The Benchmark European carbon price hit a 10-year high on Wednesday, marking a near 130% rise this year, with prices set to continue climbing over the next few years.
The European Union's Emissions Trading System (ETS) charges power plants and factories for every tonne of carbon dioxide (CO2) they emit.
The cap-and-trade scheme is the EU's key tool to meet its goal of reducing greenhouse gas emissions by 40% by 2030 compared with 1990 levels.
Each member state has a set number of permits it can auction each year which are then purchased by companies to cover their emissions.
The ETS suffered from excess supply following the financial crisis, which kept prices low and rendered the scheme ineffective, but in an effort to revive the scheme, the EU agreed on reforms in 2017 to curb oversupply.
The first of these reforms, a Market Stability Reserve (MSR), comes into effect in 2019, which will take excess permits from the market.
"This year is all about buying in anticipation of the start of the MSR," Energy Aspects analyst Trevor Sikorski said.
Carbon analysts at Thomson Reuters forecast the MSR will remove 390-million tonnes of permits in 2019, cutting the supply available from government auctions by 40%.
Over the years 2019-2023, the analysts forecast a total of almost 1.5-billion permits will be withdrawn.
In addition, Germany, Europe’s largest emitter of carbon dioxide, said this week its near weekly auctions of permits would be paused from Nov. 9, meaning around 22 million fewer than expected permits will be auctioned this year.
In a recent Reuters survey of eight analysts, the analysts on average expect prices to hit 20.76 euros a tonne by 2020 with the most bullish forecast at 30 euros/tonne.
In addition to the MSR, the total quantity of carbon permits - known as the Linear Reduction Factor - will be reduced by 2.2% each year from 2021 to 2030, up from 1.74% a year now.
This means there will be fewer permits available to buy, driving up the cost.
ELECTRICITY PRICE IMPACT
High carbon costs make fossil fuel power generation more expensive which mean they also affect wholesale electricity prices.
For a predominantly low-carbon nuclear power generator, such as France's EDF, strong carbon prices are bullish as the company can benefit from higher electricity prices.
On the flip side, companies with a large portion of fossil fuel power generation could be adversely hit by higher carbon prices if they are not well hedged and need to pay more to cover their emissions.
Most large utilities however, will be protected as they hedge many years in advance.
Germany’s RWE is the biggest company emitter of carbon dioxide in Europe as most of its electricity is produced from fossil fuels.
Earlier this week the company's half-year results revealed it has financially hedged its carbon needs until the end of 2022, limiting the impact of soaring prices.
Under the ETS, some industries are eligible for free permits if they are deemed to be vulnerable to competition from countries with looser environmental regulations, known as "carbon leakage".
The number of sectors and companies eligible for this support will be reduced in the fourth trading phase of the scheme which runs from 2021-2030, meaning more firms will need to buy carbon allowances, another long-term bullish factor.