Get in touch

The Impact of Carbon Trading on Energy

May 12th, 2024

As the impact of climate change increases and people around the world endeavour to mitigate it, carbon trading has become pivotal to environmental policy in the energy sector. 

What is carbon trading?

Carbon trading, also known as emissions trading or ‘cap and trade,’ is a market-based tool to limit greenhouse gas emissions.

The concept is simple: a limit or cap is imposed on the pollution a company can emit through its daily operations.

The company is issued an ‘emission permit’ and must hold an equivalent number of credits (or allowances). These represent the right to emit a specific amount of emissions. The total amount of credits cannot exceed the cap. If the company emits more greenhouse gases than allowed through their permit, they will have to buy more credits.

This means that in the energy sector, carbon trading can greatly influence energy production costs, particularly in industries reliant on fossil fuels. The need to purchase carbon credits creates an extra cost for these companies, which can lead to increased energy prices for the consumer.

Carbon Economics and Energy : Analysing the relationship between them

The relationship between carbon economics and energy prices is complex. Essentially, the cost of carbon credits becomes a part of the energy production cost. If the cost of carbon credits increases, energy producers may pass these costs onto consumers, leading to higher energy prices.

However, this isn’t always the case. Some energy producers may invest in cleaner technologies that reduce their carbon emissions, reducing the need for carbon credits. This could potentially lead to lower energy prices in the long run.

Examples of Emissions Trading Schemes and Price Impacts

The European Union’s Emissions Trading System (EU ETS)

The European Union’s Emissions Trading System (EU ETS) is a prime example of an emissions trading scheme designed to reduce greenhouse gas emissions, significantly impacting energy prices. Since its implementation in industrial sectors across the European Union, the EU ETS has led to fluctuations in energy prices in member countries. When the price of carbon credits in the EU ETS increases, energy prices tend to follow suit.

Here are some key points about the EU ETS:

 How It Works:

  1. The EU ETS sets a cap on the total amount of greenhouse gas emissions allowed within the system.

  2. Companies receive emission allowances (carbon credits) based on their historical emissions or other criteria.

  3. If a company emits more than its allocated allowances, it must purchase additional allowances from the market or face penalties.

  4. Conversely, companies that emit less than their allowances can sell their surplus allowances.

Impact on Energy Prices:

  1. The EU ETS affects energy prices indirectly by influencing the cost of carbon allowances.

  2. When the price of carbon credits increases, energy prices tend to rise as well.

  3. This happens because companies factor in the cost of purchasing allowances when setting energy prices.

  4. As the EU ETS tightens emission limits over time, the scarcity of allowances can drive up their price, impacting energy costs.

Fluctuations in Energy Prices:

  1. Since its implementation, the EU ETS has led to fluctuations in energy prices across member countries.

  2. When carbon credit prices rise sharply, energy prices may follow suit due to increased production costs.

  3. Conversely, during periods of low carbon credit prices, energy costs may decrease.

As outlined above, the EU ETS plays a crucial role in incentivising emission reductions and promoting low-carbon technologies. However, history tells us that the scheme does impact energy prices for consumers and businesses alike.

The Regional Greenhouse Gas Initiative (RGGI, USA)

One notable case study is the impact of the Regional Greenhouse Gas Initiative (RGGI) on energy prices in the northeastern United States. The initiative was designed as a co-operative effort amongst ten US states to reduce greenhouse gas emissions from the power sector. Since its implementation, the RGGI has not led to significant increases in energy prices. 

How It Works:

  1. The RGGI operates through a cap-and-trade system similar to the EU ETS.

  2. Participating states collectively set a cap on carbon dioxide (CO2) emissions from power plants.

  3. Power plants receive allowances (carbon credits) equal to their allocated emissions.

  4. If a power plant emits less than its allowances, it can sell the surplus allowances.

  5. Conversely, if a power plant exceeds its allowances, it must purchase additional allowances.

Impact on Energy Prices:

  1. Unlike the EU ETS, the RGGI has not significantly increased energy prices in the region or experienced extreme price spikes

  2. Several factors contribute to this outcome:

    • Energy Efficiency Investments: States within the RGGI have prioritised energy efficiency programs and renewable energy projects.

    • Auction Revenue Reinvestment: The revenue generated from auctioning carbon allowances is reinvested in clean energy initiatives.

    • Gradual Emission Reductions: The RGGI has implemented a phased approach to emission reductions, allowing the market to adjust gradually.

The RGGI serves as a positive example of how regional cooperation and thoughtful policy design can mitigate climate change while maintaining energy affordability.

Forecasting Energy Prices: How carbon trading will affect future prices

Forecasting energy prices is a complicated task that requires considering many factors, including the future of carbon trading. As countries worldwide continue to tighten their emissions caps, the demand for carbon credits will likely increase, potentially leading to higher prices.

However, advancements in renewable energy technology could offset some of these price increases. As renewable energy becomes more cost-effective, energy producers may invest in these technologies to reduce their reliance on carbon credits, potentially stabilising or even decreasing energy prices.

Strategies for Energy Companies: Managing risks and capitalising on opportunities

Energy companies can manage the risks associated with carbon trading by investing in cleaner, more efficient technologies. By reducing their carbon emissions, companies can reduce their need for carbon credits and potentially avoid future price increases.

Companies can also capitalise on opportunities presented by carbon trading. For example, companies that can reduce their emissions below their cap can sell their excess credits to other companies, creating an additional revenue stream.

In conclusion, while carbon trading can increase energy prices, it also allows energy companies to innovate and invest in cleaner technologies. As the world continues to grapple with the challenge of climate change, the role of carbon trading in shaping our energy future will only become more significant.

Interested in tracking carbon prices?