What factors influence carbon prices in energy markets?

Carbon pricing fundamentals

Carbon pricing fundamentally assigns a monetary value to emitting one tonne of CO₂. In compliance markets, this typically manifests as a cap-and-trade system. Regulators establish an emission cap and allocate allowances, either freely or through auctions. Participants are then required to surrender allowances that match their verified emissions during each compliance period.

This design embeds several structural price drivers:

• Allowance caps and allocation: the stricter the cap and the smaller the free allocation, the greater the scarcity, which generally drives prices higher.

• Compliance cycles: annual surrender deadlines can cause liquidity pressure as participants hurriedly adjust their positions. Consequently, these deadlines can induce short-term volatility.

• Market participants: utilities, industrials, and financial entities all approach the market differently. Utilities often hedge forward, industrials react to production levels, while financials contribute speculative liquidity. Market makers facilitate flows but can amplify movements if liquidity is thin.

• Time horizons: carbon markets operate across various time frames, including intraday, monthly, yearly, and multi-year periods. Intraday fluctuations might be driven by auction results or weather changes, whereas long-term agreements consider regulatory expectations and decarbonisation paths.

These fundamentals make carbon prices both a compliance cost and a forward-looking indicator of policy ambition.

Policy and regulatory drivers

Regulation is the most influential factor shaping long-term carbon price trends. Policy decisions on how the system is structured, tightened, or modified can swiftly alter market prices.

Key factors include:

• Cap setting and trajectories: this involves decisions regarding the linear reduction factor and the shape of the long-term cap, reflecting scarcity expectations. A steeper reduction path indicates potential future scarcity tightening.

• The Market Stability Reserve (MSR): in the EU ETS functions as a supply-side stabiliser by absorbing excess allowances and releasing them during market tightening. Modifications to the MSR’s withdrawal rates can greatly impact the supply-demand equilibrium.

• Free allocation and carbon border adjustment (CBAM): rules on free allocation are key to industrial compliance costs. As free allowances decrease, industries must purchase more, boosting demand. The CBAM aims to prevent carbon leakage by imposing similar costs on imports, affecting both domestic demand and global trade patterns.

• Political and legal developments: consultations, parliamentary votes, and court rulings, can influence sentiment. Unexpected delays or legal challenges in reforms may lead to revaluation.

• Transparency and reporting: regulator updates, emissions data releases, and system operator reports provide signals on whether the market is tighter or looser than expected.

Policy is therefore not just a backdrop but an active driver, with forward-looking participants constantly recalibrating price expectations based on regulatory developments.

Energy system fundamentals

While regulation influences long-term scarcity, short-term prices typically react to energy system fundamentals. Carbon allowances are ultimately connected to actual emissions, and changes in fuel consumption, weather conditions, and industrial activity directly impact demand.

• Fuel switching: arguably the most significant short-term driver. Power generators choose between coal and gas based on relative fuel costs and carbon prices. If gas is cheaper, emissions decrease, reducing demand for allowances. If coal is cheaper, higher carbon costs may be necessary to encourage switching.

• Renewable generation: whether from wind, solar, or hydro, produces a high output that reduces the need for fossil-fuel power, thereby lowering emissions and demand for allowances. Conversely, when renewable capture prices are low or curtailment occurs, dependence on thermal power can rise.

• Weather influences energy demand: cold winters boost heating needs, while hot summers raise cooling requirements. Additionally, hydro conditions in specific areas play a role, as droughts or heavy rainfall can alter generation mixes.

• Industrial production: sectors such as cement, steel, and chemicals contribute a significant share of emissions. Indicators like PMI surveys or industrial output data often offer early signals for carbon demand.

• Grid constraints and interconnectors: regional bottlenecks, curtailment, and cross-border flows all influence short-term emissions and can alter local compliance requirements.

The connection between carbon and energy commodities causes their prices to often move together with gas, coal, and power markets. However, this link can weaken during policy shocks or speculative trading.

Market structure and trading dynamics

Beyond fundamentals, market mechanics and trading behaviours add further layers of complexity.

• Liquidity cycles: trading volumes tend to cluster around allowance auctions, options expiries, and annual compliance deadlines. These events can amplify price swings.

• Speculative positioning: hedge funds and financial traders provide liquidity but can also amplify market movements. Large speculative long or short positions sometimes serve as accelerants, driving prices beyond levels supported by fundamentals.

• Correlations and decoupling: carbon prices often track gas, power, and broader risk assets. Yet correlations can break down when regulatory or policy shifts dominate.

• Allowance auctions and issuance: the pace and size of primary issuance directly influence supply. Weak auction demand may indicate bearish sentiment, while strong cover ratios can boost prices.

• Risk management factors: such as volatility, margin requirements, and collateral costs all impact trading activity. During stressed markets, margin calls may lead to forced sales, which can trigger downward spirals.

These dynamics emphasise that carbon markets function both as financial instruments and environmental policy tools. Participants must consider both compliance essentials and speculative liquidity.

Conclusion

Carbon prices in energy markets result from a complex interplay of regulation, energy fundamentals, and trading activities. Policy decisions influence overall trends by setting allowance scarcity and modifying tools like the Market Stability Reserve or free allocations. Short-term fluctuations are driven by energy system factors such as fuel switching, renewable generation, weather patterns, and industrial activity. Additionally, market structure and trading behaviours- including liquidity cycles, speculative flows, and auction results- add further complexity, often causing sentiment shifts.

For participants, the key is to view these forces not in isolation but as interconnected drivers. By establishing a framework that monitors regulatory reforms alongside fuel economics and market mechanics, firms can predict price movements with more confidence. This comprehensive approach strengthens hedge strategies, enhances procurement timing, and helps investment teams avoid unexpected shocks. In a market that functions both as a policy instrument and a financial asset, understanding the drivers of carbon prices is crucial for managing risk and supporting the broader energy transition.