EU ETS, Smarter Markets and the Road Ahead: Insights from the Smarter Markets Podcast

Name: Weathering Decarbonization Episode 2 | Mark Lewis, Partner and MD, Climate Finance Partners LLC
Uploaded: 2026-02-16T14:53:51.795294+00:00
Channel: SmarterMarkets™
Description: Summary and key takeaways on EU ETS, Smarter Markets and the Road Ahead: Insights from the Smarter Markets Podcast, covering Why Smarter Markets Matter The

SmarterMarkets™

Feb 16, 2026

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4 min read

YouTube video ID: kmF6HlLogVE

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Why Smarter Markets Matter

The podcast opens with a reminder that true price discovery only works when markets are globally integrated. A "smarter market" lets supply and demand for emissions interact across borders, unleashing the most efficient carbon price.

Guests and Context

Host: Dave Grillley, Chief Economist at ABEX Technologies
Guest: Mark Lewis, Partner & Managing Director at Climate Finance Partners (CFP)
Mark recently left Anderan Capital, wrote a book on Shakespeare and climate change, and helped launch a carbon‑compliance allowance fund.

The EU ETS Landscape – 2024‑2025

Price Evolution
2025 started around €75/t, ended the year ~€87/t (+16%).
Mid‑2024 saw a jump from €60/t (July) to €87/t (December) as speculators built net long positions from 20 Mt to 120 Mt.
What "Rubber Hitting the Road" Means
Five consecutive years of allowance deficits are eroding the historic inventory (≈1 Gt of EUAs).
The cap is falling at 4.3 %/yr (2028‑2039) and will reach zero around 2039‑2042 depending on policy tweaks.
Speculators vs. Industrials
Early 2024 price moves were driven mainly by speculators anticipating industrial hedging, not by actual industrial demand.
By mid‑January 2025 prices hit €93/t, the highest in 2½ years, before a sharp drop after geopolitical shocks.

Geopolitical & Policy Shockwaves

Trump‑Era Tariff Threat (Greenland) caused a 10 % one‑day drop.
Middle‑East Tensions & Gas Price Spikes added further volatility.
EU Political Interventions (Week of 5 days)
Peter Le Â ïsa (European Parliament) – warned that free‑allowance phase‑out may need more time; suggested revisiting the linear reduction factor (LRF) from 4.4 % to ~3.4‑4 %.
German Chancellor Olaf Scholz – hinted at postponing ETS 1, sparking an 8 % price fall before he clarified he meant only the free‑allowance schedule.
The market responded with a 12‑13 % price drop over four days, reflecting a short‑term “price‑talk‑down” while policymakers prepare the Q3 2024 ETS review.

Core Market Dynamics

Cap Decline + Free‑Allowance Reduction
The allowance “pie” shrinks each year, and the free‑allocation slice is also shrinking, forcing industries to buy more permits.
Industrial Holders of Allowances
Roughly 70 % of the existing inventory is held by heavy emitters (steel, cement, oil refining, etc.), 20 % by utilities, 10 % by financial actors.
Risk Management Across Sectors
Power sector: Already decarbonising via wind/solar; passes carbon cost to consumers; little lobbying impact.
Industrial sector: Faces a coming shortfall; must decide between using legacy allowances, buying on the market, or investing in low‑carbon tech.
Future Price Drivers
Shift from fuel‑switching (gas vs. coal) to marginal abatement cost of heavy industry.
Projections of €150/t within 3‑5 years are causing political nervousness.

Compliance Markets 2.0

The market is moving from a power‑centric price signal to a multi‑industry price discovery regime.
Similar trajectories are observed in California and Washington State, where consecutive deficits are already shaping higher prices.
This broader exposure will intensify price volatility until industrial abatement technologies mature.

Carbon Border Adjustment Mechanism (CBAM)

Implemented Jan 1 2024; initially a reporting exercise, now a payable carbon charge on imports.
Recent tweak: raised the threshold to exclude small importers.
Temporary suspension for fertilizer imports (political sensitivity) shows the delicate balance between climate policy and food‑price inflation.
Full phase‑out of free allowances for EU firms is scheduled for 2034; CBAM will reach 100 % parity by then.

Offsets and Article 6 Credits

Post‑2030, the EU may allow Article 6 (Paris‑Agreement) credits as a safety valve for industrial competitiveness.
This would integrate high‑quality offsets into the ETS, scaling the global offset market toward the size of the compliance market (~$700‑800 bn).

Takeaways from Davos & Global Context

Europe remains a climate‑diplomacy leader, but faces competitive pressure from the US (current administration hostile to climate policy) and a rapidly expanding Chinese renewable sector.
The consensus at Davos: orderly price increases are preferable to sharp spikes; policy certainty is crucial for long‑term decarbonisation investment.

Outlook

Short‑term: Expect further price swings as EU policymakers fine‑tune the cap‑reduction factor and free‑allowance schedule ahead of the Q3 review.
Medium‑term: Industrial sectors will increasingly hedge and invest in low‑carbon technologies as the allowance inventory dwindles.
Long‑term: Integration of global markets, inclusion of Article 6 offsets, and the maturation of compliance markets 2.0 will shape a more resilient carbon pricing system.

All data and quotes are taken directly from the Smarter Markets podcast transcript.

The EU ETS is entering a decisive phase where shrinking allowance inventories, the phase‑out of free permits, and geopolitical‑driven policy shocks are shifting price discovery from utilities to heavy industry; stakeholders must monitor cap‑reduction adjustments, CBAM implementation, and the emerging role of high‑quality offsets to navigate the transition toward a smarter, more integrated carbon market.

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Why Smarter Markets Matter

Helpful resources related to this video

If you want to practice or explore the concepts discussed in the video, these commonly used tools may help.

Eu Ets Guide Book Recommended

Provides a comprehensive overview of the European Union Emissions Trading System, helping readers understand cap‑and‑trade mechanics and recent policy changes, which is essential given the market volatility discussed in the article.

