It is perhaps a gross understatement to say 2022 has been eventful for global energy markets. In Europe, many companies would face an existential threat this winter, absent state bailouts, after prices escalated at an unprecedented rate.
Aluminum, pulp, glass and oil refining are among the energy-intensive industries most exposed to more expensive natural gas and electricity. This much is obvious.
What might be less obvious is that these and other industries could soon be caught up in similar dynamics related to European emissions trading. We believe this crisis may be as little as three years away.
At Arcturus, we firmly believe carbon pricing is inevitable, driven by carbon taxes, the emissions trading system itself and firm-level decisions. It will likely be imposed by national and supranational governments as a mechanism to meet binding decarbonisation commitments.
Some of the dynamics of the world to come are already at play in Europe, where we closely scrutinize the European Emissions Trading System (EU-ETS). We believe its mechanics are poorly understood.
It’s worth examining the trajectory of recent prices.
Figure 1: Price of the EU ETS allowances in auctions (Source: EEX)
This chart graphs the price of an EU-ETS allowance, i.e. the right to emit 1 ton of CO2e emissions, between early 2020 and October 2022.
Allowance prices climbed steadily through 2020 and 2021 before entering a more volatile era in 2022. They have approached EUR 100 twice, as our chart shows, falling to a level of EUR 64 in October 2022 - roughly the same price as a year earlier – before rebounding to the current price of about EUR 81.
Prices increased steadily through 2020 and 2021. When war broke out in Ukraine, we entered a more up-and-down period that has persisted ever since.
Carbon futures trading is telling us as much. The 2030 EU ETS futures contract is trading at about EUR 126. That's 50% above current end of October 2022 levels, and is in the same ballpark as the USD 130 estimate for 2030 under the International Energy Agency’s Net Zero scenario.
Acquiring these allowances, and the indirect effect of emission allowances on electricity prices, are the second-order impacts affecting the cost of operating energy-intensive businesses in Europe.
A deeper dive into how the EU-ETS influences operating costs
Let’s take a step back to examine what “carbon trading” is.
Energy-intensive industries burn fossil fuels to produce heat or electricity required in the manufacturing process. This emits CO2 into the atmosphere.
Under the EU-ETS, businesses must procure pollution allowances equal to the amount of carbon dioxide equivalent (CO2e) emitted in their operations. (They then “surrender” these allowances to national authorities.)
Let’s look at how this volatile market could theoretically translate to real costs for an actual company. Consider RWE Power AG. The unit of RWE Group generates power from coal-fired and nuclear plants and describes itself as the “backbone of security of supply in Germany.” It’s one of the biggest participants in the EU ETS program, with verified emissions of 40.5 million tonnes in 2021.
Let’s assume RWE Power had to buy 2021 allowances at the peak price (EUR 98) compared to the earlier trough of EUR 60. The additional compliance cost would have increased by about EUR 1.5 billion (40.5 million tonnes multiplied by the price difference of EUR 38). That increase represents almost 5 percent of the parent company’s 2021 revenue.
Of course, it’s highly likely that RWE, like similar companies, hedges its exposure to price fluctuations to reduce such a risk. But this example illustrates the impact of unmanaged exposure to EU-ETS prices.
Businesses can acquire pollution allowances by bidding for them at auction, buying them from other companies -- or receiving them free of charge under specific conditions.
This is a crucial point. Free allowances are a form of subsidy aimed at deterring companies from moving operations outside Europe to countries with less stringent climate regulation. This risk is commonly referred to as carbon leakage. And free allowances should be viewed as a transitional measure that will disappear.
Carbon leakage: firms that get allowances for free, for now
It thus makes sense to think of EU-ETS market participants as three groups.
Group One: companies – or more precise, their installations - that burn fossil fuels to generate energy. In 2021 this group generated 61 percent  of the verified CO2e emissions in the EU-ETS universe. These installations received few free allowances – just 13 percent of all verified emissions in 2021 - and had to buy most of their emission permits on the open market.
Group Two: the main “carbon leakage” group that receives free allowances. Its four biggest industries are steel, oil, refining, cement and chemicals, which jointly generated 24 percent of verified emissions in 2021.
Group Three: the remaining regulated installations, representing 14 percent of 2021 emissions. These enterprises engage in a wide range of activities, some of which fall under the risk of carbon leakage. As a result, they are granted some free allowances: at the moment, that roughly amounts to 70% of their verified needs.
Figure 2 compares an industry’s actual emissions to the free pollution allocations it was granted. The red dot, representing energy-producing fossil-fuel burners, is where one might expect it to be: emissions significantly exceed the free allocation.
But the four Group Two industries hew closely to the blue line, which represents where emissions and free allocations are equal. Broadly, this means Group Two was granted so many free emissions allowances that they can avoid buying more at scale.
Figure 2: 2021 Free allocations versus verified allowances for the top 5 EU-ETS sectors
(Source: European ETS and Arcturus calculations)
If power producers are effectively the only major companies buying pollution allowances, that’s a problem. Free allowances have been an excessively generous luxury  if the mechanism is meant to act as a meaningful decarbonization incentive for energy-intensive businesses outside the power sector.
The four industries in Group Two had verified emissions of approximately 310 million tonnes of CO2e in 2021. Those emissions have a market value of about EUR 17 billion (based on a median EU-ETS price of EUR 54 for 2021). Policy makers (perhaps realising this) have taken a different approach in the current phase of the ETS.
