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Guest Opinion: A Heightened Focus On CO2 Emissions Stokes Interest In The Carbon Markets

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Guest Opinion: A Heightened Focus On CO2 Emissions Stokes Interest In The Carbon Markets

(Editor's Note: The author of this Guest Opinion is Deb Ryan, Head of Low Carbon Market Analytics, S&P Global Platts, a division of S&P Global, as is S&P Global Ratings. The thoughts expressed in this Guest Opinion are those of the writer and do not necessarily reflect the views of S&P Global Ratings. Roman Kramarchuk, Head of Future Energy Scenarios, and Bhavini Patel, Lower Carbon Market Analyst, both of S&P Global Platts, also contributed to this article.)

The increasing focus on the energy transition and on environmental, social, and governance factors in investment decisions is drawing attention to specific carbon-pricing measures that policymakers have put in place to encourage companies to reduce their carbon emissions. Broadly speaking, a carbon price can take two different forms:

A carbon tax,  whereby the price of emissions per ton of CO2 or CO2 equivalent is fixed and known to participants ahead of time. While some carbon taxes may rise regularly, this model does not place a firm limit on carbon emissions themselves. Rather, companies are free to emit as much as they want so long as they pay for it.

A traded carbon market,  whereby there is a firm limit on the total volume of carbon emissions that are allowed in a specific sector or region over a given period. The price of emissions emerges as a market outcome, fluctuating as a function of the supply and demand of carbon allowances.

EU And California Carbon Prices Rise In 2021 On Increased Speculator Interest/Recovery; RGGI Is Flatter While Korea Declines

Chart 1a


Chart 1b


Chart 1C


Chart 1D


Understanding Cap-and-Trade Carbon Markets

Carbon markets can take several forms, but the typical structure is a cap-and-trade system (see chart below). In this type of market, the supply of emissions allowances is determined by annual emissions caps, with emissions allowances representing one unit (typically a metric ton) of emissions. The annual caps themselves are a function of mandated targets. For example, under the EU Emissions Trading System (ETS), the EU's cap-and-trade system covering the power and heavy industrial sectors, emissions caps were previously set to achieve those sectors' share of Europe's 2030 target to reduce greenhouse gas (GHG) emissions by 40% versus 1990 levels. On July 14, 2021, the European Commission announced its "Fit for 55" package, which proposes to increase that 2030 target to a 55% reduction (versus the 1990 level). Formally implementing this higher target will tighten annual caps and thus lower supply.

Emissions allowances can reach market participants in several ways, but the two most common are through government-run auctions or free allocation. Rules governing auction volumes and frequency, or the share of allowances being either auctioned or freely allocated, vary by market. For example, about half of ETS allowances are sold in daily auctions in any given year, with the remainder freely allocated to heavy industry. Conversely, nearly all allowances in the Regional Greenhouse Gas Initiative (RGGI), a carbon market covering the power sector in Northeast U.S., are sold in quarterly auctions.

Chart 2


Consignment auctions are a feature of California's cap-and-trade market, with the proceeds returned to ratepayers to help offset the higher carbon prices resulting from the program. Free allocations are often used to help shield trade-exposed industries from carbon "leakage," whereby carbon production and emissions are shifted to areas without a carbon price. A carbon border adjustment to account for the cost differential between goods coming in from areas with more and less stringent policies can also achieve this goal. California's program also covers emissions from imported electricity and fuels, while the ETS plans to implement a carbon border adjustment in 2026 following a phase-in period planned for 2023-2025.

Demand comes from the entities that are covered by the program. These entities, such as power plants, steel mills, or cement kilns, will emit CO2 in the course of their operations and must subsequently procure allowances from the market and submit them to the regulators for compliance. Market rules that are embedded in legislation or regulations clearly state which sectors and entities have an obligation to comply with the rules, as well as any penalties for noncompliance. The amount of demand is a function of output levels, as well as how they change over time, and the types of fuel that a covered entity consumes. Additional demand can come from covered entities seeking additional allowances beyond their compliance obligations for hedging or risk management purposes. Demand can also come from external investors that do not have a legal obligation to submit allowances, but rather purchase them as investments.

Table 1

Considerable Differences In Size And Scope Between Carbon Markets Around The World
EU ETS California/WCI RGGI U.K. ETS China Korea
2021 cap 1,600 375 91 156 3,500-4,500 600
CO2 (mil. mt)
Geography EU27+EEA states California and Quebec 11 Northeast US states U.K. (excl. NI) China Korea
Offset utilization No longer Yes, with limits Yes, with limits No Yes Yes
Next program review Jul-21 Mar-21 Fall 2021 2023 TBD TBD
Sectors covered
Power sector x x x x x x
Heavy industry x x x x
Power imports x
Supplied rescom x x
Supplied transport x x
Domestic aviation x x
mt--Metric tonnes. Source: S&P Global Platts Analytics.