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Carbon Markets Handbook

Explains how carbon pricing, speculator behavior, and compliance mechanisms work, supporting the article’s focus on price discovery and market dynamics.

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Covers financing of low‑carbon projects, complementing the discussion on industrial decarbonisation and the need for investment as allowances tighten.

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Full Transcript YouTube

It's the whole point of having a market
and of having a smart market to come
back to the title of our conversation
here. This is how you get smarter
markets. You allow for the integration
of markets globally so that the price
discovery mechanism is unleashed
globally across the widest possible sway
of emission.
>> Welcome to Smarter Markets, a weekly
podcast featuring the icons and
entrepreneurs of technology,
commodities, and finance. ranting on the
inadequacies of our systems and riffing
on ideas for how to solve them.
Together, we examine the questions, are
we facing a crisis of information or a
crisis of trust? And will building
smarter markets be the antidote?
This episode is brought to you in part
by ABEX Exchange, bringing better price
discovery and risk management tools to
navigate today's commodities markets
through centrally cleared, physically
deliverable futures contracts in energy,
environmental, battery materials, and
precious metals markets. Smarter markets
are here.
Welcome back to Weathering
Decarbonization on Smarter Markets. I'm
Dave Grillley, chief economist at ABEX
Technologies.
Our guest today is Mark Lewis, partner
and managing director at Climate Finance
Partners. We'll be discussing where the
rubber is hitting the road in the EU
ETS, the impact on market participants
and pricing dynamics, and what the
future may hold as we move into
compliance markets 2.0. Now, hello Mark.
Welcome back to Smarter Markets.
>> Hi, Dave. It's great to be back. Uh,
looking forward to another great
conversation.
>> Oh, me too. Me too. And since last year
when you were here, you've taken on a
new role at Climate Finance Partners.
So, I was hoping we could start off you
could just catch us up a little bit.
Tell us a little bit about Climate
Finance Partners and what you're doing
now.
>> Sure. Well, I quit my old job at Anderan
Capital. I felt I wanted some time off
and spent the summer actually starting
to write a book on Shakespeare and
climate change. So, uh hopefully that'll
be in all good bookshops later this
year. And had this great opportunity to
join Climate Finance Partners as you
said, which is a fund management come
boutique carbon consultancy and advisory
service. We are uh subadvisor to crane
shares on their carbon ETFs and
we are also in the process of hopefully
launching a carbon dedicated carbon
compliance allowance
fund later this year. So just felt it
was the right time to launch a
compliance dedicated compliance
allowance fund. Yeah. So very excited
about that.
Well, that's great. And speaking of
timing, the last time you were here with
us, you emphasized that in terms of the
EU ETS, you know that we were over
halfway through the lifetime of the EUS
carbon market and that the rubber was
about to hit the road in a big way with
industrials moving to that margin for
price formation, whereas traditionally
it had always been utilities that drove
price formation under that system. And I
was curious looking back over the past
year, has the rubber in fact hit the
road and what have been the results?
>> Yeah. Well, I mean, absolutely, and
you're right to hold me to what I said
last time. So, I I like I'm a great
believer in continuity and revisiting
what's been said before. I think I would
answer your question with a qualified
yes in that the rubber is in the process
of hitting the road. What I mean by that
is first of all look at the price
evolution of European carbon allowances
in 2025. Okay, prices were fairly
volatile over the course of the year but
we ended the year 16% higher than we
began it. We closed at 8750 having
started the year around €75
and I guess at the beginning of the year
in January 25 we'll come to January 26
in a minute because we've had a lot of
volatility here as well but January 25
we saw prices take quite a big step up
we went from kind of 75 at the beginning
of January to 84 by the end and I think
that was based on a lot of expectations
that the rubber was really starting to
hit the road. What do we mean by that?
What does everybody in the market mean
by that? When we say that, what we
really mean is that the market is
looking down the barrel of five years,
five consecutive years of annual
deficits. That is to say, the supply of
allowances to the market will be lower
than the demand for allowances. So
you'll have these consecutive annual
deficits that will lead to a reduction
in the accumulated inventory that has
built up over the last 17 years.
Remember there's still a billion tons
worth of EUAs out there. The so-called
TAC, the total number of allowances in
circulation to use the jargon, but in
any other commodity market that TAC
really equates to inventory. It's what
has so far proved surplus to compliance
requirements. But remember, as the cap
starts to decline aggressively over the
next decade and a half, that inventory
will fall. And it starts falling when
you get annual deficits. And we're
looking at consecutive annual deficits
going forward. So
that was the story of let's say the
first quarter of last year. Then prices
went into a bit of a lull and we really
started to see prices come back over the
fourth quarter of last year.
where we went from around €60 a ton in
late July, early August to finish the
year at €87 a ton. Now, was that the
rubber hitting the road, starting to hit
the road? I think in a sense it was more
a question of speculators
front running what they see as the
coming industrial demand, right? Because
net speculative length in this market
increased very dramatically over the
final four months of the year. We went
from speculative investment funds
holding a net position of 20 million
tons long in early August to an all-time
high by the end of the year of 120
million tons. Now, why did they build up
that length? Because the reason they did
that was because they're looking at
their spreadsheets. They're looking at
the forecasts of all the different
brokers and service vendors who crunch
the numbers on this market and they're
seeing this barrel of can down this
barrel as I said earlier of consecutive
annual deficits. So that net length
built up in the expectation that
industrials were going to have to start
hedging more aggressively. So in a way
that's why I say I'd give a qualified
yes to your question. The rubber hit the
road in that speculators sensed
something dramatic was about to happen
and built up this length as a result.
Prices went up and that's how this year
began. I'll just finish by saying
bringing your audience up to date on
where we are right now and then we can
get into some of the more dramatic
developments we've had already. Even
though this year is only 6 weeks old,
it's been a dramatic start to the year.
But through the middle of January this
year, net length and prices continued to
rise. Okay. And middle of January, we
were back at 93. I think the high for
the year so far was 9380.
