More trading does not always mean a better market


Carbon markets need some liquidity to provide efficient price signals, but low cost abatement is the ultimate objective, not more trading.

Carbon markets have become widespread because trading can allow emissions to be reduced at lower cost, providing flexibility to emitters and revealing information about where low cost abatement is available.  However, this does not imply that higher trading volumes should be an end in themselves.  Liquidity needs to be sufficient to allow for emitters to take advantage of flexibility and to understand their own costs in relation to others’.  Beyond this, large trading volumes may be a sign of difficulties, for example excessively volatile prices.

In particular, some have claimed that higher trading volumes imply that the EUETS is functioning better than the California scheme.  Trading volumes are indeed higher in the EU than in California relative to the size of the market, but this does not make for a more effective price signal.  Indeed the California scheme seems currently to provide the better price signal.

The chart below shows data from Bloomberg New Energy Finance (BNEF) on the ratio of trading volumes to the annual cap in the EU, California and China.  This data is for trading on secondary markets – it excludes the volumes from the original auctions.  In the EUETS trading is about three times the volume of the cap.  In California the volume of trading is slightly more than the annual cap, implying that on average allowances are bought and sold once after their original auction.  In contrast there are very few trades at all in the Guangdong or Shanghai pilot schemes in China, with only 5 and 2 million tonnes of recorded trades respectively (other Chinese pilot schemes show similar behaviour), about 1% of the annual cap.

Ratio of traded volumes on secondary markets to the annual cap in different emissions trading schemes in 2015


Source:  Bloomberg New Energy Finance

The low volumes of trading in the Chinese schemes indicate that the schemes are not yet functioning effectively to provide market-determined price signals in the way they would in Europe or the US, although this does not, of course, imply that the schemes are having no effect.  However the greater volume of trading in the EUETS is not the sign of a more efficient price signal than in California.

Trading in California seems clearly sufficient to allow higher cost emitters to purchase allowances rather than undertake expensive abatement, especially given that these trades are in addition to the original auctioning of allowances which in itself creates a market price.  The main reason that trading volumes are lower than California than in the EU looks to be that the auction reserve price in California has led to a stable market price, close to the reserve price, and this is likely to persist as the auction reserve price continues to escalate at its specified rate of 5% p.a. plus inflation.  In contrast, the EUA price continues to remain relatively volatile, creating more opportunities for trading (although price volatility is a feature of most commodity markets and not necessarily a sign of a badly functioning market).  Yet prices in California are both higher than in the EU (currently about $13/tCO2 in California compared with about $7/tCO2 in the EU), and more stable.  Higher, more stable prices give a better signal for companies looking at low carbon investment.

There are also some additional restrictions in the California scheme such as allowance holding limits, which are intended to prevent market manipulation and may affect some market participants.  However none of these rules seem likely to inhibit efficient price formation.

There continue to be some, especially in the EU, who object to price containment, such as auction reserve prices, in principle.  However these objections are not well founded.  In the California system additional opportunities for abatement below the auction reserve price lead to more abatement, rather than lower prices.  This is a more efficient outcome, and more in line with the way that normal markets work (see here).  Indeed, even the California price lies well below the social cost of carbon, so is still too low.

Markets are a means to an end: efficient emissions reduction.  Trading should serve this overall objective.  Suggesting that the EUETS is somehow a better functioning market than California because it has higher trading volumes misses the larger goal, which is efficient abatement, not increasing the number of opportunities for traders.

Adam Whitmore – 28th January 2016

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