EMISSIONS TRADING MARKET ANALYSIS

Market Challenges And Opportunities

Emissions Trading Market Drivers:

• Environmental concerns and climate change mitigation: The primary driver behind emissions trading is the global concern about climate change and its adverse impacts. Governments and international bodies recognize the need to reduce greenhouse gas emissions to limit global warming and its consequences. Emissions trading provide a market-based approach to incentivize emission reductions and promote the transition to cleaner and more sustainable practices. According to the International Renewable Energy Agency (IRENA), the total renewable energy generation capacity globally reached 2,537 GW by the end of 2020, a 10% increase from the previous year. Increasing environmental concerns have led to the adoption of sustainable manufacturing practices. According to a survey by the United Nations Industrial Development Organization (UNIDO), 68% of companies worldwide have implemented at least one green initiative in their manufacturing processes.
• Regulatory compliance and international commitments: Many countries have set emission reduction targets and commitments under international agreements like the Paris Agreement. Emissions trading enable countries and industries to meet their regulatory obligations more cost-effectively by trading emission allowances and credits, thus providing flexibility in achieving emission reduction goals. For instance, the European Union’s Green Deal aims to make Europe the first climate-neutral continent by 2050. This has led to increased investments in renewable energy, energy efficiency, and other low-carbon technologies.
• Economic efficiency and cost-effectiveness: Emissions trading allows companies to find the most cost-effective ways to reduce emissions. It creates a market for emission allowances, where those able to reduce emissions at lower costs can sell their surplus allowances to those facing higher costs, encouraging emission reductions where they are most economically viable.
• Stimulating clean technologies and innovation: Emissions trading incentivizes businesses to invest in cleaner technologies and practices. Companies that reduce emissions below their allocated allowances can sell the excess allowances, thereby creating financial incentives to invest in low-carbon technologies and innovative solutions to decrease emissions.

Emissions Trading Market Opportunities:

• Expansion of emissions trading schemes: As more countries and regions commit to reduce greenhouse gas emissions, there are opportunities to expand existing emissions trading schemes and implement new ones. Governments can explore the potential of emissions trading in different sectors, such as transportation, industry, and agriculture, to achieve broader emission reduction targets. According to the report provided by the World Bank’s State and Trends of Carbon Pricing till 2020, there were 61 carbon pricing initiatives implemented or scheduled for implementation worldwide. These initiatives cover 12 gigatons of carbon dioxide equivalent (GtCO2e), or about 22% of global greenhouse gas emissions.
• Linking emissions trading systems: Linking emissions trading systems between different countries or regions offers opportunities to create a larger and more liquid market for emission allowances and credits. This linkage can enhance cost-effectiveness, encourage international cooperation, and increase the overall impact of emission reduction efforts.
• Inclusion of new greenhouse gases: Current emissions trading systems primarily focus on carbon dioxide (CO2) emissions. Opportunities exist to expand these systems to include other greenhouse gases like methane (CH4), nitrous oxide (N2O), and hydrofluorocarbons (HFCs). Integrating a broader range of greenhouse gases into emissions trading can address a more comprehensive set of climate change challenges. The inclusion of new Green House Gases in emissions trading schemes can create new markets for emissions reductions. For instance, the California Cap-and-Trade Program, one of the largest emissions trading schemes in the world, includes multiple GHGs, including CO2, CH4, and N2O. According to the California Air Resources Board, the program covered approximately 360 businesses representing roughly 85% of California’s GHG emissions in 2020.
• Market-based solutions for net-zero goals: Countries and companies that are aiming for net-zero emissions have opportunities to use emissions trading as a market-based solution to offset residual emissions. Investing in carbon offset projects and nature-based solutions can help achieve net-zero goals more efficiently.