That's the highest price we've seen in
this market for 2 and 1/2 years since
August 23, I think. And so that's a
sense that the market is smelling the
rubber beginning to burn, if we can put
it that way. But it's not yet. I have to
say, and this is why I can't give a a
definitive yes answer to your question.
I don't think it's yet fair to say that
it's the industrials that have been
driving the price. It's really been
speculators that have been front running
in expectation of industrials stepping
in. And so, just to complete the answer,
what has been happening in the first six
weeks of the year? Well, we hit that
level of 9380
in mid January and then right after
that, President Trump came out with the
threat of tariffs on the European Union
and on the UK for that matter in
connection with the controversy over
Greenland. And as soon as that happened
over the course of a weekend and so on
the Monday and Tuesday immediately
following the Trump tariff threat which
was coincidentally
the weekend before the Davos conference
prices came off quite dramatically. EUA
prices fell 10% in the first day and a
half following President Trump's
comments about a potential tariff over
Greenland and then it recovered
somewhat. So we went down to 83 I think
and then back to 88 by the end of the
week. Bit of a roller coaster. Then
we've had further geopolitical
nervousness over the Middle East and
we've also Iran in particular and gas
prices increasing. So we've had quite a
few bumps along the road over the last 3
weeks. So life has got a lot bumpier in
the last 3 weeks and prices have come
back down to trading right now around
8150 as we hold this conversation but we
got as low as 77 last week. So all
you're seeing there is some of the to
come back to the the rubber hitting the
road analogy some of the air coming out
of the tires you know and and what that
is is the speculators reducing their net
length. And there's also been one other
thing to throw into the mix which we can
get into in greater detail because this
is structurally very important is at the
end of last week there was some concern
being expressed in Brussels about the
pressure on industrial companies that
higher carbon prices will have. Of
course, we're living in a very different
world even only even though it's only
one year since our last conversation.
You know, President Trump's back in the
White House. Lots of talk around
delobalization,
supply chains,
industrial competitiveness. This is even
more of a hot issue than it was already
a year ago. So,
some concerns in the market, I think,
around the question as to whether or not
the EU will dilute somewhat the
trajectory for the cap, but not before
2030. That will happen really post 2030.
So you throw all of that into the mix,
it's been a very interesting last 3 or 4
months and a very interesting start to
the year in particular, but I get the
sense the market having suffered these
shocks is now kind of back to some kind
of equilibrium for the time being.
>> Thank you for that, Mark. You know,
you've given us so many great threads
that I want to pull on in the remainder
of the conversation. But first, I do
want to note for our listeners that Mark
and I originally sat down on Monday of
this week to record this conversation,
and a whole lot happened over the course
of the week, both in the United States
and Europe. Mark was good enough to come
back and sit down with us on Friday, and
give us his most up-to-date thoughts on
what everything happening this week
meant. So, let me turn back to you,
Mark. Thank you. And can you put this
week together for us?
>> Thanks very much, Dave, and appreciate
the opportunity to come back on Friday
5:30 European time as we're recording
this segment. Now, we've literally just
had the settlement
of this week's closing price. We're
closing at or was settling at €7.68.
Now, that compares with the settle on
Monday evening when we recorded the rest
of this show originally of 81.35. We've
dropped 11 euros
nearly, which is to say we've dropped
13.5%
in 4 days. That's Tuesday through
Friday, right? So, what has happened?
What has happened is quite simply there
have been a number of high-profile
interventions by European
policy makers.
by which I mean a very senior European
parliamentarian, Peter Leisa, who until
quite recently was the leading figure in
the European Parliament responsible for
channeling the the legislation on the
EUTS through the European Parliament. He
made a significant intervention on
Tuesday and then on Wednesday the German
Chancellor Friedriz
made an intervention and both of these
inter interventions scared the horses
basically. So what were the
interventions and what does it all mean?
because I think that's ultimately what
your listeners are interested in, right?
Well, on Tuesday, Peter Leisa said that
well, the common thread in both of them
first of all is the issue of free
allocations and we recorded a big
segment on this obviously in the rest of
the episode that your listeners will
hear later on. But there's an emerging
consensus very clearly that European
industry needs more time to adapt to the
phase out of free allowances. So both
Peter Leisa on Tuesday and Fred on
Wednesday voiced their concern about
protecting European industry.
Competitiveness, industrial
competitiveness is obviously probably
the number one issue right now in
European politics across the entire
block and therefore industry has been
lobbying very hard in Brussels for more
time in terms of the phase out of free
allowances. So both of them emphasize
that. Now, in and of itself, that's not
a big deal, I don't think, for prices
because that doesn't affect the supply
demand balance, right? All that affects
is how the total number of allowances
under the cap are distributed. Um,
however, what Peter Leisa also said on
Tuesday was that we're probably going to
have to revisit the rate at which the
cap declines in the future. Currently as
as everyone knows from 2028 so currently
the cap is declining at 4.3% per year
and from 2028 that will increase to 4.4%
a year and that gets you to zero by 2039
as we discussed and your listeners will
hear on the rest of the show. But what
Peter Leisa said was we may have to
revisit that and 3.4% 4% which is a
lower linear reduction factor obviously
and therefore it takes longer for the
cap to fall to zero would be a more
appropriate number. Now actually when
you sit down and work through the
numbers it doesn't make a huge
difference and certainly not in the near
term. So we have written two blog pieces
special blog pieces this week in
response to Lisa's intervention and
Meltz's intervention. So what I'm about
to say you can find and digest in more
detail at climatearketnow.com
where we publish our regular updates on
the European and other uh compliance
markets globally. And crunching the
numbers if you move to a 3.4% linear
reduction factor from the current 4.4%.
All it means is most of the impact, in
other words, the increase in the cap
that you would get relative to where the
cap is in the current legislation, um
the extra most of the extra volume would
be available only from 2036 onwards. So
if you assume that the cap starts
falling at only 3.4% rather than 4.4% 4%
from 2031,
then the total increase in the cap
relative to the current legislation is
930 million or thereabouts.
And of that number, 2/3 of that increase
