase 1 established a price for carbon and a trading system and allowed for the infrastructure needed to monitor potential emissions from new installations. Figure 1 below shows the EU ETS prices from the start of the market in 2005 until now, with the system’s phases delineated by the shaded areas.