The process governing free allowances still considers whether an industry has a high risk of carbon leakage, but also assesses an industry’s expected production (sectors with shrinking output should receive fewer allowances) and the emission efficiency of individual installations versus their peers (the most efficient installations should be rewarded with relatively more free allowances – a higher incentive for companies to decarbonise). 
The prospect of a carbon tariff at the EU’s border
The European Green Deal also envisages a future that chooses a different way to fight carbon leakage. It proposes a Carbon Border Adjustment Mechanism – a tariff that hits carbon-intensive imports to the EU. 
Companies in Group Two – expecting to see their free allowance subsidy wound down-towards the end of phase 4 - might consider moving polluting activities offshore. But then imports would be hit by the EU’s new carbon tariff.
So they would instead turn to acquiring most of their pollution allowances the same way as Group One through market transactions – indicating how prices may surge with new buyers entering the emissions market.
Other regulatory developments and price action
Returning to the current movements in prices, we believe it is due to a combination of factors. Partly, the prospect of recession is weighing on demand.
However, amid the simultaneous crises of Ukraine and volatile gas prices, with the prospect of shortages in this and next winter, there is speculation that a mechanism known as the Market Stability Reserve (MRS) will be releasing emissions allowances into the market to ease stress on industry. The MRS’s sales are also aimed at raising funds for investment in making Europe more energy independent.
That’s in the context of REPowerEU – the European Commission’s plan to make Europe independent from Russian fossil fuels before 2030.  This development should not distract market observers from the long-term structural undersupply of emission allowances built into the system. (The supply of allowances was calculated to align with the EU’s climate change goal: a 55% reduction in emissions by 2030 compared to 1990.) 
Despite the current dynamics, the supply will become extremely tight over the long term. The Market Stability Reserve is designed to reduce the current oversupply of allowances. This structural undersupply is inevitable unless companies significantly increase their decarbonisation efforts and reduce actual emissions.
A cost of doing business?
The price of carbon allowances might be viewed as just another cost of doing business by energy-intensive manufacturers and utilities.
Back to that USD 130 estimate for 2030 carbon prices by the IEA. The agency’s Net Zero scenario foresees even steeper increases in the two decades to follow: USD 205 by 2040 and USD 250 in advanced economies.
The resolve of EU policymakers shouldn’t be in doubt. Besides the carbon tariff proposal and changes to EU ETS, there is an increased target of 45% for renewable energy as part of the bloc’s power mix by 2030.
And the US is catching up fast. President Biden’s Inflation Reduction Act, passed in August, will lead to investment of USD 370 billion in cleaner energy and manufacturing. (Many US corporates have also set ambitious decarbonisation goals; more than 1,400 have made Net Zero commitments, and more than 1,800 have set science-based targets. Some 148 members of the S&P 500 have either committed or set a target as of October 2022.)
How does Arcturus help investors and companies manage carbon risk?
Find out what you will have to spend on emissions compliance.
In one scenario for a company operating in an energy-intense industry, Arcturus calculated that the potential cost implied by the futures curve on the EEX (European Energy Exchange) was equal to 30 percent of the firm’s 2021 EBITDA and 80 percent of its capital spending. And this assumes that the company is already hedging the price risk.
Faced with such a likelihood of escalating carbon prices, energy-intensive businesses have two options:
The status quo, paying ever more for emissions allowances, absorbing these costs, placing pressure on future cash flows, debt service, and capital investment plans.
Or investing now in decarbonisation.
Companies will face unrelenting pressure to plan for a decarbonised business model and maximise their use of renewable energy, low-carbon fuels and technologies. This will be combined with regulated emissions allowances and voluntary offset purchases as part of a risk-management toolkit.
Arcturus has a dedicated software solution for companies, including decarbonisation insights, and business intelligence on peers and private companies’ environmental profiles.
For investors and financial institutions, Arcturus delivers:
workflow tools to automate the assessment of financed emissions assessment
granular insights on energy transition
proprietary analytics that include a range of forward-looking carbon adjusted metrics – drawing linkages between the financial impact of rising carbon costs and a company’s cash flows.
Investors and companies should be planning ahead.
Short-term energy market movements and political imperatives will not fundamentally change the long-term outlook – or even the medium-term one.
The changes won’t just apply to European-based companies, but global firms that have material operations in Europe and stand to be impacted by the EU and UK emissions trading systems. The continuing focus of EU leaders and regulators on carbon leakage means that the “quick fix” of relocating or shutting facilities in Europe is unlikely to be a viable alternative to decarbonising.
 The European Commission defined energy-intensive industries that are particularly exposed to the risk of carbon leakage and can be eligible for state-aid in relation to the European Emission Trading system: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020XC0925%2801%29.
 The relative numbers about the EU-ETS verified emissions and registered installation in 2021 include aircraft operations
 Figure 2 is a simplification. The EU-ETS scheme allowed for a meaningful amount of allowances from previous periods to be banked which resulted in an oversupply of allowances. In order to understand the true position of emitters one has to look at the whole series of traded, surrendered, cancelled and allocated emission allowances. Companies in Group Two and Three had very little economic reasons in past phases to purchase allowances in the market.
 REPowerEU is a European initiative to drive Europe closer and faster to energy independence. For reference please see https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal/repowereu-affordable-secure-and-sustainable-energy-europe_en#financing-repowereu