comes through from 2036 onwards. And
instead of falling to zero in 2039,
the cap would fall to zero in 2042. So
it's a three-year extension. It's not a
massive deal in the grand scheme of
things. Okay. So I think the LISA
intervention in and of itself whilst it
led to the market dropping was not a
huge bombshell. This has been discussed
in Brussels for the last 2 or 3 months.
The market knew that there were
rumblings to the effect that later in
the year when we get the actual ETS
review um the linear reduction factor
could and probably would be reduced from
the current 4.4%. So the market took
that I wouldn't say it took it in its
stride but after dropping on the news
hitting the tape it came back. The real
hammer blow was delivered on Wednesday
by Fredmatz and his voice obviously
carries more weight than probably
anybody's in the European Union because
he is the chancellor of the government
of the most important industrial country
in the EU, the biggest economic power in
Europe and the largest emitter of CO2 in
the EU ETS. Now what Meltz said was very
confusing and again we've deconstructed
his intervention on our blog
climatemarket.com
and our take was that he had made a
confusing intervention because he talked
about possibly postponing the ETS as
we've done with the ETS2. Now again for
the benefit of of our listeners here,
the ETS2 remember is a new compliance
scheme which was originally meant to
come into force in 2027 and was
postponed in December and will not now
enter into force until 2028. But when
you have mers saying we might have to
postpone the EUTS1,
people get very jumpy, right? The market
dropped 8% yesterday on Meltz's
intervention and by the end of the day
he was having to row back or at least
clarify what he had said and what he
said was it's not about postponing the
EUTS per se but rather postponing the
phase out of free allowances which again
to me is not the main pointed issue
here. It's really the cap that is is is
the driver of the supply demand balance.
All of that to say, in the last 4 days,
since we did the original recording
here, the market has come a very long
way. We've dropped 11
13 12% in 4 days. And there's a
reassessment going on. There's a
recalibration going on. And there seems
to be, and there's no doubt about it, a
concerted effort amongst the European
policymaking elite to talk down the
price of carbon in the short term until
we can have the formal review of the
EUETS, which was has already been
programmed for a long time to take place
in Q3 of this year. My take at the end
of this very turbulent week and we have
seen many turbulent weeks over the last
20 years in the history of this market
but this one is taking place in the
context as you suggested in your opening
remark there Dave of a changed global
geopolitical environment right where we
have President Trump a disruptive
presence to Europe's policym agenda no
doubt and as a result I view the events
of this week as really a shortterm stop
gap whereby European policy makers talk
down the price in the short term buy
themselves time uh for the EU ETS review
in Q3 and we end up probably with two
things a lower linear reduction factor
in other words the cap will increase
between 2031
and beyond and will now fall to zero
probably in 2042 or 2043 depending on
when the change in the LRF takes place
from whether it's 2031 or even 2029 Lisa
was suggesting might be possible as well
doesn't make a massive difference that's
the first thing and secondly a phase out
of free allowances that will take longer
to happen and at the margin I mean I say
it doesn't affect prices because it
doesn't change the supply demand balance
it simply changes the way in which
allowances are allocated however in
terms of industries incentives for
reducing emissions. Behaviorally, it
means if you extend pre-allocation,
there's less need for industry to step
into the market and hedge their future
liabilities.
So, those are the key takeaways from
what's been a very turbulent week. And I
think we'll end up also one final
comment because the commission itself
obviously and we have to view this in
terms of the EUTS being up and running
for 20 years. is one of the European
Union's major major policy achievements.
I always say to people there is only one
price that is homogeneous across the
entire European Union and that is the
price of carbon emissions. There's no
other price across Europe that is the
same in every single country. But that
price is so this is a real achievement.
It's driven down emissions and that
should never be forgotten. The
commission will certainly be reminding
people in Q3 that that needs to be
remembered. And so I think what they
will do is tie the phase out of the
longer term phase out of free allowances
and the more generous time frame to
commitments on the part of industry.
Hey, if we're going to give you free
allowances for longer, you have to
commit to investing in lowcarbon
technology into decarbonizing your
industrial manufacturing processes. So,
those are the big takeaways from this
turbulent week and I think we're all
glad that it's the weekend now.
>> And I'm glad that you were able to make
time to come back with us, Mark, and
bring us up to speed on those key
takeaways from a turbulent week. I
really appreciate that. So our listeners
have your most up-to-date assessments of
the markets. And you know, thinking back
to where we started this conversation, I
think one thing that definitely has held
up is that it's difficult to tell when
the rubber will really hit the road when
the regulators are able to lower the
height of the road. But that said, I'd
love to get back to where we were
recording our conversation on Monday
because so many great threads there to
pull on. so many long-term developments
that we'll be tracking that, you know, I
think the events of this week helps give
a little bit more context to why what we
were talking about is so important. So,
thanks Mark and we'll get back to the
previously recorded conversation.
You had brought up these inventories of
allowances that are out there and I'm
curious following on to your
conversation about speculators. I'm
curious where who holds those
allowances. Have these been held by the
utilities or the industrials in
preparation or are investors sitting on
these and other financial market
participants? I'm just curious about
where those sit.
>> That is a really great question. I would
say it would be a very very laborious
and difficult exercise to go through and
check. I think in theory you probably
could because you could look at the
historical
allocation of allowances to industry
and look at how much industry has
actually had to how many allowances
industry has had to hand over the last
17 years since 2008 this scheme has been
running but overall I would say this my
kind of sense is that the majority of
those allowances is indeed held by
industry I would say certainly over 50%
probably something approaching ing 70%
of that roughly 1 billion tons is held
by industry by which I mean you know the
steel industry the cement industry oil
refiners cement glass pulp and paper
utilities it'll be a much smaller number
because utilities were never
overallocated in the first place they've
always had to purchase their allowances
on the open market but nonetheless some
of them certainly will still have
surpluses because in particular the
larger utilities that have both coal and
