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Europe's US$38b carbon market is finally doing its job

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Steam rising from a RWE coal power plant in Germany. From carmaker Volkswagen to RWE, which is Germany's largest power generator, industry is cleaning up its smokestacks by turning towards renewables.

London

EUROPE'S US$38 billion a year carbon market is finally starting to work the way it was intended, reining in pollution with a minimum of squealing from industry.

Thirteen years after it was created to limit carbon-dioxide emissions, prices for the allowances are rising. European Union policymakers have enacted measures expected to keep the cost of pollution on an upward trajectory through 2030, prompting hedge funds that abandoned the market to pile back in.

"For a five-year-plus period, this market was in the desert," said Per Lekander, a fund manager at Lansdowne Partners UK LLP in London. "What's happened over the past five months is the investment community is getting behind it again and putting on positions."

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Big polluters have heard the message and are starting to adapt. From carmaker Volkswagen AG to RWE AG, which is Germany's largest power generator, industry is cleaning up its smokestacks by turning towards renewables and bracing for a time when coal plants are regulated out of existence. Some are buying before allowances get even more expensive.

All this is happening without noticeable complaints from industry in part because policymakers from German Chancellor Angela Merkel to UK Prime Minister Theresa May have made it clear they want to phase out coal within the next decade, slashing greenhouse gases. Companies favour the carbon market because it gives them more flexibility on how to comply with tighter emissions rules than regulation or taxes. The alternative to a market could be much worse for industry.

It's also a good sign for the global effort to rein in climate change, showing that market mechanisms and government policy can persuade industry to step away from fossil fuels in a way that doesn't create turmoil in the broader economy. Europe's carbon market is the biggest of more than 45 systems working worldwide and a model being tried everywhere from China to Mexico and parts of the US.

"We are very much in favour of the European Emissions Trading System," said Klaus Schaefer, chief executive officer of the German power generator Uniper SE. "In order to deliver the CO2 reductions that we all agreed to in Europe, you will have to see higher prices."

Carbon trading wasn't an immediate success. Europe's permits surged to more than 29 euros (S$47) a ton in 2006 and 2008, only to plunge more than 90 per cent after the financial crisis hobbled industry and helped create a surplus of the pollution rights. That glut took policymakers years to mop up, culminating in an agreement that got final approval only last month.

Utilities like Uniper will feel the brunt of the impact of higher carbon prices - governments cut off the supply of free permits to most power generators while doling out allocations for industries like steelmakers. EU emission allowances are the best performing energy commodity this year, according to a report by Bloomberg New Energy Finance. They've surged 57 per cent to as much as 13.04 euros for each ton emitted on March 22 on the ICE Futures Europe exchange.

Higher carbon prices drive up the cost of using hard coal and lignite to run power plants. It's one of the mechanisms the 28-nation European Union is using to move industry away from the most polluting fuels and reaching the goals for curbing climate change set out in the 2015 Paris Agreement.

"Climate policy will drive accelerating coal phase-outs in the next few years," said Phil MacDonald, an analyst at Sandbag, an environmental research group.

Some of the biggest energy users remain concerned about the upward drift in prices. Steelmakers especially blame the carbon market for reducing their competitiveness. At Britain's EEF group representing manufacturers, Roz Bulleid, who is head of climate policy, supports emissions trading but says her members are "increasingly jaded" about the impact.

"The original intention to deliver emissions reductions at least cost has been replaced by a focus on achieving a certain carbon price," Ms Bulleid said. "There are a number of overlapping policies in this area muddying investment signals. Overseas competitors are not facing the same policy costs."

The European Steel Association, which represents companies including ArcelorMittal and Thyssenkrupp AG, said higher carbon prices create "additional problems" for an industry suffering with increasing competition from Asian manufacturers.

Even so, the broader response of business to higher carbon prices has been surprisingly muted - and even supportive. Britain's main business lobby group, the CBI, believes "a strong European carbon price has the best potential to reduce greenhouse gas emissions in the lowest-cost way", according to Michelle Hubert, head of energy and climate at the London-based group. BLOOMBERG