[NGW Magazine] Carbon Reacts to Tightening Market

Carbon prices in Europe are on the rise as the European Union starts to get tougher over emissions goals. This could be good news for gas demand as coal is increasingly priced out of the market, but political risk within the bloc cannot be discounted.

Prices on the European Union’s Emissions Trading System (ETS) have more than trebled since they reached a record low of just €4.38/metric ton (mt) in May 2017, breaching the €16/mt mark in late May this year for the first time since June 2011.

By the start of June, however, the market had cooled off slightly, following some disagreement among European officials over policy details, alongside the installation of a populist Euro-sceptic government in Italy, which could pose a risk to the ETS.

Established in 2005, the ETS is the world’s largest carbon market, involving more than 11,000 power stations and industrial plants across the EU. Permits are issued through auctions, the latest of which cleared at €16.02/mt on May 30 in the UK, a premium of 7 eurocents to the futures contract.

Prices on the system had been low because of an oversupply of allowances, but from January 2019 a new Market Stability Reserve will come into force, which will cancel 24% of the surplus credits each year up to 2023 and 12% thereafter. This is the main factor behind the rise to €16/mt, and think-tank Carbon Tracker projects that ETS carbon prices could hit €20/mt in 2019 and €25-30/mt in 2020-21 as the supply squeeze starts to bite. Some observers believe it will go higher still as rules are tightened to ensure emissions reduction commitments are met.

Higher German power baseload year-ahead contract prices also helped push up carbon prices through the spring. But recently they have softened slightly, and with carbon prices still high this has put pressure on coal-fired power plant margins across northwest Europe. The German front-year clean-dark spread (for a 36% efficient coal power plant) fell to -€2.46/MWh on May 25 and then down to -€3.74/MWh on June 1, making them uneconomic to run.

Adding cost to carbon emissions

This negative spread is likely to be temporary, but many think a higher carbon price is the right way to go to reduce emissions. President Emmanuel Macron of France has been calling for a significant rise in the cost of emitting carbon: recently, France added a new fixed price carbon tax of €44/mt for petroleum products, rising to €84/mt from 2022. And the UK has already imposed its own, higher carbon price – which has all but eliminated coal from the summer generating mix, expanding the share of gas and renewables. In Germany, however, the new coalition government is opposed to any new taxes because of the country's relatively high dependence on coal. 

Unfortunately for the Germans, the sharp rise in the ETS has much the same impact as another carbon tax on the power sector in many respects. In a written reply to NGW, James Eddy, CEO of McKinsey Energy Insights (MEI), said: “Only looking at power generation, the rise in EU ETS prices could indeed have a similar effect as an additional carbon tax, to the extent that they impose additional costs to carbon emissions. The exact impacts depend on the scope and mechanisms used to impose a tax – the EU ETS has clearly defined rules and mechanisms.”

He said these higher carbon prices would shift generation towards less carbon-intensive power sources: “The first to react is baseload coal. It will quickly be replaced by gas and/or renewables, depending on your location. The UK is a good example for this, where the introduction of the carbon price floor in 2015 led to a steep decline in coal generation, falling from more than 30% to less than 10% generation share within three or four years.”

The UK policy was adopted in 2013, and operates in combination with the EU ETS, establishing a carbon price floor. When EU prices are lower than the UK’s price floor, electricity generators have to buy credits from the UK finance ministry to make up the difference. Increasingly uncompetitive UK coal plants have all announced they will shut down or convert to other fuel sources before 2025, which is the deadline for removing all coal from the UK system.

Meeting Paris commitments

Despite Germany’s apparent opposition to new carbon taxes, EU member states last month officially called on the EC to come up with a plan for bringing the bloc into line with the goals of the Paris Agreement, which limits anticipated global temperature rises to 1.5°C. If this happens, additional taxes would need to be imposed or prices on the ETS system would have to rise further. One study from Carbon Tracker* estimates that ETS prices could reach €26/mt by 2021 and €55/mt by 2030 if the EC uses it to bring emissions into line with Paris treaty targets.

This cost of carbon would force remaining European coal plants off the grid, to be replaced by gas and renewables – as has been the case in the UK. “Our analysis shows that already carbon prices of about €20/mt of CO2e could shift 10-15% of [German] generation share from coal to gas. Yet, the big shift occurs with prices of above $50/mt of CO2e: then we see a decline of up to 30% in the generation share of coal in Germany. Note that this is also highly dependent on the future evolution of gas prices and the cost of renewables,” said Eddy.

However, less reassuringly for the gas industry, MEI suggests that the switch away from coal would then quickly be followed by the replacement of baseload gas with renewables: “Our analysis shows, that with time and quickly declining renewables costs, the next shift would be away from gas as a baseload provider, to renewables. Depending on the geography and the further cost development, renewables could replace gas baseload generation on a larger scale between 2020 and 2030. Battery storage will play an important role here, as it can provide stability to the grid in combination with renewable sources, especially solar photovoltaic technology. Higher carbon prices would just accelerate this process.”

There is still some uncertainty about why and how far ETS prices will rise as the year progresses, which has to some extent been justified already, given the latest falls related to political instability. And while an attempt to formulate tougher policy is on-going between the EC and the European Parliament, any attempt to legislate to enforce the Paris goals through higher carbon prices would be likely to face strong opposition from eastern European states – which have no wish to increase their dependence on Russian gas at the expense of domestic coal use – and even from Germany. 

* Carbon Clampdown: Closing the gap to a Paris compliant EU-ETS.

Jeremy Bowden