CERAWEEK: Energy system shock brings long-term opportunity for carbon markets

Market-driven climate solutions will continue to push forward as policymakers shift their focus to geopolitical uncertainty, creating an opportunity for carbon markets to turn the Middle East war from a headwind into a tailwind, speakers said on a March 24 conference panel.

The major disruption occurring in the global energy system caused by the war in the Middle East poses a significant challenge to global energy transition efforts, Dirk Forrister, CEO of the International Emissions Trading Association, said during a panel discussion at the CERAWeek by S&P Global energy conference in Houston.

"We have to figure out ways to work together across international borders to fix the problem," Forrister said. "It's not something any individual country can do, and in fact, if we all try to operate in silos around the world, it's going to cost us more and take longer, and time is not on our side."

Panelists noted that LNG supply disruptions tend to be a boon for coal. This leads to cases in which coal-fired products have a significant advantage over cleaner alternatives.

However, panelists also made a positive case for the impact of geopolitical whiplash on the energy transition. The climate challenge "is something that will not go away," and a shift in focus toward national and energy security "cleans up" the projects that are less serious or don't "make sense," said Ricardo Mussa, CEO of Sustainable Business COP.

"When you have a crisis like that, it's a good moment for us to take a chance and move toward some transformation," he said.

This geopolitical shift allows carbon markets to "catch up" with policymakers, said Roman Kramarchuk, head of integrated narratives and policy analysis at S&P Global.

"A lot of the time we've seen regulations are being driven by policy; sometimes they're thought through, sometimes they're not measured well," Kramarchuk said. "We are absolutely going to see it slow down in the short run. But that doesn't stop [market-driven] efforts."

"If anything, it gives us more time to make sure that when the next round comes around, it's not [carbon] accounting trying to catch up to policymakers and fix it, but it's the other way around," Kramarchuk added.

The accounting problem

Carbon measurement is acting as a binding constraint in the energy-transition space, Mussa said. He said carbon markets around the world "struggle" with the "fundamentals," especially in carbon accounting.

"People are concerned that this discussion of carbon accounting will delay the process... I completely disagree on that," he said. "If we don't fix this fundamental thing and have the right measurement, the right accounting, we will never be able to attract the financial sector, never be able to [make the] carbon markets work properly."

How carbon markets "draw the line" is key to properly incentivizing products with lower carbon footprints, Kramarchuk said. One example he gave is found in California, with the state's cap-and-invest program and its Low Carbon Fuel Standard: biofuels count as zero-emissions in the cap-and-invest program, but there is greater scrutiny of feedstocks and land use for biofuels in the LCFS, he said.

"Granted, California can be a very complex jurisdiction to play in, but there are two different ways that the treatment of biofuels is being held," he said.

Another example is how the EU considers the carbon footprint of aluminum. The EU is "just focusing on the processing of the aluminum," Kramarchuk said, while not considering the type of power used for aluminum production.

"If you're a Canadian aluminum maker that is producing its aluminum from hydropower, your total scope is actually really good, but in the CBAM world ... that's not being accounted for," Kramarchuk said. "Another country with somewhat better processing but using coal fire or fossil fuel power to make the aluminum actually comes out ahead in that process ... think about the incentives that that creates."

Standardization through collaboration

Forrister emphasized the importance of "building cooperative models," pointing to California and Quebec linking their compliance carbon markets. The joint California-Quebec program is also looking to link with the Washington state cap-and-invest program. Forrister also mentioned the EU's 27 member states collaborating in one system while also adding Norway and Switzerland.

"It's a lot easier if you've got a system of credits, a pool of credits that can be used, be it from nature or from technology," he said. "It can help to even out the costs in different places if everybody in those covered sectors has access to the same pools of credits."

The cap-and-invest program in Washington state has significantly higher emissions allowance costs than those of other North American compliance programs. The state took a more aggressive stance than California, starting off with strict emissions caps and tight supply. The high costs sparked a political backlash, prompting state Republicans to add an initiative to the November 2024 ballot that gave voters the option to repeal the program altogether. The initiative failed by a wide margin, but the state sought to improve the program's political stability by linking it to the much larger California market.

Platts, part of S&P Global Energy, assessed next-December California carbon allowances at $29.19/allowance March 24. In Washington state, where demand is outpacing supply, the last quarterly emissions auction settled at $65.26/allowance.

The process of linking markets has been complicated as each jurisdiction works to align its regulations. Significant steps taken in this process, such as the release of a draft linkage agreement, cause Washington state carbon allowance costs to edge lower, as market participants prepare to see allowance costs anchored to the much lower California price.