What is carbon trading
What are carbon emissions?
Carbon emissions are the greenhouse gases emitted from the burning of coal, oil and natural gas, collectively known as fossil fuels. Carbon dioxide (CO2) is released naturally during various processes, such as respiration and decomposition. But human activity produces carbon at such high rates that nature cannot keep up.
As a result, we have global warming. As scientists and activists encourage consumers and businesses to switch to carbon-neutral technologies – like wind, solar and hydropower – the process of sequestration has also begun.
Sequestration covers any process that reduces the impact of the carbon emitted. You may also know it as “carbon offsetting”.
What is a carbon credit?
A carbon credit is a standardized permit that allows its holder to emit one tonne of carbon dioxide – or another greenhouse gas. The credit system is designed as a measurable form of carbon offsetting that aims to reduce, eliminate or avoid CO2 as much as possible.
The carbon credit scheme was introduced by the European Commission (EC) in January 2005 as part of efforts to limit the amount of environmental pollution by companies and to encourage rapid compliance with set emission reduction targets. under the Kyoto Protocol.
Each company or nation receives a certain number of credits which allow it to emit a certain amount of carbon. If they go beyond that, they must buy additional credits, but any unnecessary credits can be sold to another party.
This encourages companies to reduce their pollution faster so they can sell allowances to others or save them for future use.
The total cap will decrease over time to encourage companies to continue their efforts to reduce production. In 2017, the EU decided to lower the carbon cap by 2.2% each year until 2030 – the cap reduction factor was previously set at 1.74%.
The program was so popular that the price of carbon credits jumped 989% throughout 2021 as companies tried to reach net zero by 2050 – the price rose from 80 cents per metric ton on January 4 2021 at $8.71/mt on November 22.
But the system was a mess. Too many credits were created, sometimes they were counted twice – by the country where it was created and the country where it was sold – and there was no way to really gauge whether emissions were being reduced.
Thus, at the Glasgow Cop26 climate summit in November 2021, it was agreed that a global carbon credit market would be created with better quality credits and stricter rules. Although the market is more regulated, the increased trust and transparency could lead to an increase in trading volume.
What is carbon emissions trading?
Carbon emissions trading is speculation on the price of carbon. The price of carbon is set using futures contracts on European Union (EUA) allowances. A contract is equivalent to a credit, which gives its holder the right to emit one tonne of carbon equivalent gas.
Due to the growing popularity of EUAs, futures contracts have become the new choice for people who want to earn profit and hedge risk under carbon market conditions. There are other carbon futures providers, but the EUAs account for the majority of the global market value.
Unlike other futures contracts – where the buyer receives the underlying asset at expiration – the buyer of an EUA would have a legal obligation to redeem their contracts based on the amount of greenhouse gas. of greenhouse they produced during the year. If they do not return the correct amount, they will be fined €100/tonne of CO2 equivalent for each excess ton of carbon, and will then have to purchase the correct amount of additional EUAs to make up the difference.
The price of EUA futures fluctuated between $57 and $96 in the first three months of 2022. The price increase will likely also cause the fine price to increase by €100/tonne.
What impacts the price of carbon credits?
As there is no fixed price for carbon, it is determined by market supply and demand in the same way as other commodity markets, meaning that individual traders can take a position on the rise or fall in price.
If companies need more credits than there are currently to buy, demand will outweigh supply and the market price will rise. But, if companies reduce their demand and start selling their credits, the supply increases beyond the demand and the price will go down. This makes the carbon market quite unique because the goal is for it to become obsolete once companies no longer need to buy carbon credits.
Research has shown that economic activity has the greatest impact on prices. When the economy is healthier, industrial production increases as demand for infrastructure, housing starts and consumer products increase. This results in an increase in polluting activity.
For example, from December 2020 – at the height of the pandemic – to November 2021, when the economy was growing again, the price of EUAs went from €33/tonne CO2 to €73/tonne CO2.
The carbon market also tends to show the most liquidity – and the most stable prices – in December, as there is a clearer view of companies’ actual annual emissions as the end of the compliance period approaches. (it ends on December 31). They will need to start thinking about whether they have bought enough credits to cover the current year and how many contracts they will need to buy to cover future years’ obligations.
How to trade carbon credits
You can go long or short on carbon emissions (EUA futures) with City Index, allowing you to speculate on the rise or fall of the market price. Our market is open daily from 7:01 a.m. to 5:00 p.m. (GMT).
To start trading carbon futures, follow these quick steps:
- Open a City Index account or sign in to an existing account
- Search “Carbon Emissions” on our award-winning platform
- Choose whether you want to “buy” or “sell”
- Set your position size and manage your risk with stops and limits
- Place your trade and watch the market
Alternatively, you can practice trading carbon credits in a risk-free environment using a City Index demo account.