gas power plants and which choose to run
either coal or gas as a function of the
carbon price. And sometimes, as has
happened over the last year, gas prices
in Europe came down and at the end of
last year certainly gas was very much in
the money, cheaper than coal. And if
you'd contracted to sell coal fired
generation, you would have bought more
allowances than you needed, right? and
they won't necessarily have sold all
those allowances straight away on the
market. They can hold them for their own
trading purposes or because they
themselves think, hey, allowances are
going to go up. They've got better
information than anybody. It's like,
who's got the best information on the
oil market? Well, the oil companies,
funnily enough. So, they have their own
trading departments, and they are very
savvy in terms of both long-term
structural setup, but also
month-to-month and even day-to-day
trading activities. And then finally, of
course, speculators do hold some of it,
but I would say that's a very small
amount because most of the speculators
don't have physical registry accounts.
Most speculators trade only on the
futures market. They're trading paper
futures, not physical allowances. So
yeah, I'd say probably 70% is industry,
20% maybe utilities and 10% other
actors, investment funds,
commercial banks maybe holding as a
proxy for industry and so on.
>> Do you feel like industry and
industrials are starting to feel the
pinch of this yet or not quite? Some of
them are certainly I think there's two
dynamics in play and this is where also
the politics starts to get very
important again. So the two dynamics in
play remember very simple first of all
the cap is declining which means the
overall pie if you like the pi of
allowances is shrinking it's getting
smaller every year and then at the same
time the number of allowances that are
being allocated free of charge to
industry is also declining. So the pi is
declining and the amount of the pi that
you are getting free of charge is also
declining. Right now if your industry
that means you're getting fewer
allowances every year which means
there's probably now for the first time
for a lot of these companies a shortfall
versus what they need to meet their
compliance requirements. So they have to
go into the market and start buying or
they can still use probably some of the
allowances they've accumulated over the
years that form part of the TAC that we
were just talking about. They can take
those off the balance sheet and use
those for compliance and it will be for
each company to decide what the optimal
strategy is for their particular
activity. But those are the two key
dynamics that will force industry over
the second half of this decade between
now and 2030 to become more actively
engaged in the market. And that's why of
course to come back to our original
where we started this conversation
that's why speculators have been pushing
prices up in advance of that because
they think there's going to be a big
change in the behavioral psychology of
industry.
>> Yeah. And in terms of the impact of that
on pricing dynamics, and I realize it's
probably too soon to tell, but kind of
curious when you think about what
factors prices will be more responsive
to in the future when it was very much
about the power sector and imagine like
often gas, coal prices, spreads were
strong drivers. Sounds like as you get
more industrials, it's more kind of the
overall economy. Trump tariffs. How are
you thinking about how the pricing
dynamics may evolve?
>> Right? So, I mean, in theory,
what we should see is like any market,
the price is a function of where supply
meets marginal demand, right? And so
we're looking now instead of, as you
rightly said, Dave, instead of the
so-called fuel switching price in the
power sector, which you rightly
identified as having been the main
driver of prices really ever since this
market came into being in 2005,
to the marginal cost of abatement in
industry.
And the whole point of having an
emissions market as opposed to a carbon
tax is that from an economic efficiency
point of view, allowing the market to
discover the lowest price that clears
the market. That's the whole point of
having a carbon trading market. Now,
nobody really knows yet what the
marginal cost of abatement for the steel
sector is or for the cement sector or
for oil refining and so on. But I think
what everybody is assuming is that it's
significantly higher than where carbon
prices are trading at the moment. So,
and this by the way is a great question
to ask because this also explains why
there is growing political nervousness
around the risk of much higher prices on
a 1 2 3ear view. Right? Because if for
sake of argument we just allow the
market to continue price discovery until
we get a clear uh signal that this is
where abatement is happening. Say the
steel sector can achieve significant
decarbonization reduction in emissions
at a carbon price of 150 euros a ton
just for sake of argument. Then that
would be the price towards which we
would gravitate and you get a chunk of
decarbonization happening at that level
and until the cap declines so much that
then other sectors have to start abating
more aggressively. And you do this
progressively until the market clears. I
think however there have been a number
of assessments, projections, let's say
pricing projections by market analysts
suggesting that prices could could go to
150 or even higher on a 3 to 5 year view
that have made some people in Brussels
very nervous particularly as we also now
have this as we mentioned free
allowances declining because we've also
had the introduction of the carbon
border adjustment mechanism so called
CBAM from January this year. That's a
slow start, slow burn, but that becomes
progressively more important and that is
why pre-allowances are being phased out
because companies outside Europe
exporting into Europe who are under the
scope of CBAM will have to start paying
the same carbon price as European
producers. Now you put all of that
together, there are a lot of industrial
companies in Europe who are lobbying
very hard in Brussels for either an
extension of the period of free
allowances so that they continue to
receive free allowances or for a change
in the trajectory of the cap. And we can
come back and revisit all of these
points because they're super important
and some member state governments who
are also arguing for that. And of course
the other variable in all this which
plays to the point around the
convergence between compliance markets
and not so much voluntary markets but
the offset market is the other thing
Europe could do to soften the blow on
industry is allow offsets into the EU
ETS again none of this is going to
happen before 2030 but between 2030 and
2040 they could allow so-called article
6 credits under the Paris agreement into
the scheme to soften the blow. Now, you
know, those are all different ways in
which industries exposure to higher
carbon prices could be reduced. And I
think all three of those issues are
being debated hard behind closed doors
in Brussels at the moment because we
have the so-called EU ETS review coming
up in the third quarter of this year.
now. But the EUETS review is really all
about fixing the rules beyond 2030,
not about changing the rules between now
and 2030.
But all of this culminated last week. I
