For Europe’s Hot Carbon Market, Politics Is the Ceiling

Designed to encourage industries to clean up, the total credit supply will shrink annually, yet demand is expected to grow, in the near term at least, with more electrification and the program’s extension. This sounds like a recipe for a one-way bet, and there have been whispers of something akin to a short squeeze, as companies become forced buyers of a dwindling stock of credits.

What investors need to remember is that politics could push supply the other way too. Although they are traded like a commodity, carbon credits are conceptual, not physical. The market rules can be adjusted if its price isn’t meeting EU objectives.

Along with tighter regulation and “green deal” subsidies, carbon costs are a key tool for the EU to decarbonize its economy. Many expect the price of credits to rise well above €100 a metric ton, eventually, generating extra cash to help fund the transition. Europe sees decarbonization as an opportunity to take the lead in the next industrial revolution, as well as an environmental necessity.

With this goal in mind, the ETS is functioning well enough that the EU is building on it. It recently proposed a “carbon border adjustment mechanism” to levy its carbon price on some imports from regions that don’t tax carbon. It is also expanding the market: Shipping is expected to be covered by the existing ETS, while a new one is being drawn up for buildings and transport to reflect their different costs and challenges.

Crucially, though, EU politicians also need businesses to remain competitive through the transition, so the ETS remains a work in progress. They will likely intervene if the trade-off between decarbonization and competitiveness becomes a problem.

Existing rules allow the injection of additional allowances, if for six months the price exceeds three times the average of the prior two years. But six months is a long time and if the carbon price jumped enough to threaten its industrial base, the bloc might change the rules.

EU decision making usually takes years, but in some crises, the bloc has acted quickly. Sky-high emission prices would likely count as a crisis: Energy costs are a hot-button issue, particularly since the 2018 “gilet jaunes” protests in France. Officials used other tools to deal with this winter’s energy crisis, mostly because it is expected to be temporary and carbon emission prices weren’t the cause. Significantly higher carbon prices, particularly if due to speculation, would likely trigger a different response.

Investors are smart to use European ETS credits to hedge against rising carbon costs and bet on the green transition, but there are limits. If too many try to squeeze in, it might just ruin the party.

Write to Rochelle Toplensky at rochelle.toplensky@wsj.com