Cap-and-trade markets serve a variety of purposes. On the one hand, they ensure compliance with a short-term emissions cap or target, with the associated carbon price being a way to guarantee that compliance. On the other hand, the markets provide a price signal for low-carbon investment and raise revenue for the governments that sell allowances. There is inherent tension between these purposes, with some market participants wanting a low carbon price, as it means lower compliance costs and a reduced impact on end consumers, but others wanting a higher price to stimulate investment.

With this in mind, it is very common for cap-and-trade markets to have mechanisms to guide carbon prices in a certain direction. For example, the Californian and Western Climate Initiative (WCI) markets have very clear price ceilings and floors. In contrast, after years of prices that fell short of expectations, the ETS implemented a Market Stability Reserve (MSR) program. This controls the amount of supply coming into the market based on calculations of overall market surplus, with the intention of influencing prices. The RGGI has a combination of both types of mechanisms.

Prices in cap-and-trade markets will ultimately be a function of all the aforementioned drivers. Near-term prices can be set by current supply-demand balances and the cost of real-time emissions abatement, such as the carbon cost required to encourage coal-to-gas switching in the power sector. Also playing a role are the upcoming compliance periods; the impact of weather on the demand for emissions allowances from the power sector; temporary delays in new supply; and the buying habits of investors. Longer-term price expectations can be a function of the cost of bringing new technologies to market, or market participants' general view about whether policymakers will adopt more stringent climate targets. Any price ceilings or floors in a market are ultimately very important as well.

The Impact Of Carbon Prices Depends On The Fuel Being Consumed

Different fuels have different carbon contents, and so the impact of a carbon price on the cost of combusting those fuels can vary considerably. For example, a hypothetical price of $10 per ton of carbon would add around 50 cents per metric million British thermal units (MMBtu) to the cost of burning natural gas, but nearly twice that amount for combusting one MMBtu of coal. Put another way, it would add over $20 per metric ton to the price of coal for use in combustion. In contrast, the impact on the final price of petroleum products is far smaller.

Chart 3


On an energy-equivalent basis, the impact of the carbon price on coal is nearly double that for gas. However, when it comes to the electricity markets, the better heat and efficiency rates of gas plants magnify the greater impact of carbon prices on coal versus gas. For example, $10 per ton of carbon raises the cost of producing electricity from natural gas in an efficient combined-cycle unit to $3.60 per megawatt hour (/MWh) versus $8.6/MWh for coal-fired generation.

Coal-to-gas switching is one form of carbon abatement that is the cheapest way of reducing emissions in the near term. It is possible to calculate the carbon price needed to switch off 1 MWh of coal-fired generation in favor of 1 MWh of gas-fired generation using a range of different thermal efficiencies for coal and gas power plants and forward curve prices. For example, in August 2021, the implied carbon price rose strongly on rising gas prices, lifting the switching costs in favor of coal-fired generation. Such a situation can support demand for EU allowances (EUAs). Further down along the curve, the implied carbon price is set to fall, which implies downward pressure on EUA prices and a reduction in the cost of offsetting emissions.

Global Carbon Markets: Key Features

There are a number of mandatory carbon markets around the world, with important differences in their size and scope (see table 1).

The EU's ETS

The EU's ETS, which has been operating since 2005, covers the power sector; heavy industry, including steel and cement producers and refineries; and intra-EU aviation. The ETS is also the most liquid of the major carbon markets. Prior to 2017, EUA prices were much too low to encourage reductions in emissions via coal-to-gas switching--historically the cheapest form of emissions abatement--much less investments in clean energy. Many speculators left the market, and EUA prices largely moved on any policy efforts to save the market from the massive surplus that had accumulated after the 2008-2009 financial crisis.

Those efforts resulted in the MSR, a mechanism intended to add some supply-side flexibility that the market previously lacked. The MSR was originally approved in 2015, but in 2017, a decision was made to strengthen it for its first five years of operation. As a result, long-term market balances began to look much tighter than before, and investors returned to the market. EUA prices effectively recalibrated to a level where they were helping determine dispatch rates and encourage coal-to-gas switching. EUA prices have continued to rise, and have shrugged off the massive drop in demand due to the pandemic last year. They were around €25 as recently as November 2020, but are now above €60.