mentioned the price volatility already
that we've seen since the beginning of
the year. And last week was a
particularly volatile week because there
were news reports from a German
newspaper Handles Blat and then
Bloomberg on Thursday reporting that the
EU was looking at some of these either
perhaps reducing the linear reduction
factor. Remember at the moment the cap
reduces at 4.3% per year and then from
2027 at 4.4% per year which means the
cap falls to zero by 2040. It's very
clear that that will no longer be what
happens. the cap will be extended beyond
2040 because there's nobody I think in
the whole of Europe who thinks that
European industry can physically
decarbonize to zero by 2040 unless you
want to shut down the whole of European
industry.
>> It's a fascinating problem. This is why
we call it price discovery, right? In
that the billion dollar question is as
the price moves up, what'll be the
margin of adjustment? Will it be
industry find a lower carbon process
that can make the adjustment and that'll
become some technology will become
profitable? Will it go all the way to
the extreme of shutting down the
European steel industry which no one
wants and so in the interim will then
voluntary carbon market credits be
allowed? Will CBAM make sure that it's
not just European steel being shut down
so that steel's produced in in another
country? So, I'd love to come back to
some of those points, but I wanted to
ask you first, are you seeing a change
in how like the the the market
participants are managing their risks
given no one really knows where the
price is going to go right now,
>> right? Well, I would say look, it varies
from industry to industry and it varies
I guess also from largesized companies
to smaller sized companies. You know
there are lots of this is a very unequal
market by nature right you know so if we
talk about the power sector first the
power sector has been very simple from
the beginning because the thing about
the power market is you don't face
competition from outside Europe or
there's hardly any electricity you've
got the link between the interconnector
between the UK and the EU and the
interconnector between some some far
eastern European and Balkan countries
that are not part part of the the EU,
but to all intents and purposes, the EU
consumes all of its own electricity,
which means you don't have to worry
about competition from outside, which
means European utilities, who've had to
pay for all of their allowances ever
since 2008, just pass through the cost
to the consumer. And so what you get
with electricity is the full allocative
efficiency of carbon. In other words,
the consumer is being incentivized to
switch to cheaper forms of electricity,
less carbonintensive forms of
electricity. So, as far as they're
concerned, there's no change in behavior
and no change in lobbying. The power
sector is decarbonizing anyway. You
don't need a carbon price anymore really
to incentivize the decarbonization of
the power sector because the cheapest
forms of new electricity generation are
solar and wind anyway. And that's what's
happening. So that will continue for the
other sectors in terms of changing
behavior and what is going on there. I
think there's a number of points to be
made and the first is and this worries
me quite a lot. I totally understand why
there is a lot of concern around high
prices and the impact of industrial on
Europe's industrial competitiveness. But
if you start tinkering with the rules
and saying well we need to give more
free allocation to these extend free
allocation for longer to these sectors
or to these companies cuz they're
particularly at risk. I think you
introduce an element of moral hazard
into the market because for the last
ever since 2008 the broad set of rules
for this market has been fixed and
certainly since 2021 it has been very
clear according to the legislation the
current legislation that free allowances
were going to be phased out. So if you
extend free allowances, there's an
argument that you're penalizing the
companies that have been playing by the
rules, right? The ones that have been
preparing for the phase out of free
allowances and saying, "Well, this is
coming. We need to be responsible and
start making investments in lower
carbonintensive production equipment." I
have sympathy of course for European
industry in an environment of high
energy prices because of all the
geopolitical stuff with Russia, Ukraine
and the gas and all the rest of it. On
the other hand, I think you know we have
to be honest and say that large parts of
European industry have had a long time
to prepare for this changing
environment. They've been given free
allowances for a very long time and they
should have been using that time to
prepare for the era of decarbonization.
So I think the European Commission and
the European Union more broadly
have to tread very carefully here. Yes,
industrial competitiveness is a bigger
issue than it was even a year ago and
certainly than it was 5 years ago before
we had the explosion in European gas
prices. But Europe needs to maintain the
integrity of its carbon market and above
all it needs to maintain the incentives
for decarbonization
that carbon pricing provides. And I
think if you start changing the rules
now too radically
and on too much of an ad hoc basis
subject to what pressure you're getting
on any given day, any given month from a
particular industry, ironically, you
risk deferring investment in
decarbonization such that 5 years from
now, we have to go through that process
again. And people say again, well, we
can always get the EU to soften its
targets if we lobby hard enough. So this
is a very delicate balance that they
have to strike here and obviously that's
what the market is focused on and and
that's why we've had this volatility in
prices over the last two to three weeks
because of this flurry of stories around
the lobbying that is happening right
which I think naturally brings me to a
topic I wanted to ask you about which is
Davos I saw you were recently there
you've got government leaders policy
makers business leaders kind of all
gathered ing and I was curious what's
the temperature on changing the rules or
sticking to the rules and what broadly
was the conversation there concerning
these markets?
Yeah. Well, we had some great
conversations with investors in Daros. A
lot of interest still in compliance
carbon markets, but undoubtedly
a lot of concern over Europe's place in
the world. not just in terms of energy
costs and industrial competitiveness but
the broader question of Europe's
geopolitical alliances and standing in
the world and the point I have made
consistently over the years whenever
there have been these slings and arrows
of outrageous fortune as as Hamler calls
them the changing events the vagaries of
politics the one thing that Europe is
renowned for globally is its climate
diplomacy it's really been the leader
in developing tools to fight climate
change and I think globally that has
been its preeminent diplomatic
achievement. So that is not to be
underestimated and we shouldn't
overestimate either the extent to which
the current US administration
marks a permanent shift in even the
United States attitude towards climate
change.
We know that we're under an
administration at the moment in
President Trump that is particularly
hostile to the idea that climate change