Emissions Trading Market Restraints:

• Lack of commitment by large emitters: Lack of commitment by large emitters is a major roadblock for the growth of emissions trading markets. The emissions trading system is based on the principle of cap and trade, where targets are set to limit overall emissions from sources like power plants, factories, and heavy industries. However, if large corporate entities and industrial sectors do not stringently follow the prescribed emission reduction targets, it hampers the effectiveness of the whole system. When big emitters do not tightly control their greenhouse gas emissions and buy excessive emission permits instead of investing in cleaner technologies, it sets a wrong precedence. Other market players also tend to relax their own efforts knowing that top players are not fully compliant. This defeats the basic purpose of emissions trading which is to encourage entities to lower their carbon footprint through means like energy efficiency and adopting renewable energy. Without full coordination between policymakers and active commitment from large-scale polluters, emissions caps become unrealistic and trading volumes remain suboptimal. For example, greenhouse gas emissions from global heavy industry increased by over 2% in 2021 as compared to the 2020, according to the International Energy Agency. The steel and cement sectors together account for over 20% of direct CO2 emissions worldwide but are still in the early stages of adopting low-carbon equipment and processes. Unless major industrial hubs and corporate groups make large-scale investments and switch to cleaner production methods, emissions from this sector will keep rising despite the presence of carbon markets. This ultimately restricts the potential growth of emissions trading schemes as overall supply and demand remain unbalanced with inadequate efforts on the ground to cut emissions.
• Counterbalance: The major industrial hubs and the corporates need to make investments in cleaner and environmentally friendly emissions method to reduce the emissions from industrial sectors.
• Prevalence of free allocation of emissions allowances: The free allocation of emissions allowances has played a significant role in restraining the growth potential of emissions trading markets. When allowances are freely distributed to heavy polluting industries, it fails to incentivize them towards investing in cleaner production methods and transitioning to greener operations. Without having to pay directly for their emissions, these industries do not face adequate cost pressure that could drive more environmentally friendly business decisions. This is amply evident from the experience of the EU Emissions Trading System, one of the largest and oldest carbon markets. In the earlier phases of the EU ETS (2005-2012), the majority of allowances were freely given out based on historical emissions. This resulted in carbon price instability and a generally low price signal. In 2018, according to a report by the European Environment Agency, the average price during the first phase was just €0.30/tCO2e. With such a negligible cost of polluting, there was hardly any motivation for industries to curb emissions. Even subsequent phases witnessed significant free allocation which continued weakening the carbon price signal. Free allocation also leads to windfall profits for industries which are able to either pass on the carbon costs to consumers or gain competitiveness without actually reducing their carbon footprint. According to the International Carbon Action Partnership’s status report of the EU ETS, in 2021, around 45% of the total allowances were given out without any emissions reduction requirements in the third phase (2013-2020). This flood of free permits distorted the supply-demand balance and exerted downward pressure on carbon prices, failing to make low-carbon options sufficiently financially attractive.
• Carbon leakage risk: Carbon leakage risk is a major concern that is restraining the growth of emissions trading markets. Carbon leakage occurs when stringent climate policies that increase costs for high-emitting industries in one country cause businesses to relocate production to other countries with less stringent climate regulations. This weakens the environmental effect of the original country’s climate policy and does not reduce overall global greenhouse gas emissions. The risk of carbon leakage gives industries an incentive to oppose tougher emissions regulations and the expansion of emissions trading schemes. Industries perception of international competitiveness will be jeopardized by having to pay more for the carbon emissions at home; this will lead to lobbying of the governments against strengthening climate policies. They may argue that more stringent rules could damage economic growth and cost jobs, if production moves abroad in response to higher compliance costs. This risk of carbon leakage makes governments and regulators more cautious about increasing the scope and ambition of emissions trading systems out of fear of negative economic impacts. The carbon leakage problem also impacts the potential for linking emissions trading schemes between different countries. Countries will be reluctant to form linkages if there are large differences in the carbon price between the systems. Industries in the country with the higher carbon price fear production may shift to the other country. This reluctance limits the potential for emissions trading systems to be connected on a wider international level through linking, which could significantly boost the scale and growth of emissions markets.