There have been some temporary as well as long-term drivers at play during this year's price rise. First, Europe had a cold winter in 2020, followed by record-high gas prices. This meant that fuel-switch price signals remained firmly in favor of coal-fired generation, which led to greater use of fossil fuels in the power sector and thus more emissions. Additionally, there have been delays to both auctions and free allocations this year, leading to tighter near-term supply of EUAs. However, Europe's stronger climate ambitions, including a 2050 net-zero emissions target, are also playing a major role. Europe's decarbonization efforts continue to attract new investors to the market. Market participants have been expecting policymakers to propose additional reforms to make sure that the ETS is a central part of the energy transition, which could support prices in both the near and long term.

Table 2

The Impact Of A Carbon Price Varies Considerably Depending On The Fuel
$/MMBtu Volumetric basis
Natural gas $0.53
Coal $0.95 $/metric ton $23.20
Gasoline/petrol $0.71 ¢/gal $.09
Diesel $0.73 ¢/gal $0.10
Heating oil $0.79 ¢/gal $0.12
Propane $0.63 ¢/gal $0.06
$/MWh (elec) Btu/KWh
Natural gas (CC) $3.60 6,700 (51%)
Coal $8.60 9,000 (38%)
MWh--Megawatt hour. KWh--Kilowatt hour. Btu--British thermal unit. gal--Gallon. Source: S&P Global Platts Analytics.

The European Commission's Fit for 55 package, released on July 14, 2021, included separate legislative proposals across a range of policy areas, with several other proposals coming in the fourth quarter of this year. The first set of proposals included another round of reforms of the ETS to align the market with a stronger 2030 GHG reduction target. In April 2021, policymakers agreed to increase the EU's 2030 target from a 40% cut versus 1990 levels to a 55% cut. The European Commission is also planning on including the international shipping sector in the ETS. Additional measures include the strengthening of the MSR through 2030; the establishment of a separate ETS for the building and transport sectors; an increase in the linear reduction factor--the annual reduction in allowances in the market; and a one-off downward adjustment to the cap on emissions.


There is no national carbon market in the U.S., but there are two large regional markets that are very active. The Californian carbon market started in 2013-2015, covering the power sector, heavy industry, power sector imports into the state, and emissions associated with fuels supplied for residential and commercial use such as heating and transportation. Unlike the ETS, the Californian carbon market, which, since 2014, has been linked to a similar market in the Canadian province of Quebec via the WCI, includes specific price floors and ceilings. The annual auction reserve price specifies the minimum price for an allowance to be sold at quarterly auctions, which effectively translates into a price floor for secondary markets. The reserve price rises annually by 5% plus inflation, and this rise has been the major driver of prices in this market. California will also begin a review of its numerous climate policies later this year. This, along with an expectation of tighter supply-demand balances later this decade, will also support carbon prices.

The RGGI market only covers the power sector and has been in operation since 2009. It has grown over the past several years and now covers 11 states in total. The RGGI includes several price-stability mechanisms, including a hard price floor, as well as "softer" price supports above the floor and ceilings that guide prices according to changes in market supply. Historically, market participants' expectations of policy developments at the federal level have also heavily influenced the RGGI. Thus prices responded positively earlier this year when the Democrats won the Senate and President Joe Biden took office. An upcoming program review later this year could support prices further. The governor of Pennsylvania is also taking steps to join the market. While the governor has run into several roadblocks in the state legislature, Pennsylvania is a large, coal-intensive state that would increase the size of the RGGI by 70%. North Carolina is expressing interest in the RGGI as well.


Seven Chinese provinces developed pilot carbon-trading programs in 2013-2014, while an eighth province started a pilot program in 2016. These pilots intended for experiments in market design to inform a national program, and to provide industries with carbon-market experience. China announced the formal launch of its national carbon-trading program in December 2017, and trading was originally due to begin in late 2020, though this was delayed. Rules for the national carbon-trading program entered into force on Feb. 1, 2021, and trading began on July 16, 2021. Although the national program will eventually expand to cover seven more carbon-intensive industrial sectors such as petrochemicals, aluminium, cement, and steel, initially it only covers the power sector. All pilot programs will eventually be folded into the national program, though some pilots will co-exist with the national program for at least a year.

Unlike other carbon-trading programs, the Chinese program does not focus on coal-to-gas switching, but on optimizing the coal fleet. With the coal fleet being relatively young, operators should be able to comfortably meet the different benchmark emissions rates for plant size and fuel that would trigger legal obligations to comply with these rates. Trading will initially focus on obligations for 2019-2020 emissions, as opposed to those for this year. When the program opened for trading on July 16, 2021, prices started at around $7 per tonne of CO2 and are set to increase to $20-$30 per tonne of CO2 by 2030.


