Dohoshin and Rebecca Mari
Bank of England Research Agenda (Bear) Set up important areas of new research at the bank for the next few years. This post is an example of the issues considered below Financial System Theme It focuses on changing landscapes and new risks facing monetary policymakers.
Carbon pricing has emerged as one of the major mitigation measures adopted around the world to combat climate change. In the UK and the EU, rising carbon prices in Emissions Trading Schemes (ETS) serve as an incentive to replace centralized emissions activities and power sources. Such an increase could be the result of government direct policies, but as explained in this post, changes in carbon prices appear to be endogenously related to the development of energy markets as well. Understanding the possible transmission channels underlying the relationship between the two is important to assess how climate-related risks are related to broader macroeconomic developments and thus financial and financial stability.
Carbon pricing generally involves applying monetary expenses to greenhouse gas emissions through either carbon tax or ETS. Generally in the form of a “cap-and-trade” system, the government sets an emissions cap and the market determines the price. Several government policies supporting the transition to net zero focus on rising carbon prices. These include reducing the supply of ETS emissions. Changes in carbon prices have a major impact on the economy, with the effect being greater for more emission-intensive countries and businesses. Rising carbon prices are linked to negative impacts on GDP and stock prices, increased consumer prices and risk premiers in the short term. This is commonly referred to as short-term trade-offs associated with migration at the macro level.
But in reality Short-term fluctuations in ETS allowance prices are not only exogenously determined by government policies.. Carbon prices show strong correlation with gas market development, as shown in Chart 1, where the UK and EU ETS allowable prices (UKA and EUA Spot series) are plotted against UK benchmark gas prices (UK NBP Daidie Series). Identify three possible transmission channels behind this historical correlation.
Chart 1: UK and EU carbon prices track each other widely, gas prices
Note: From 20/5/2021 (UK ETS launch) to 2 July 2025.
Source: Bloomberg and Bank Calculations.
The first and most important transmission channels are related to alternative effects that affect power producer choices. When gas prices rise, electricity producers switch from natural gas to coal if gas becomes more expensive than coal. Coal is more carbon-intensive than gas, which increases demand for ETS allowances and increases carbon prices. This was observed in Europe during the 2022 energy shock. Coal as a power source has increased by 4% compared to 2021, but gas has decreased by 6%. Market Intelligence This suggests that this contributed to the higher carbon prices observed over 2022 (Chart 1).
This channel operates directly in countries that produce both gas and coal. As some European countries continue to generate coal, if gas prices rise, they can raise EU carbon prices through the gas-to-coal switch mentioned above. Coupled with higher carbon prices and higher gas prices, It will boost EU electricity prices. This is driven in part by a combination of gas and carbon prices.
International waves Energy Market Interconnectivity However, this means that carbon prices in countries that do not produce either of the two energy sources could still be affected. In the UK, for example, despite the last coal power plant closure in September 2024, the global gas price shock could still affect UK carbon prices through interconnection with European wholesale electricity markets. The UK has 9.8G of power interconnect capacity with Europeit can flow from cheaper markets to cheaper markets. Rising EU electricity prices such as above could encourage EU electricity suppliers to increase the import of electricity in GB to maximize profits. The increase in demand will lead to rising carbon prices in the UK as current production and storage constraints are likely to be met by an increase in GB-based generation based on non-coal fossil fuels, taking into account constraints on renewable electricity. This channel can explain the correlation between the UK and EU ETS allowances as rising EU carbon prices flows through the electricity market.
Another channel is related to alternative effects that occur in the non-power sector. Also, rising gas prices will lead to the switch of fuels from gas to more carbon-intensive fuels in these sectors, increasing carbon prices. Chart 2 shows that, amid a long-term upward trend, the share of natural gas across core fossil fuel consumption tends to fall when gas prices in the UK manufacturing sector rise when they are within the UK ETS range.
This supports an alternative between gas and more carbon-intensive fuels such as oil and coal in the non-power sector as another potential propagation channel for gas and carbon prices. The importance of this transmission channel could grow if the non-power sector ends up having less ETS allowances for free in the future.
Chart 2: Gas prices increase generally encourages the use of other fossil fuels in manufacturing
Note: The core fuels in manufacturing are defined as natural gas, coal, gasoline and fuel oil. Gas prices are the average gas prices purchased by UK manufacturing.
source: Energy Security and Net Zero Sector – Fuel Prices for Manufacturing, National Bureau of Statistics – Fossil fuels by fuel type and industry and bank calculations.
Finally, the final channel is a financial speculator who trades based on the predictive relationship between gas prices and carbon prices discussed above. Despite the phase-out of coal, speculators were able to continue purchasing ETS allowances when gas prices rise, amplifying the impact of gas prices impact on carbon prices. Speculators were also able to trade on the correlation between the UK and the EU, amplifying the EU outflow.
These three channels may contribute to the correlation between gas prices and carbon prices. As the economy undergoes structural changes as a result of climate change and related policies, the drivers behind carbon price changes could also evolve.
Once the grid moved to zero carbon, the electricity sector could see a decrease in the replacement effect on fuel selection between gas and coal. At the same time, if the non-power sector gets more and more within the range of ETS or loses free ETS allowances, fuel choice could have a strong impact on carbon prices. moreover, Changes driven by carbon price transition policy have a major macroeconomic impact on the economyit could have a second effect on carbon prices themselves through side effects of demand.
Overall, much of the future market dynamics of carbon prices are likely to depend on green technology and government policies, but today the gas market remains a central role. Bank of England 2025 Bank Capital Stress Test (BCST) scenario We focus our attention on the relationship between gas prices and carbon prices, a concrete example of how climate-related risks interact with traditional financial risk drivers. Ongoing banking work explores how climate-related risks affect the UK’s financial system through various channels.
Dooho Shin and Rebecca Mari work in the bank’s climate, sustainability and community sectors.
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