CO2 regulation and the emergence of carbon markets
The concept behind carbon markets stems mainly from the 1992 United Nations Framework Convention on Climate Change. Their development can be divided into five phases:
Carbon pricing for investment decisions
Global carbon pricing systems and their implementation mechanisms have gained momentum. Our analysis explains existing and planned carbon pricing mechanisms and their potential impact on economic sectors, regions and company valuations, so you can make better investment decisions.
Three key insights
Driving change
Global warming is a global problem that knows no borders or countries. In addition to political measures, a carbon price can provide incentives for entire industries. The increasing regulation of greenhouse gas emissions has resulted in new carbon taxes and markets. In this way, carbon pricing via cap-and-trade markets can have a significant impact on sectors, regions and companies.
The Kyoto Protocol in 1997 ultimately set binding emission targets and CO2 reduction measures for 37 developed and emerging countries. However, it has not been ratified by some of the largest greenhouse gas emitters, such as China and the USA. This prompted the EU to develop the EU emissions trading scheme (EU ETS). This was followed by a significant expansion of the carbon markets.
Europe is a leader in emissions trading
Global carbon markets are estimated to have amounted to USD 85 billion in 2021, an increase of 164% compared to 2020. The EU ETS is the most important carbon market with an annual trading volume equivalent to ten times the emissions. Industry experts predict that the global carbon market will grow substantially by 2050 and may exceed the oil markets by 2030.
Influencing factors for pricing on the carbon markets
The price drivers on the carbon markets can be divided into three categories, each comprising sub-groups of indicators:
Fundamental indicators
- Supply and demand for certificates in circulation
- Temperature and economic-related CO2 emissions
- Change of fuel used
Financial indicators
- Volatility and liquidity of certificates
- Financing
- Speculation
Regulatory indicators
- Perceived stability
Carbon prices will increase rather than decrease
Since 2016, carbon markets have experienced price increases of an average of 23% per year. According to the International Energy Agency (IEA), carbon pricing must be introduced in all regions to achieve net-zero emissions by 2050. Prices of around USD 130 (2030) to USD 250 (2050) per tonne of CO2 are required for this target.
Assessment of the carbon risk by sector affiliation and geographic distribution
One possible way to quantify a company's carbon risk is by sector affiliation. Sectors such as utilities, raw materials, energy and industry are exposed to the carbon risk the most due to their carbon-intensive business. Geographically, companies in China, South Africa, India and Saudi Arabia have the highest carbon risk due to their large energy, oil, metal, steel, cement and chemical industries. In the USA, on the other hand, the average company is significantly less exposed to the carbon risk, as the country has a diversified economy with a large service sector.
Analysis of carbon risk at the company level is critical
In addition to sector affiliation and geographical location, other factors can influence the carbon risk for the valuation of a company:
- Total carbon intensity
The higher the carbon intensity of a company – measured as the ratio of CO2 emissions to revenue – the more it is affected by higher carbon costs. - Lock-in risk
Companies with a shorter remaining service life are potentially better positioned to replace the existing infrastructure with low-carbon systems. - Operational and financial flexibility
Companies with high operating margins (EBIT) and financial flexibility can absorb rising carbon costs. - Transfer of costs
This refers to the ability to pass on higher carbon and investment costs to reduce carbon intensity. - Hedging
Some companies already hedge their future carbon risk by purchasing carbon certificates for their future emissions at today's prices in order to protect themselves against rising prices.
Major risks
Carbon pricing also carries risks that could lead to global carbon prices rising less than expected or even falling. This includes:
- Energy cost shocks
Supply shocks have a negative impact on the affordability of energy and can lead to a partial weakening of the political consensus in climate policy. - carbon-induced inflation
The transition from a fossil fuel-based economy to a net-zero economy can create a disequilibrium between supply and demand, leading to inflation. This can reduce policy support in the short term. - Risk of politicisation
Free emissions certificates are still widely used to maintain competitiveness.
Summary
Further reforms of the EU ETS and the introduction of the Carbon Border Adjustment Mechanism CBAM are expected to lead to significant carbon risks for specific sectors and companies in the coming years. A sectoral assessment of the carbon risks must therefore always be complemented by a fundamental analysis in order to fully capture the carbon risks of a company.
