Climate Change Policies: Carbon Pricing and Potential Credit Implications in Europe

The highly-anticipated announcement of revised European climate and energy policies, the so-called “Fit for 55” package, is rapidly approaching. In this DBRS Morningstar commentary, we take a look at the credit implications of carbon pricing policy, in particular the European Union’s Emissions Trading System (EU ETS). Carbon pricing is a climate change mitigation policy that has been gaining relevance in recent years. We highlight the potential credit implications associated with this policy, and explore the likely impact of rising carbon prices and the implications of the potential extension of the EU ETS to other sectors. The EU ETS is currently under review as part of the strengthening of the climate mitigation policy framework in the EU to be presented in mid-July 2021.

Key highlights:
-- Carbon pricing has the potential to increase financial pressures on regulated companies, through higher costs. The impact of carbon pricing largely depends on the carbon price level (or stringency of the policy), the carbon intensity of an issuer's activities, and the ability of companies to pass on costs, adopt mitigation strategies, or become more energy-efficient. Complementary policies also play a role in assisting some companies to transition to cleaner energy and reduce carbon emissions.
-- After remaining low for several years, the carbon price in the EU has increased sharply since December 2020, by about 90% to above EUR 50 per tonne of carbon dioxide equivalent. Further increases appear likely, with experts suggesting that a carbon price three times higher would likely be needed to keep global warming at 1.5oC. We see some risk that companies operating within the EU will have difficulty in adjusting to a significantly higher carbon price.
-- At the same time as the EU carbon price has been relatively low, the sectors covered by the EU ETS have benefitted from free EU allowances, especially in industry. Some of these free allowances will now phase out. Moreover, the European Commission is considering the extension of the EU ETS scope to maritime transport, road transport, and buildings (residential and commercial heating). The extension of the ETS could lead to higher carbon costs for the newly-regulated companies. But, a broader EU ETS could also accelerate investment in green technologies.

“Carbon pricing is certainly gaining importance. Climate policies are becoming more stringent and countries around the world are adopting new tools to reduce emissions. In Europe, 2021 is becoming the year of significant changes in climate policies. This is likely to have credit implications for some issuers.” notes Adriana Alvarado, Vice President in the Global Sovereign Ratings Group.