The European carbon market doesn’t pay any attention to spiking inflation or climbing interest rates, and its price – which has doubled in the last year – might only keep going up…

What exactly is a carbon market?

The best way to set a price that’s both high enough to incentivize polluters to cut their emissions and low enough to avoid sending whole industries into bankruptcy is the “cap and trade” system.

Under the “cap and trade” system, the European Union (EU) allows firms in polluting industries to emit greenhouse gases, but only up to a set amount. The companies that exceed their cap have to buy “allowances” in the EU’s ETS (Emissions Trading System) market – the world’s first and biggest carbon market, which covers around 40% of the EU’s greenhouse gas emissions.

Those that polluted less than their cap, meanwhile, can sell their unused credits. The higher the price of carbon, the higher the cost of polluting – and the more likely companies will switch to greener alternatives, allowing the EU to meet its emissions targets.

After a rather chaotic first decade, the market’s grown significantly and prices have picked up at a rapid pace over the last year – going up from €28 per ton of CO2 a year ago to €55 currently.

Why have carbon prices been going ballistic?

Simple: a constrained supply combined with a booming demand.

The supply is controlled by the EU, which can decide how many allowances are issued each year. And because the EU needs higher prices to reach their ever more ambitious emission-reduction goals, they carefully limit the supply of permits they offer.

The demand started to boom when it became clear that the price of carbon was the tool the EU’s using to fight climate change. And it wasn’t just environmentally friendly players who wanted in: profit-driven businesses like commodity trading firms, prop trading desks, and hedge funds did too.

So where will carbon prices go next?

Experts seem to agree that higher prices are necessary for the EU to meet its 2030 environmental goals. But how much higher depends on who you ask: the EU’s own projections forecast a price of €85 by 2030, while others – like BloombergNEF – claim a price of €108 is needed.

The more immediate question is what happens in the short term. BloombergNEF expects a year-end price of €48-53 – slightly lower than the €55 we’re at right now. But some hedge funds are much more bullish, and they’re expecting prices to breach €100 in the second half of the year. Three factors could make that happen.

First, many investors believe the downside is limited, as the EU can’t allow lower prices if it wants to meet its climate goals. The EU presented an ambitious “Green Deal” last November, targeting greenhouse gas emissions reductions of at least 55% by 2030.

Second, the EU is currently drafting its biggest carbon market reform to date, which is set to be unveiled on July 14th. The reform is widely expected to be positive for prices – not only because it’ll reduce the supply of carbon permits over time, but also because it’ll expand its coverage to other sectors, such as shipping, housing and transport.

Third, institutional investments should continue to boost the market, as the trade is both ESG-friendly and a good way to diversify traditional portfolios of stocks and bonds. And as trading volumes grow and investing in carbon becomes more accessible, more and more players should enter the market and add to the demand.

So what are the risks?

Some analysts are worried about the fact that the EU indirectly but single-handedly “controls” carbon prices. Yes, the EU wants higher prices, but it also cares about how fast we get there. The EU, after all, has to balance its climate goals with keeping European firms competitive.

If prices rise too far, too fast, the EU might signal it’ll intervene – either by increasing the allowances or by limiting the participation of speculators in the derivatives markets. And given the strong rally we’ve seen, that could lead to a correction and higher volatility in the short term.

What’s the opportunity here?

What makes trading on carbon prices so appealing is that it’s a unique way to diversify right now, as the rationale doesn’t have anything to do with interest rates, inflation, or economic growth – factors that impact almost every traditional asset class.

It’s all down to the fact that the world needs higher carbon prices and has the means to achieve them. And while prices have gone up a lot .

This trade is niche, even for institutional investors. But it is possible for retail investors: the cleanest way is through contracts for differences (CFDs) – derivative contracts that allow investors to bet directly on the price of EU ETS futures. Just remember to carefully size your positions, not risk more than you can afford to lose, and take full advantage of stop losses, as your losses can quickly spiral out of hand in leveraged trading.

Meanwhile, if you have access to US ETFs (and the right credentials), the KFA Global Carbon ETF (ticker: KRBN) is another way to implement the trade – although the fund also holds other carbon markets such as the one in California and other regions.