The U.K. left the ETS at the end of 2020, when it signed a trade deal with the EU, and replaced the ETS obligations with a domestic U.K. ETS on Jan. 1, 2021. Market activity began in earnest with the first U.K. ETS allowance auction on May 19, 2021, as well as with the start of secondary market trading. The structure of the U.K. ETS is very similar to the ETS, though a £22/tonne auction price floor represents one major departure. Initial market balances could be somewhat tight, once compliance demand, forward hedging, and investor interest are taken into account. Given the degree to which coal has been phased out of U.K. power supply, U.K. ETS demand will not be concentrated in the power sector, but rather in the industrial sectors that often have less flexibility in reducing emissions, which can lead to higher ETS prices. Highly ambitious U.K. climate policies will also be constructive for prices in this market, although the small number of market players means that liquidity and price volatility could be key issues.

While there is no direct link between the two markets, S&P Global Platts Analytics sees ETS prices as a key indicator of U.K. ETS prices. After a volatile start, U.K. ETS prices have started to move in tandem with ETS prices, and are currently trading at a small premium to the ETS price. There is the possibility of a link between the U.K. and ETS prices in the future, and the interconnectedness of the underlying power and gas markets suggests that carbon-market participants in one region will not be able to completely ignore developments in the other.


Korea has operated a cap-and-trade program since 2015, covering power generation, steel production, refining, and other large stationary sources of air pollution. Historically tight market supply-demand balances loosened once entities were allowed to borrow allowances from future compliance periods, and also as a result of lower demand due to the coronavirus pandemic. Prices were as high as North Korean won (KPW) 40,000/metric ton of CO2 (about $36) in mid-2020, but have come down dramatically to around KPW13,000-KPW15,000 ($12-$14). This year is the first year that entities not directly covered by the program will be allowed to participate in the market.

Other Types Of Carbon Markets (Outside Of Mandatory Cap-And-Trade Programs) Are Also Having An Impact

A cap-and-trade market is the most typical form of a carbon-trading market, but it is by no means the only one. For example, the California Low Carbon Fuel Standard (LCFS) program does not place a firm cap on emissions, but rather targets reductions in the lifecycle carbon intensity of transportation fuels by encouraging increased penetration of biofuels and electrification. A similar program is operational in neighboring Oregon, and Washington passed legislation for its own program in 2021. British Columbia also has been operating a LCFS for the transportation sector since 2010. Canada is set to launch a federal, economy-wide, clean fuel standard that sets a carbon-intensity limit on liquid fuels at the end of 2022. The Canadian province of Alberta has also run a carbon market focused on the carbon intensity of the power sector, where entities did not trade tons of CO2, but rather tons of CO2 per MWh.

Table 3

North American Low Carbon Fuel Standard Programs
Jurisdiction California Oregon British Columbia China Federal
Start year 2011 2016 2010 End-2022
Affects Transportation Transportation Transportation Transportation
Goal 7.5% (relaxed from 10%) CI reduction 2020 versus 2010; 20% in 2030 10% CI reduction 2025 versus 2015; expanding to 25% reduction in 2035 9% (relaxed from 10%) CI reduction 2020 versus 2010; 20% in 2030 13% CI reduction versus 2016 by 2030
Cost containment Market-based + firm $200/mt ($2016) Market-based (soft) + firm $200/mt ($2016) Administrative penalty C$200/mt Market (soft) C$300/mt ($2022); compliance fund C$350/mt ($2022)
Recent credit price CY2020 market value $190/mt $4.3 billion $125/mt $103 million C$400/mt C$26 million N/A; use C$100/mt as an example
2021 credit price values (penalty for pretroleum fuels and premium for low carbon replacements):
Petroleum gasoline $0.19/g $0.05/g C$0.12/L C$0.01/L
Petroleum diesel $0.23/g $0.09/g C$0.16/L C$0.01/L
Renewable diesel
CI=30 $1.52/g $1.06/g C$0.80/L C$0.21/L
CI=50 $1.03/g $0.73/g C$0.50/L C$0.14/L
N/A--Not applicable. L--Litre. g--Gram. CI--Carbon intensity. CY--Chinese yuan. Mt--Metric tonnes. Souce: S&P Global Platts Analytics.

Voluntary carbon markets are also rising in prominence. As the name suggests, these markets do not focus on compliance with a mandatory program, but rather on securing corporate or individual commitments to reduce emissions via the use of carbon offsets. Projects can earn offsets by either reducing, avoiding emissions, and can then sell these offsets to other entities that can use them to meet their own commitments. There are a number of carbon offset registries, both independent and government-run, that oversee the standards that particular offsetting projects must meet. Nevertheless, while projects can be very transparent, the traded offset price can be far less transparent. There is also some interaction between the voluntary markets and mandatory ones, as several mandatory programs allow limited use of offsets for compliance purposes. Additionally, the Carbon Offsetting and Reduction Scheme for International Aviation program--which addresses GHG emissions from international aviation and started this year--focuses on offsets.


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