Europe’s carbon market keeps growing but at a slower pace

The EU ETS – the world’s largest carbon market by turnover – continued to grow in 2023, but the 5.4% increase looks modest compared to the 11.8% growth in 2022, or the staggering 150% in 2021. Our assessment of EUA trading – volumes and prices – in 2023 shows a market value of €783 billion. See Figure 1 and Table 1.

Figure 1. EUA turnover, by market segment.

Table 1. EUA turnover, by market segment. Billion euros.

The traded volume stayed flat, from 9.16 billion units to 9.24 bn. The EUA front-Dec futures contract, considered the reference price, fluctuated between €66/t and €100/t. Overall, we observed a downtrend from the beginning to the end of the year. See Figure 2.

Figure 2. EUA front-Dec prices Jan to Dec 2023.

When assessing the size of the European carbon market we multiply volume by price at the time of each transaction. See Textbox 2 for more details.

The EUA price reached an all-time high just above €100/t on 21 February. We believe the fundamental driver for that push was the growing realization that in the second half of this decade, the market balance is set to become increasingly short. Additional support came from technical analysis of price patterns in the weeks leading up to that date. Pulling in the opposite direction in the early months was a sharp fall in gas prices due to healthy storage levels and mild temperatures.

Eventually, the bullish impact from the long-term tightening was also offset by nearer-term concerns over the EUA auction volumes that are being frontloaded to 2023-2026 to help finance the REPowerEU plan to jumpstart Europe’s green transition. During much of the summer and autumn carbon hovered between €80 and €90. Throughout November and early December, against the backdrop of economic gloom and falling emissions, carbon declined to reach a year-low at €66/t on 15 December. Since then, carbon recovered and closed the year at €80.37/t, down 4.3% compared to the last trading day of 2022.

If we compare yearly averages, we see a slight uptick, from €81.20/t in 2022 to €85.30/t in 2023.

Looking at the segments that constitute the EU ETS, we see that futures contracts continue to represent the lion’s share, with 85% of the total turnover (Table 1 and Figure 1). Spot is next, at 9%. The auctions of fresh EUAs (on behalf of member states’ governments, the Modernisation Fund, the Innovation Fund, and REPowerEU) that take place nearly every day at the EEX exchange make up the remaining 6%.

Comparing volumes, we see roughly the same segment split as for turnover (spot and auction prices generally follow futures). Compared to 2022, the futures volume is slightly down, from 7.92 billion to 7.88 billion units. The two smaller segments, spot, and auctions, increased.

Drilling into the auction numbers, we find that altogether they raised 43.6 billion, of which 33.3 billion went to the member states. Some 5.6 billion entered the Modernisation Fund and another 1.8 billion into the Innovation Fund. Some 2.8 billion were monetised for the REPowerEU programme, of which 1.5 billion was redirected from the Innovation Fund and 1.3 billion from the member states’ auction volumes. Table 2 also lists the top beneficiary states.

Table 2. Distribution of auction revenues. Billion euros.

Market reform will eventually tighten supply, but the near-term balance is loose

A gloomy economic outlook has weighed on carbon prices in 2023, as has the anticipation of extra EUA auctions to raise funding for the ongoing green transition. If prices have nevertheless held up, it is primarily because a longer-term view reveals a looming shortage from 2027 onwards. Technical analysis (predictions based on price patterns) gave additional guidance for many traders, especially during parts of the autumn when the €80 mark served as a psychological floor. Finally, temperature and wind have in periods served as important price drivers.

EUA supply. The issuance and availability of EUAs 2023 were decided mainly by the ETS framework that was decided back in 2018 for the 2021-2030 trading period (Phase 4). Key aspects, such as the linear reduction factor and the MSR operated as in the preceding years.

As usual, in May, the European Commission announced the annual surplus indicator, the total number of allowances in circulation (TNAC). It was then at 1.1 billion allowances, 307 million lower than in May 2022. The Market Stability Reserve, operating at a 24 percent intake rate, will soak up 272 million EUAs from 1 September 2023 -31 August 2024. For the calendar year 2023 (Jan-Dec), the total intake to the MSR was 322 Mt, slightly lower than the 368 Mt absorbed in 2022.

In 2023 the first invalidation of allowances of allowances from the Market Stability Reserve took place. With the publication of TNAC the European Commission announced that 2.5 bn allowances became invalid on 1 January 2023.