is even happening. That doesn't mean
that the US is now forever on a path of
saying, you know, we don't think climate
change is real and we're going to
discourage carbon pricing and put
tariffs on and so on. So, we have to
keep the faith. Europe has to keep the
faith and I think that is a message that
certainly we were trying to convey in
Daros and in in a way there is an
argument for saying that the European
carbon market had got ahead of itself. I
mean I I mentioned this idea of
speculators front running the industrial
buying and hedging and I think prices
had run up very aggressively from what I
said €60 late July early August to 93
only 5 months later in the middle of
middle of January you know that's a 50%
increase in only four and a half months
5 months that's not helpful really when
there is political pressure on pricing,
you know, so a more orderly increase in
prices is really what ideally you would
want to see. So I think Davos there was
a sense that this still matters.
Europe should still be flying the flag
for dealing with climate change. And the
other things to say is the United States
is not the only superpower in the world
anymore and China is taking climate
change extremely seriously. is the
world's number one renewable energy
superpower by a mile and that will only
increase going forward and is
constructively engaging on the Paris
agreement and on this and China has
tremendous leadership obviously
geopolitically in a large part of the
world in the global south in Asia and so
on so it's easy to feel
down if you're in climate change and
carbon markets at the moment
But we've been here before. We've
weathered storms, political storms like
this before. And I think you have to
keep your eyes on the horizon because
climate change is not going away. But in
Davos, you know, climate change was not
the focus that it has been in some of
these WE conferences in previous years
for obvious reasons. But the threat of
climate change certainly has not gone
away. It's accelerating. It's getting
worse. and we should be continuing to
keep a focus on carbon pricing as the
preeminent tool to fight it. And in
terms of that preeminent tool, I've
heard you remark recently uh that we're
moving into compliance markets 2.0 and I
wanted to ask you what do you mean by
that?
Well, particularly what I really mean is
is actually what we've already been
discussing that the period where you
move away from just the power sector
setting the price and you really allow
price discovery to impact all these
other price discovery to be unleashed in
all the other key emitting industries.
And Europe is further advanced than some
of the other jurisdictions that have
carbon pricing regimes in terms of that
evolution.
And I think on an 18 month 24 month
period horizon
that is exactly what we're going to see.
So that's really really what I meant by
it. And if you look at California even
in California you start to see annual
deficits on the modeling that most
forecasters have for the California
carbon market. uh that that market is
going into consecutive annual deficits
from next year and this will start
having an impact on exactly the same
argument the accumulated balance of of
allowances the bank of allowances that
has so far acred which is around 370
million tons that that will start
falling over time. So there and and
Washington state is already in carbon
markets 2.0 0 land because they already
have an accumulated deficit which is why
the price by US standards is much higher
than any others almost at the level of
European prices I mean you know around
$75 a ton so those four markets EU UK
Washington
are heading into that 2.0
zone where the rubber famously hits the
road and we have to see price discovery
across a whole range of industries that
have not yet been subject to the price
discovery process.
>> Another area where the rubber's hitting
the road that brought up a little bit
earlier is the much much discussed EU
carbon border adjustment mechanism or
CBAM. you know, it's really moved from
what was a reporting exercise to more of
a reality just starting January 1st of
this year. So, it's early days, but
wanted to get your thoughts on how's it
going so far and is it playing out as
intended?
>> Yeah, I mean, this was always going to
be a very complic technically
complicated thing to implement, right?
already even before 1st of January. And
bear in mind the the legislation on this
was passed two 3 years ago. The closer
we've got to the actual implementation,
the more there has been fine-tuning and
issues discovered and so on. So last
year about a year ago we already had a
significant tweak in taking out a number
of small the threshold for inclusion in
CBAM was raised so that really small
importers were not affected by it. So
you're really trying to focus on the big
industrial importers of goods from
outside the European Union. So that was
a smart thing to do. But I'd say the one
kind of serious glitch we've had so far
is which was only last month, few weeks
ago, the European Commission allowing
for a temporary suspension of CBAM rules
on the fertilizer sector. Now the
fertilizer sector is obviously extremely
politically sensitive because fertilizer
has a big impact on food prices, right?
And so I think that was the logic behind
that when we're already in an era of
high food prices. This is why inflation
in so many countries has been stubbornly
high. And I think there was a concern
that if you introduce CBAM for
fertilizer imports from day one that
will only contribute to a worsening
short-term worsening of inflation in the
in the food sector at a time when
consumers in Europe are already
struggling with high prices. So clearly
again you you have this question of
moral hazard. If you exempt one sector
from CBAM, isn't there a risk then that
other sectors will engage in special
pleading? And now for the time being, my
latest understanding of events at the
moment is that fertilizer exemption is
temporary and it will be included sooner
or later, but we don't have a fixed date
on and there is no other sector at the
moment where an exemption is planned or
imminent. But nonetheless, there has
been a precedent set. So these glitches
are, I think, normal when you introduce
something as comprehensive and
technically complicated as putting a
price on all goods that meet that have
an embedded level of carbon in them. And
so far, I think other than the
fertilizer thing, there haven't been any
major issues reported. But clearly the
bigger pressure is around this question
of free allowances and whether or not
there is an extension of free allowances
and therefore that would entail by
definition a change in the timeline for
phasing out free allowances
which is the flip side to CBAM. So any
extension of free allowances will mean
that CBAM is not fully implemented for
longer because just to remind the
audience I mean CBAM was introduced on
the 1st of January. If 100% of the
policy was implemented from day one,
what it would mean was uh there are no
more free allowances handed out to
European companies and at the same time
all imports from outside Europe in the
sectors covered by CBAM would pay 100%
equivalent carbon price to that being
paid by the Europeans. Instead, what
we've gone for is a classic European
compromise where free allowances and
therefore the carbon price for imports
is only progressively introduced. So
