10 Feb 2022 5 min read

Carbon pricing: mobilising capital markets to address climate change

By John Daly

Can market forces, supported by governments, help address carbon 'free riders'?


We are in a climate emergency. Governments are responding by mobilising pools of capital to help in this fight, including pension scheme assets. Under new climate-related governance regulations, part of the UK Pension Schemes Act 2021, trustees of schemes are required to consider climate-related risks and opportunities. It’s also expected that legislation will change in the years ahead to force companies to be more transparent in the reporting of their carbon footprint.

In a previous article, I set out how the cost of carbon varies around the world and the significant ‘free rider’ issue that exists. Can market forces, supported by governments, help address this issue?

Market-based solutions to address externalities – carbon pricing

There are two main types of carbon pricing. Emissions trading systems (ETS) are market-based mechanisms that aim to provide economic incentives for companies to reduce their carbon emissions. The other is a carbon tax, which directly sets a price on carbon. Governments will adopt different instruments based on different circumstances; however, we will focus on ETS in this article.

In an ETS, a set number of carbon allowances is allocated by the governing authority to companies within the region, consistent with the overall aims to reduce year-on-year carbon emissions. The system is a legally binding regulated market. Some companies will not use all their permits because they may have implemented carbon reduction investment plans (i.e. they will have a surplus), whereas other companies with inefficient plants for example will go over their limits. In this case, carbon permit trading can take place. The price of carbon is then determined by supply and demand factors – the total supply of permits and demand given by the rate of carbon reduction initiatives, the level of economic activity, etc.

The advantage of the system is that it requires little government intervention. The invisible hand of capitalism can find the best solution for carbon reduction. And crucially, authorities can influence the carbon price through restricting supply year-on-year, to a point that industry is still able to compete with peers internationally. 

However, to date ETS have failed to reduce the amount of carbon emissions. They work well in theory, but in the real world there are measurement problems, issues around setting the right carbon price, enforcement and punishment problems, and ‘carbon leakage’ – companies re-locating operations or sub-contracting manufacturing to areas where carbon externalities are not taxed. However, that may all be about to change.

Reinvigorating the cost of carbon permits within the EU

The EU has set an overall carbon emissions reduction target of 55% by 2030 relative to 1990 levels. The EU ETS is the cornerstone of Europe’s climate change policy so this ambition will be reflected in the EU’s ETS cap. The EU has therefore proposed some key reforms to its ETS to improve the functioning of this market.

  • Strengthened Market Stability Reserve (MSR). A surplus of emission allowances built up in the ETS since 2009 largely due to the economic crisis (lower level of economic activity), reducing the level of emissions more than anticipated. This depressed the price of carbon in the ETS. Essentially, additional powers given to the MSR seeks to address this by cutting the supply of emissions allowances in the system, thereby supporting the carbon price.  
  • The annual permit cap reduction has been increased from 2.2% to 4.2%. And new sectors have been added to the system like maritime and buildings/transport. This should help to restrict the supply of carbon permits handed out, a criticism in the past as to why the carbon price was too low.
  • A carbon border adjustment mechanism (CBAM) has been added to help address ‘carbon leakage’ in the face of increasing carbon prices in the EU. Starting in 2026, importers would be required to surrender newly created CBAM certificates (independently verified) annually, equivalent to the embedded emissions of their products, at a price equivalent to average closing prices at EU ETS auctions each week. This should prevent companies exporting the externalities of carbon emissions.

All these revisions together mean that the price of carbon in the EU is structurally designed to rise over time. Importantly, if the revisions to the system make for a more efficient functioning market, it may provide a blueprint for other regions around the world to emulate.

Carbon ETS blog chart.png

Why increase the cost of carbon?

Legislating carbon emissions out of existence by a certain date would be a draconian measure that would likely have unintended consequences. Our society and economy have been built on fossil fuels over the past century and it will take time to transition to a low-carbon future. Using market forces such as ETS is politically more palatable and more likely to work as market forces seek out the most efficient solutions.

Some market participants believe that once the price of carbon hits a certain threshold for a sustained period, this will make new forms of energy competitive and mobilise private capital market investment.  For example, ‘green hydrogen’ (hydrogen formed though electrolysis using offshore wind) is expected to become viable at €80 per ton. This is expected to play a huge role in the race to net zero, especially in hard-to-decarbonise industries such as steel and cement production, heavy industry, heavy goods vehicles, shipping, and aviation. Other applications include replacing natural gas for home heating and as a store of renewable energy, i.e. re-creating electricity from hydrogen to meet grid demand. It’s worth noting, though, that some of the recent rally in the EU carbon price is down to short-term factors such as the squeeze in gas prices due to geopolitical tensions.

Reshaping incentives

Functioning carbon markets are a key tool for reshaping incentives to reduce emissions and to re-direct investment to low-carbon solutions. The EU’s ETS is a cornerstone of EU climate policy and is being reinvigorated to help mobilise capital investment. A unified global emissions trading market would help prevent ‘carbon leakage’ significantly, but that is likely some way off given countries’ different ambitions to be net zero.

However, with the increased adoption of ETS, a structurally rising price of carbon in the years ahead is likely to speed the transition to a low-carbon future. This presents both opportunity and risk for investors. For us as investors, the carbon price is a variable that we use in use in our Destination@Risk climate model. For our climate-aligned portfolios, we use a forward-looking temperature alignment metric, scoring companies as to their progress on their pathway alignment to net zero to help us to identify and mitigate climate investment disruption risk.

John Daly

Senior Solutions Strategy Manager

John is a Senior Solutions Strategy Manager within the Solutions Group and has over 20 years of industry experience working in asset-management companies. He focuses on long-term global investment-grade credit and active liability investment strategies. His role encompasses designing developing and servicing investment strategies for DB pension schemes and other financial clients. John has been with LGIM since 2009 and has previously held institutional distribution roles at PIMCO and Fidelity. John holds a BSc in Business Economics from Cardiff University and is a CFA charterholder.

John Daly