Understanding the trading of emissions as a commodity is a little more difficult that most futures contracts, largely because of the abstract nature of the commodity. Before diving into the discussion of emissions pricing though, let’s touch on some house cleaning matters.
The first thing to note is that the trading of emissions finds its root in the Kyoto Protocol, which is an international treaty that sets binding obligations on industrialized countries to reduce emissions of greenhouse gases. It’s also referred to as Cap and Trade. The treaty has a goal of preventing dangerous anthropogenic interference of the climate system. Through the treaty, each participating country – which does not include the US – was limited to an amount of pollutants it is allowed to discharge. Each country then allocates allowances to different sectors in the industries and the underlying companies operating in these industries. To ensure that the standards are upheld, each country establishes agencies to control the output of emissions.
The fact that each company has a specific amount of pollutant it can release to the atmosphere is what creates the emissions market. As with most things in life, some companies would need more emissions cap, while others would not be able to exhaust theirs. This therefore creates a market where companies can trade emissions cap. With a foundation already set, let’s now look into the factors that affect emissions prices.
Essentially, a strong economic growth would result in an increase in the price of emissions. You should note that an economic growth signal improved industrialization. This, in turn, means an increase in the output – or production – of companies. And when there is an increase in output, it is likely that an increase in output of pollutants would follow. This, therefore, brings about a rise in emissions prices, as the demand for allowances would be high.
And since the market is quite sensitive, any event that suggests a change in economic strength is likely to change how traders look at the emissions market, which would end up bearing weight on emissions prices. For instance, forecasts of a strong economic growth would result in traders thinking that companies would need more allowances, which might result in a price surge.
Fuel prices are another big factor affecting the price of emissions. This is because the price of fuels is a big determinant in the choice of fuel that companies use. And bear in mind that some fuels are cleaner than others are. To make for business sense, if there is a spike in the price of a certain fuel, companies would opt for cheaper fuels. However, if the cheaper fuel generates more pollutant, the demand for allowances would be high, which would result in high emissions prices. As a rule of the thumb, a spike in the price of a clean fuel, like natural gas, would lead to a spike in emissions prices, as dirtier fuel inputs, like coal, would see more demand.
Weather affects the emissions market in number of different ways. First, let’s consider a hot summer. During a hot summer, it is normal that the demand for electricity would be high. This drives up the demand for coal, which is a dirty source of electricity. This would lead to high demand for allowances and hence high emissions prices. On the other hand, during cold winters, when natural gas prices are usually high, companies might switch to coal, which increases the demand for allowances. In the end, higher emissions prices could be witnessed.
Due to the nature of the commodity, emissions legislations bear a lot of weight on emissions prices. When governments put out legislations that tighten the release of pollutants into the environment, one thing that would follow is the demand for more allowances. Therefore, in summary, the more the legislations that tightens the release of pollutants into the environment, the higher the demand for allowances, which would result in higher emissions prices. So it’s important for traders to lookout for governmental moves regarding the release of emissions into the environment.
For instance, in Australia, the senate is currently planning to repeal carbon price. This move is contrary to what economists think is good for the economy and the environment at large. Economists are arguing that such a move would do little to limit the release of pollutants into the environment. From the argument of the economists, it’s safe to say that such a move would reduce the demand for allowances – at least in Australia – which would end up driving emissions prices low.
The coal market also plays a role in determining emissions prices. On the surface, low coal prices could lead to more demand for allowances, which would lead to higher emissions prices. Here is why. When coal is cheap, powerhouses would be inclined to go for coal as a source of energy in order to keep margins wide. Now, since coal is a big generator of pollutants, the demand for allowances would be high and hence emissions prices. However, on the other hand, if anything stalls the supply or demand of coal, chances are that emissions prices would be low. This is because powerhouses would be forced to consider other, and possibly cleaner, fuel inputs to generate electric, which is likely to lower the demand for allowances.
Crude oil market
Like the coal market, the crude oil market also plays a huge role in determining the demand for allowances, which ends up influencing emissions prices. High crude oil prices, instigated by uncertainties in the oil market, which could stall supplies, would lower emissions prices to some extent, as the demand for allowances would be lower than when crude oil prices are low. Flipping the coin to the other side, when the crude oil market is stable, and supplies are coming in as expected, it’s possible that emissions prices would be high. This is because crude oil is usually a first choice when it comes to energy generation. Hence, the demand for allowances would become higher than when crude oil is unstable.
Long story short, an increase in the use of less-polluting energy types would lead to a decline in the demand for allowances, which would end up lowering emissions prices.