free allowances will not be reduced to
zero until 2034
under the current legislation. Right? So
that's 9 years away and this year it's
only 2 and a half%. is a very very very
soft start and then I think we get up to
10% next year and then it increases over
time such that by 2034
importers of goods from outside the
European Union are paying 100% of the
carbon price and no European company is
receiving any free allowances at all. We
will see if that that's where we end up
because as we've mentioned throughout
our conversation, there's a lot of
lobbying going on at the moment and it
may well be that some sectors at least
receive
free allowances for longer or that there
are other ways found to provide free
allowances to industry. This was
mentioned in a Bloomberg story last week
which caused a drop in the price because
there is a so-called buffer of
allowances being held back by the EU
under the EUTS directive. The so-called
CSCF buffer cross- sectoral correction
factor. We don't need to go into the ins
and outs of that is exceedingly
technical. But there's 380 million tons
worth of allowances that have been held
back. Now those allowances are coming to
market one way or the other. So it
shouldn't really be too much of an issue
for the market. It caused a drop in the
price on Thursday when the Bloomberg
story came out because I think some
people interpreted it to mean, oh, these
370 million allowances, which we know
have to come to market between now and
2030 anyway, may come to market much
more quickly
than we thought. And I don't think
that's at all what's going to happen.
But what was being floated by a very
influential
now academic but former very senior
member of the European Commission Jos
Delbeck in some ways the architect of
the EUTS and he was the head of the DG
climate action directorate. So he was
the guy the civil servant the most
senior civil servant in charge of the
EUTS for the first 20 years of its
operation. and he's now an academic,
very influential academic who publishes
a lot of theoretical pieces around the
EUETS. and he'd given an interview to
Bloomberg suggesting that that buffer of
allowances, the 380 million, instead of
being auctioned to the market, which is
the default way in which they will come
to market, could be allocated for free
on top of the free allowances that are
already out there to companies that
commit as long as the companies
receiving them commit to making
long-term investments in
decarbonization. Now, on the face of it,
that's actually quite a smart thing to
do, but not if you frontload it and give
these companies 380 million tons in the
next year because that again would have
a very negative impact on prices because
those companies wouldn't need to go into
the market again for a while. So, as
ever, this market keeps us on our toes.
I think the price action since the
beginning of the year has been a
salutary reminder that nobody has a
right to make money betting on there's
no such thing as a one-way bet in any
market however
constructive the setup looks and I think
there were too many people at the
beginning of this year in the
speculative fund community who just
thought this is a one-way bet can only
keep going on up and they forgot they
rather forgot that there's a political
element to market and you have to pay
attention to what is happening in
Brussels and you have to be able to
separate the signal from the noise in
all the political chatter that goes on
in Brussels.
>> Another potential source of allowances
that regulators and the people in
Brussels might allow which is projects
from the voluntary carbon markets. Do
you think there is any appetite for
allowing those types of credits into the
EU ETFs?
>> We have to be very clear on the
terminology here, Dave. I would just
sort of take issue with the use of the
word voluntary rather than offset. I
think if we say offset, we're on very
safe ground. Projects, we're on very
safe ground. But I think the only
credits that could conceivably
be considered for inclusion in the EUETS
beyond 2030, again this won't happen
before 2030 are so-called article 6
credits under the Paris agreement. Now
these are project credits as you rightly
say. So, let's say, for example, Mexico
has a mangrove project and that project
is reducing emissions quite
significantly on a 40-year basis. Mexico
can choose to do one of two things. They
can either say, "Well, this is great.
These emissions reductions are
happening, and we're going to count
those emissions reductions towards our
own Paris target under our so-called
NDC. Every country has a target for
reducing emissions under the Paris
Agreement." Or they could say, well,
hey, these mangrove credits command a
high price on the international market.
They've traded a premium to other
project credits. We can sell them onto
the market internationally as long as we
make a so-called corresponding
adjustment whereby we commit to not
counting those emissions reductions even
though they happened on our territory
towards our NDC. Instead, we give the
right to those emissions reductions to
the people buying those credits. Now,
this is where if Europe is smart, what
they would do is they would say, "Okay,
it's too difficult to get to absolute
zero emissions in Europe for the ETS by
2040. But what we can do is allow in a
certain quot of offsets under the
article 6 project mechanism
that would do a number of things. Number
one, it would be a safety valve on
prices for European companies. That and
that would be the the clear economically
smart thing for Europe to do in terms of
industrial competitiveness. Number two,
it would help scale up the article 6
market globally so that it becomes a
genuine and this is where the contrast
with what you mentioned in terms of the
voluntary market is super important
because the voluntary market has been
around forever, right? But it's still a
market that's only worth about $600
million a year. The global compliance
market is worth about 700 $800 billion
a year. What we want to see is an offset
market globally achieving real emissions
reductions
scaling up so that it's of a size much
closer in magnitude to that of the
global compliance market. And I think
article six is the way you can do that.
And the beauty of doing it through
article 6 is that all of the tons that
we're measuring here are captured under
the accounting framework of the Paris
agreement. So there would be no risk to
Europe in accepting credits under the
article 6 mechanism because there's no
question of double counting. You're not
undermining the integrity of the of the
Paris agreement. On the contrary, you
are supporting and cementing the
integrity of the Paris agreement because
you are using all emissions reductions
globally in the most efficient manner
possible. It's the whole point again.
It's the whole point of having a market
and of having a smart market. To come
back to the title of of our conversation
here, this is how you get smarter
markets. You allow for the integration
of markets globally so that the price
discovery mechanism is unleashed
globally across the widest possible
swave of emissions.
Thanks again to Mark Lewis, partner and
managing director at Climate Finance
Partners. We hope you enjoyed the
episode. We'll be back next week with
another episode of Weathering
Decarbonization. We hope you'll join us.
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