Coevolution of policy, market and technical price risks in the EU ETS

Within the EU, there have been calls for governments to provide greater certainty over carbon prices, even though it is evident that their price risk is not entirely due to policy uncertainty. We develop a stochastic simulation model of price formation in the EU ETS to analyse the coevolution of policy, market and technology risks under different initiatives. The current situation of a weak (20%) overall abatement target motivates various technology-support interventions, elevating policy uncertainty as the major source of carbon price risk. In contrast, taking a firm decision to move to a more stringent 30% cap would leave the EU–ETS price formation driven much more by market forces than by policy risks. This leads to considerations of how much risk mitigation by governments would be appropriate, and how much should be taken as business risk by the market participants.

► Methodology is developed to track EU–ETS risk factors and their interactions.
► Policy risks are found to be the most significant when carbon prices are low.
► Robust carbon signals in a cap-and-trade require stringent targets.
► Multiple policies create downward price pressure, increasing policy risk exposure.
► Fuel prices also are important, whilst technology risk plays a small part until later.