Carbon Pricing Dynamics: Understanding Interconnections in Energy Markets

Dooho Shin and Rebecca Mari

The Bank of England Agenda for Research (BEAR) identifies key research areas to navigate the evolving landscape and risks in financial policymaking.

Carbon pricing has gained traction globally as a principal strategy to mitigate climate change effects. In both the UK and EU, rising carbon prices within Emissions Trading Schemes (ETS) serve as a critical mechanism to encourage the shift from emissions-heavy power sources. While these increases often stem from direct governmental policies, they are also intricately woven into the developments of energy markets. Understanding the pathways through which these markets influence carbon prices is essential for evaluating the interconnected risks that climate change poses to economic stability and overall financial resilience.

Essentially, carbon pricing involves assigning a monetary value to greenhouse gas emissions, typically operationalized through either a carbon tax or an ETS framework. In ETS systems, a 'cap-and-trade' approach is implemented whereby a limit on emission allowances is established and market forces decide the pricing. Several government initiatives aimed at facilitating the transition to net zero emphasize increasing carbon prices by curtailing emission allowance availability. Research has shown that changes in carbon pricing can substantially impact economic dynamics, especially in more carbon-intensive nations and sectors.

The implications of growing carbon prices manifest primarily as a short-term trade-off: while higher carbon costs adversely affect GDP and equity valuations, they generally provoke an uptick in consumer prices and interest rates. This scenario often emerges as a necessary shift toward sustainability, highlighting the macroeconomic consequences involved.

However, the reality is that short-term fluctuations in ETS allowance prices aren't solely dictated by policy changes. Evidence suggests a considerable correlation between carbon prices and movements in gas markets; this can be illustrated in Chart 1, plotting UK and EU ETS allowances (UKA and EUA) against UK benchmark gas prices (UK NBP day-ahead series). Identifying three primary transmission channels reveals the foundation of this correlation.

Chart 1: Correlation between UK and EU carbon prices and gas prices

Notes: 20/5/2021 (start of the UK ETS) to 7/2/2025. Sources: Bloomberg and Bank calculations.

The most critical transmission channel emerges from substitution effects specific to electricity generation. In scenarios where gas prices escalate, electricity producers are prompted to switch from using natural gas to coal when it becomes economically favorable. Since coal has a higher carbon intensity than gas, this transition invariably leads to increased demand for ETS allowances, thereby inflating carbon prices. This phenomenon was evident during the energy shock of 2022 when coal usage rose by 4%, while gas output fell by 6% compared to 2021 levels. Market intelligence indicates these trends contributed to surging carbon prices throughout 2022 (as demonstrated in Chart 1).

In countries with both gas and coal production, the connection between rising gas prices and carbon prices becomes even more pronounced. For example, European nations that still rely on coal for power generation see EU carbon prices increase in tandem with higher gas costs due to the described gas-to-coal switch. Thus, a simultaneous rise in carbon and gas prices can lead to elevated electricity prices across the EU, particularly when both factors are partly rooted in carbon pricing.

Additionally, the interconnectedness of international energy markets can have significant effects even for countries not directly producing gas or coal. For instance, the UK’s carbon prices are still influenced by European wholesale market activities despite the closure of the last coal power station in September 2024. The UK electricity market, linked by 9.8GW of interconnector capacity with Europe, allows for electricity trade between regions with varying price points. When EU electricity prices rise, UK suppliers may increase power exports to capitalize on higher demand, leading to greater reliance on non-coal fossil fuel generation, ultimately lifting UK carbon prices. This linkage explains a significant element of correlation between carbon price movements in the UK and the EU.

Another pivotal channel is the shifting consumption patterns in non-power sectors responding to soaring gas prices, which results in a fuel switch away from gas to more carbon-intensive alternatives. Chart 2 depicts how an increase in gas prices correlates with a decline in natural gas consumption among core fossil fuels in the UK manufacturing sector, an area subject to the ETS framework.

Chart 2: Fuel switching in the manufacturing sector

Notes: Manufacturing industry's core fuels include natural gas, coal, petrol, and fuel oil. The gas price shown is an average of prices paid by the UK manufacturing sector.

Sources: Department for Energy Security and Net Zero – manufacturing industry fuel prices, Office for National Statistics – fossil fuels data, and Bank calculations.

Lastly, the behavior of financial speculators plays a role. Trading based on anticipated movements in gas and carbon prices may continue even post-coal phase-out, with speculators buying ETS allowances in response to rising gas prices. This buying pressure can amplify the effects of gas price shocks on carbon priced in the market while also intensifying spillover impacts between UK and EU markets.

These channels underscore the complex interdependencies driving carbon price changes. As economies adapt to climate challenges and policies, the factors influencing carbon pricing are expected to evolve as well.

In the shift toward zero-carbon grids, the power sector may experience a diminishment of the gas to coal substitution effect. Furthermore, if non-power sectors participate increasingly in the ETS or receive fewer allowances, their impact on carbon pricing could amplify. The broader economic influence of carbon pricing changes must also be acknowledged, indicating potential secondary effects that might feed back into carbon pricing via demand shifts.

Ultimately, while the future dynamics of carbon pricing depend significantly on advancements in green technologies and policy directions, the current market realities indicate that gas markets remain pivotal in shaping carbon pricing trends. The 2025 Bank Capital Stress Test (BCST) scenario emphasizes the crucial interplay between gas prices and carbon prices, reflecting how climate risks interact with traditional financial risk factors—an essential element in the Bank of England's ongoing research on climate-related risks within the financial system.

Dooho Shin and Rebecca Mari are part of the Bank’s Climate, Sustainability and Community Division.

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