Carbon price uncertainty is a drag on industrial 'green' investment
High carbon prices matter, but high volatility may matter even more. What to do?
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Decarbonising the four most energy intensive sectors in Europe (chemicals, basic metals, non-metallic minerals, and paper) is expected to require €500 billion of investment over the next 15 years, according to the Draghi Report on the future of European Competitiveness.
Much of this funding will need to come from the private sector. Across Europe, carbon mitigation investment has doubled as a share of GDP (from 0.4% in 2007 to 0.8% in 2023), but remains well below the levels thought necessary to accelerate Europe's decarbonisation.
While the EU ETS is the primary policy for leveraging private sector finance, carbon price volatility is a barrier to bringing that investment to fruition. As I explained in The Fear Index, the carbon price is the ‘Currency of Decarbonisation’, and in the same way that excess currency volatility imposes a cost, investors in decarbonisation incur a penalty if there is a high degree of uncertainty over the future carbon price:
"Volatile exchange rates discourage inward investment and make it more expensive to agree terms with trading partners. High carbon price volatility also imposes a cost. The level of funding required to invest in industrial decarbonisation is enormous, requiring a multi-decade long commitment, and high sunk costs. Exposure to high carbon price volatility makes it much harder for these large-scale projects to be seen as ‘bankable’ by investors."
For while standard economic logic predicts that higher carbon prices make low carbon investments more attractive, real options theory cautions that when the future carbon price is uncertain, firms may rationally seek to defer projects until uncertainty is quelled. Could this “wait-and-see” behaviour lead to systematic underinvestment, even under the EU ETS, the most ambitious carbon pricing regimes? And if so, what can be done about it?