The most recent ETS reform, the “Fit for 55” revision was on traders’ radar and impacted prices in 2021 and 2022. The certainty that the new, tighter supply-side parameters will kick in from January 2024 has been the anchor for the price since the political agreement was reached in December 2022. The growing realization that from 2027 onward the balance will be short, i.e. demand will outpace supply, has buoyed the EUA price throughout 2023 as well, and spurred the brief attempt above the €100 mark in February.

See Textbox 1 for a quick reminder of how key parameters are being recalibrated and how that will affect issuance going forward. The recalibration is done to align the EU ETS with the new 2030 target of reducing emissions by at least 55% across the economy.

What traders have tried to understand and anticipate throughout 2023, is how the rechannelling and frontloading of EUAs to help finance the REPowerEU programme would impact the timing and volume of EUA auctions. In short, this means extra supply coming to market in the years 2023-2026 and less in the subsequent years (see more details on REPowerEU in the policy section below).

The near-term volume boost has weighed on prices, producing the opposite effect of the FF55 reform. This has arguably been the single most important bearish driver in 2023, especially during the second half of the year.

Fundamental demand: emissions. Overall, the emissions from installations covered under the ETS continued to decrease last year. Verified data for 2022, unveiled on 1 April 2023, showed a sharp drop in industry emissions as many factories scaled down in response to the skyrocketing energy prices triggered by the war in Ukraine and the ensuing sanctions on Russian fossil fuels. Emissions from the power sector inched up because of higher coal burn. Across all sectors, 2022 emissions came in at 1,360 Mt, down 0.4% from 2021.

In 2023, both power and industry emissions declined. Based on power generation data we assess emissions from this sector to be down 20% compared to 2022. The main reason is the 2.5% drop in overall electricity demand, which mainly hit fossil-based generation (down 22%). Europe’s total generation inched down from 2,717 TWh in 2022, to 2,698 TWh in 2023.

A breakdown into high-level categories in Figure 3 shows how fossil-based generation (coal, gas, and oil) dropped 208 TWh to 738 TWh, down 22%. Coal (hard and brown combined) was down 27%, gas was down 17%.

Renewable sources (hydro, solar, wind, and bio) increased 130 TWh to 1,240 TWh, up 12%. Nuclear generation was virtually unchanged.

Figure 3. Fuel mix in European power generation 2022-2023

Among the fossil sources, we observed significant drops in gas (from 499 to 412 TWh), hard coal (from 201 to 141 TWh), and lignite (from 227 to 169 TWh).

Had it not been for the sharp drop in gas prices in 2023, gas generation would have been lower and coal generation higher. Cheaper gas incentivised coal-to-gas switching. Figure 4 compares the theoretical CO2 switching price from a 39% efficient coal plant to a 50% efficient gas power plant, to the actual CO2 price throughout the year. Gas was largely in the money between February and October, and again in late December.

Figure 4. Coal-to-gas switching.

This switch to less-polluting gas helped reduce power sector emissions in 2023, even though the effect was limited compared to what resulted from decreased electricity demand.

In short, we see that the fossil uptick in 2022 has been reversed – which is good news. But we also see that the main driver behind the 20% emission reduction is not a structural shift, but rather a positive side-effect of power demand destruction.

For industry, we see that the decrease in emissions that started in 2022 has continued throughout 2023. The latest industrial production data from Eurostat, which includes the month of October, shows a 0.5% decrease month-on-month, and a full 5.5 % drop year-on-year. That level of contraction will almost inevitably lead to reduced demand for EUAs. An Ifo Institute poll on German industrials’ investment plans, published in early December, shows increasing reluctance. Expressing the difference between the share of companies intending to ramp up investments and those set to scale down, the Ifo index, based on polls in November, is at 2.2, sharply down from 14.7 in March 2023.

We estimate that total industry emissions in 2023 amounted to 581 Mt and we expect the same level in 2024 (580 Mt).

Policy developments: FF55 adopted, CBAM started, auction volume adjusted

Policy has been less of an important driver in 2023 compared to the preceding years when the EUA price reacted to developments in the negotiations over the FF55 parameters. Also, the energy and climate files that are currently top of the agenda, such as NZIA and EMR, have only a tangential impact on the EU ETS. As it turned out in 2023, the policy file with real price impact for carbon was REPowerEU, through its immediate effect on auction volumes and hence the market balance.

That said, 2023 was the year when the “Fit for 55” reform of the EU ETS was formally adopted, with the amended directive signed off on 10 May by the European Parliament and the Council presidencies. Most of the changes, such as the scope expansion to include maritime transport emissions or the increased linear reduction factor, take effect from 1 January 2024.

Implementation. While the ETS directive provides the overarching setup and defines the key parameters, many important details need to be spelled out in secondary legislation. Overall, the European Commission is revising some 55 delegated and implementing acts to complete the regulatory framework for the EU ETS.

