A market mechanism that could see the UK government intervening to bring down prices has been triggered by a sustained rally that brought the price of carbon allowances to new highs.
After the UN climate summit in Glasgow, a surge in the price of allowances issued by the EU and UK emissions trading systems has resulted in a surge in the price of allowances.
The cap on emissions is set by governments and they create permits or allowances for each unit of emissions issued under the cap. The companies that are big polluters are obliged to buy credits that give them permission to emit one tonne of carbon.
A gas shortage has led some energy producers to switch to cheaper but dirtier coal, which is regulated under the systems. Demand for allowances has increased since coal is more carbon intensive than gas.
Credits in the UK have remained at elevated prices for several months and came close to a new record of more than 75 a tonne last week. The price of the EU system hit a new high of more than €81 on Monday. At the beginning of the year, this compares to €32 a tonne.
According to Ingvild S Rhus, lead analyst at Refinitiv Carbon Research, prices were just crazy but remained supported by fundamentals, including the energy crunch, as the European winter began to set in.
Since September, high prices have triggered the CCM of the UK for the first time, which obliges policymakers to consider whether to intervene in the market. The government said it would announce if it would take action by December 14.
Even before the energy crunch, the EU and UK carbon prices were rising as companies and traders digested the implications of increasingly ambitious national decarbonisation plans prompted by the UN climate summit in November.
Redshaw Advisors also noted on Monday that auctions for new allowances will not be held for almost a month after the final December sales.
The intervention mechanism is triggered by the UK rules if allowances trade at more than double the average price of the previous two years for three consecutive months.
The threshold is calculated using a combination of historic UK and EU prices since the system was established in May. The newer UK scheme has fewer price and time triggers for the first two years it operates, compared to the EU equivalent mechanism.
The UK government's response to the rally will depend on its assessment of the reasons for the rally. Policymakers must consider whether consistently high prices correspond to market fundamentals. If you want to reduce prices, you can increase the number of credits that will be sold in upcoming auctions, which occur every two weeks, by bringing forward allowances from future years.
Sebastian Rilling, EU power and carbon markets analyst at ICIS, said it would be important for the government to explain the basis for its decision. He said that there was little supply in the new UK market, but there was substantial demand due to the effects of the gas crisis.
Increased short-term supply of allowances is likely to reduce supply in the long term, because a finite number of credits is auctioned each year and the number sold annually is designed to fall over time to incentivise companies to reduce emissions.
Rilling said that the impact of any action taken to be limited is why we would expect it to be limited.