Why the carbon market is also Europe’s resilience tool
The EU Emissions Trading System (EU ETS) is often blamed for rising energy costs, but recent events show it can help to dampen fuel price shocks. Short-term relief measures should be carefully targeted, while preserving the price signals needed to drive clean investment and reduce reliance on fossil gas.
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Frauke Thies
The escalating conflict in the Middle East underscores a sobering reality: global energy markets remain highly exposed to geopolitical risks. The region is central to global oil and liquefied natural gas (LNG) supply, while critical transit routes such as the Strait of Hormuz serve as chokepoints for global energy trade. Even limited disruptions can trigger sharp price increases and volatility, with wide-ranging effects across energy systems and economies.
For energy-importing regions such as the European Union, these shocks rapidly translate into economic and political pressure. Rising fossil fuel prices hit households and industry, strain public budgets and increase the risk of short-term policy interventions which may be detrimental to climate and industrial goals in the long term. The current crisis therefore raises a fundamental question: how can Europe better shield itself against external energy shocks while preserving affordability and competitiveness?
A key part of the answer is that climate policy and energy security go hand in hand. Reducing dependence on internationally traded fossil fuels – through renewables, electrification, energy efficiency and flexibility – strengthens Europe’s resilience while advancing the transformation of its economy.
A changing gas market and rising vulnerability
Europe’s gas supply has profoundly shifted in recent years. While gas demand has declined since 2019, supply structures have changed even more dramatically. With Russian pipeline gas imports sharply reduced after 2022, the EU has increasingly relied on liquified natural gas (LNG), emerging as the world’s largest LNG import market.
This diversification has improved supply security in some respects, but it has also increased Europe’s exposure to global market dynamics. LNG prices are set internationally forcing Europe to compete with major buyers in Asia. As a result, disruptions affecting producers, shipping routes, or key maritime chokepoints can quickly trigger price spikes in European gas markets.
The current situation highlights this vulnerability. About 20% of global LNG passes through the Strait of Hormuz. Any disruption tightens global supply and amplifies price volatility.
The carbon market as an investment signal – and a dampener of fuel price shocks
As expenses for fuels rise putting pressure on businesses and power prices, the EU ETS plays an important role in mitigating the impact. Many factors, including political uncertainty and economic expectations, influence the carbon price. However, recent market dynamics do reveal an important counterbalancing effect: as oil and gas prices rise, fossil-based industrial activity tends to slow, reducing emissions.
While such crisis-driven fossil fuel demand drops are no substitute for structural transformation, they show how the EU ETS can cushion industry against price spikes rather than increase costs. During the current energy shock, CO₂ prices have fallen by around 18%, significantly contributing to a reduction of carbon-related generation costs.
This adjustment has partially offset the surge in oil and gas costs as illustrated in the graph for electricity generation. While electricity prices have still increased – partly because gas-fired power generation amplifies fuel cost changes due to efficiency losses – the carbon market has thus dampened the impact of fossil fuel price shocks on the power price.
Most importantly, the EU ETS has a fundamental structural role in the industrial transformation. It is Europe’s central tool to provide the critical investment signal to move towards clean technologies such as electrification. The faster the shift, the greater the reduction in fossil fuels demand across a large market – and the stronger the downward pressure on global fuel prices.
Weakening or suspending the carbon market in times of crisis would undermine its counterbalancing effect and enhance fossil fuel demand, shifting economic rents to external suppliers. At a time of geopolitical turbulence, the EU ETS should be understood and safeguarded as a core instrument of energy security.
Short-term relief while safeguarding a well-functioning system
While governments understandably look to shield households and industry from high energy prices, short-term measures must be carefully designed. Experience from the 2022–2023 energy crisis shows that broad market interventions – such as a price cap on gas – can distort price signals, increase fossil fuel consumption and raise overall costs, while failing to ensure that the relief reaches the intended recipients.
More effective approaches focus instead on targeted support and demand reduction. Encouraging energy savings, supporting vulnerable consumers through direct transfers, and rebalancing energy taxation can provide relief while preserving market functioning. Robust price signals remain essential to incentivise efficiency and reduce demand at times of scarcity.
In this context too, the ETS can play an important role, providing a predictable revenue stream that can fund targeted support for vulnerable households and strategic industrial sectors without undermining market signals. Critically, governments should use the revenues wisely to help industry to make the switch to clean technologies, thus furthering the structural shift away from fossil fuels.
Structural solutions for long-term resilience
Ultimately, the most effective way to reduce exposure to global energy shocks is to address their root cause: dependence on imported fossil fuels.
Accelerating the deployment of renewable energy is central to this shift. Renewable energy generation reduces the number of hours in which gas sets electricity prices, lowering both fossil fuel import and electricity costs. Investments in grid infrastructure, storage and system flexibility further enhance these benefits, while reducing power price volatility.
Electrification across various sectors – buildings, industry and transport – can significantly reduce gas demand. For industry alone, around 60 percent of current fuel use for process heat could be electrified with mature technologies today, rising to around 90 percent with technologies expected by 2035. Governments play a key role in developing the enabling conditions necessary to scale electrification upon which policy and technology options already exist: For example, making heat pumps affordable and accessible for all, improving grid access and competitive electricity prices to drive electrification of industrial heat alongside renewables-based district heating systems all contribute to lowering LNG import needs.
At the same time, improving demand-side flexibility allows consumers to respond to price signals, shifting consumption to periods of abundant renewable energy generation and reducing peak demand pressures, while reducing their bills.
Taken together, such measures can substantially reduce Europe’s reliance on LNG and its exposure to global market volatility.
The current crisis accentuates a broader lesson: consistent and credible policy frameworks are crucial to achieve long-term resilience. The EU ETS plays a central role in this framework. It provides a predictable investment signal, supports the transition to clean energy, and can act as a buffer against fossil fuel price shocks.
Equally important is the internal power market built on the principle of “merit order”, ensuring electricity is generated at the lowest cost by dispatching the cheapest available power first. When low-cost sources like wind and solar are abundant, prices fall – the more renewables in the system, the less often fossil gas sets the price. This design sends the right price signals to consumers, producers, and investors, especially for renewables and storage.
As Europe navigates a period of heightened geopolitical uncertainty, these existing frameworks form a strong foundation for a broader strategy of energy independence. In a world of volatile fossil fuel markets, the most effective protection lies in reducing exposure to them. By accelerating the transition to renewables-based power systems and upholding the integrity of Europe’s policy framework, policymakers can significantly strengthen the bloc’s economic resilience and energy independence.