The Innovation Fund Regulation was adopted on 15 September, to introduce competitive bidding to complement the previous system for awarding grants (scoring). The Auction Regulation was adopted in October and entered into force on 20 December after a two-month scrutiny period. That gave the final confirmation of the EUA volumes that will be offered in the years to come and allowed EEX to publish the 2024 auction calendar the following day.

Another key text adopted in October was the Registry Regulation, which prepares for the inclusion of maritime emissions (from 2024) and buildings and road transport (ETS2 from 2027). The revised Modernisation Fund Regulation, adopted in November, increases the list of member states eligible for support.

Then followed the Free Allocation Regulation, which outlines rules on the conditionality principle, the review of benchmarks, and special allocation rules for district heating and installations in CBAM sectors. A draft text was published on 5 December, and adoption is expected in January.

REPowerEU. While the parameter changes that make up the FF55 reform of the EU ETS have been known since December 2022, a policy file that was closely watched and did impact prices in 2023 was REPowerEU, an initiative launched in 2022 in reaction to Russia’s invasion of Ukraine. The plan is to end Europe’s dependence on Russian fossil fuels and accelerate its transition to renewable energy sources. The lion’s share of the €320 bn programme will come from the Resilience and Recovery Facility, a funding source created during the Covid pandemic, but an additional €20 bn will come from the sale of EUAs sourced partly from the Innovation Fund, partly from the member states’ auction volumes.

The target for EUA monetisation – the €20 bn – has been clear all along, as has the overall timeline, with the auctions starting in September 2023 and ending in August 2026. That said, questions about the exact timing and volume of this extra EUA sale have kept market participants busy through much of 2023.

A note from the European Commission on 17 November clarified that 86.7 million EUAs will be auctioned for REPowerEU in 2024. That number reflects an assumed average price of €75/t, in which case the sale will raise €6.5 billion this year.

By the end of 2023, the REpowerEU sales had monetised €2.8 bn, of which €1.5 bn was sourced from the Innovation Fund, and €1.3 bn from the member states. The volumes for 2025 and 2026 (January-August) will be adjusted according to actual prices, to ensure that the monetisation reaches €20 bn by (or before) August 2026.

CBAM. In parallel and as a complement to the revision of the ETS directive, Europe has launched a carbon border adjustment mechanism, CBAM, to protect its industry against competition from third-country manufacturers with limited carbon emission costs. An old idea, CBAM was always seen as controversial both within and outside Europe, but with an increased focus on phasing out free allocation of EUAs – a key element of the FF55 revision – CBAM has been chosen as the new protection against carbon leakage. It obliges importers of hydrogen, electricity, fertilisers, cement, iron/steel, and aluminium, to buy and surrender certificates to even out the difference in emissions costs.

CBAM is currently in a transitional phase in which importers must report embedded emissions. From 2026 onward, they will also need to pay the difference between their carbon cost and that of their European peers. In mid-August, the European Commission released the first of a slate of secondary legislation that will govern the implementation of the CBAM regulation.

While the ETS directive and the CBAM regulation form the cornerstones of Europe’s framework for carbon trading, other climate and energy files are also relevant, though more indirectly. The revised Renewable Energy Directive (RED III) was formally adopted on 9 October 2023. It raises the target share of renewable energy in the EU’s overall energy consumption to 42.5% by 2030 with an additional 2.5% indicative top-up to allow the target of 45% to be achieved. All member states will contribute to this common target.

Removals. For Europe to reach its target of net zero emissions in 2050, simply avoiding emissions will not be enough, there will also be a need to remove CO2 already in the atmosphere. To encourage innovative carbon removal technologies and sustainable carbon farming solutions, the Commission proposed a preliminary certification framework in late 2022, which addresses three main types of removal/storage. First, nature-based (e.g. restoring forests); second, technology (e.g. direct air carbon capture and storage); and third, long-lasting products and materials (e.g. wood-based construction).

The member states in the Council agreed on a position on this file on 17 November, and three days later the European Parliament plenary decided its negotiating mandate, by endorsing rapporteur Pereira’s report, which seeks to ensure that emitters of fossil fuels are not certified for removals that could be reversed later. The most difficult part of the plenary debate was the idea of ‘carbon farming’ for which MEPs failed to agree on a clear definition beyond the notion that it shall reduce emissions for at least five years. With both lawmakers having a negotiating mandate, trilogue has started, and will hopefully conclude during the Belgian presidency in H1 of 2024.

Box 2. Methodology