CO2 is pumping up inflation

6:45 PM January 12, 2022

Rising prices have become a real problem all over the world. We can look for the sources of inflation almost everywhere, but the world pays attention mainly to rising energy prices. This is a problem in economies that do not have direct access to energy resources, and the share of renewable energy is still insufficient. These problems are obviously visible in the countries of the European Union.

Supply shortages or delivery issues have caused oil prices to rise to their highest level since 2014, and gas in Europe has jumped to extremely high levels never seen in history. Unwanted coal has also become expensive due to rising prices of other raw materials. Additionally, alternative sources were not able to supply as much energy as needed.

Energy prices are rising sharply

Energy affects every aspect of our lives and sooner or later we will feel the impact of its high prices on virtually all aspects of our lives. This is what happened all over Europe, where inflation for the euro area rose to 5% - the highest level in history. In turn, inflation in Poland reached the levels of over 8%, which was last observed at the beginning of the previous decade.

An artificial creation, real consequences

It turns out, however, that besides the high prices of energy resources, there are also other problems! There is a shortage of raw materials in Europe, which is why the effects of price increases are much more severe than in the United States. However, with these higher commodities prices, European energy and industry sectors have to grapple with an artificially created problem in the form of greenhouse gas emissions permits.

CO2 emission permits are an artificial creation invented by the European Union, the aim of which is to significantly reduce harmful gases released into the atmosphere. These, of course, are produced primarily by the energy, heating and industry sectors. The European Union points out that the emissions allowances are responsible only in 20% for the recent increase in energy prices. However, as the reality showed, energy prices currently account for 60% of the costs associated with the purchase of emission permits!

What is ETS?

The ETS is the European Emissions Trading System. It was created to force industry, energy and aviation sectors to reduce greenhouse gas emissions. The system will allocate some of the free permits, depending on the level of current emissions and the size of the economy. The remaining part of the permits is intended for sale. If a given industrial or energy company does not have a sufficient number of permits for its emissions, it must purchase such an additional amount at national auctions or on the secondary market. Primary trading takes place on the ICE and EEX exchanges, while secondary trading, primarily on futures, takes place on EEX, ICE and NYMEX.

In the initial phase, the system did not work as planned by its creators, so it was decided to significantly reduce the permits traded on the market, and the number of permits granted each year is decreasing. Additionally, due to the provisions of the property law, financial institutions may operate on the market. These big players can bet on whether future permits will be worth more or less than they currently are.

It is worth noting, however, that the system was designed in such a way as to force the energy sector and industry to transform, which gave financial institutions a high degree of certainty that prices will move higher. This led to an anomaly in the form of a shortage of emission allowances on the market which led to price rally. The level of EUR 100 for a contract to emit one tonne of CO2 was not expected to be reached until 2030. In fact, prices have come close to that level by the end of 2021!

Is the system bad?

The very assumption of an emissions system is not negative, of course. It forces the branches of the economy that are most harmful to the climate to transform and individual countries need to allocate funds from the sale of their permits to support the transformation and mitigate the effects of price increases. The reality is often different, however, and ultimately it is the final consumers who bear the greatest cost. Moreover, the ETS is one of the most restrictive systems, with a relatively small share of emissions worldwide. Europe is responsible for less than 20% of global emissions, while Asia is responsible for more than 50% of emissions and its share is growing. Of course, it's worth remembering that Europe and North America developed earlier than Asia. On the other hand, European and American industries are losing their competitiveness. As a result, companies from the Western world, due to problems with emissions, decide to transfer production to other parts of the world.

What's next for EMISS prices?

The prices of emission allowances rose sharply within the last 4 years, with the biggest increases in 2021, when prices exceeded EUR 90 per contract. Many analyzes indicate that prices will average at the level of EUR 100 in the next 2 years, although it is worth remembering that at the beginning of last year no one expected that price would rise to EUR 50 per contract. It is possible that due to the highly speculative nature of this market, prices may surprise participants more than once. On the other hand, it is worth mentioning that when the price oscillated around EUR 20-30, the energy sector began to switch to more expensive, but less emitting gas. In turn, around the level of EUR 40-50, wind projects start to become profitable. Prices are also currently being boosted by temporary shortage problems and high gas prices, forcing countries to switch to more carbon-intensive coal. Prices may drop, although local regulations in Germany or the Netherlands do not allow emissions to be traded below EUR 60.

You can trade CO2 emission permits on the xStation5 platform via CFDs with the EMISS symbol. CFD is a derivative instrument which is considered an efficient way to trade CO2 emission due to access to leverage, which enables an investor to use less capital to gain greater exposure to an underlying instrument.  Of course, keep in mind that this is a highly volatile market and large fluctuations can lead to loss of capital. It is also worth knowing that the futures contracts traded by financial institutions and CFDs intended for retail clients allow you to profit from falling markets as well as rising ones. This means that the investor can take advantage of both increases and decreases in emission allowance prices.

Will the system change?

Significant increases in emission allowance prices have led to protests from some countries and industries. Coal-based economies, such as Poland, the Czech Republic and Spain, demand changes to the ETS system. They indicate that financial institutions are primarily responsible for higher prices and want to introduce certain restrictions for them. These institutions are responsible for over 50% of contract trading, which shows that they have a huge impact on prices. At the same time, however, the European regulator did not find any issues when it comes to price manipulation, so at the moment we should not expect a quick change of the system, in particular, as the European Union wants to achieve the ambitious target of reducing emissions by 55% by the end of this decade, compared to 1990.

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