The latest reforms to Europe’s trading system for carbon credits have breathed fresh life into the market. After years of lying low, carbon prices have been sent to new highs. The reforms are aimed at speeding up the transition to low carbon technologies and the switch from coal to gas. But solar and wind look increasingly likely to benefit most from market developments and drop below the price of gas

Under reforms to the EU Emissions Trading System (ETS), planned since 2014, the bloc’s member countries agreed to introduce a Market Stability Reserve (MSR) from January 2019 to absorb a massive surplus of EU emissions allowances and repair the cap and trade system on which ETS is based following years of depressed prices. The reforms are among efforts by the EU to step up greenhouse gas emissions reductions from electricity and energy-intensive installations and from airlines operating between EU countries. As a result, the price of European carbon emissions allowances (EUAs) for December 2019 rose to a high of around €25 a tonne in September 2018, compared with a price range of between €5 and €7 a tonne in 2016 and 2017. The higher prices were driven primarily by increased buying in the futures market from market participants anticipating the removal of unallocated allowances under the MSR. The MSR is meant to take out around 550-700 million excess allowances each year for five years. The reforms are inspiring other nations such as China and Mexico, which have signed cooperation agreements with the EU under the so-called Florence Process, an initiative that gathers international carbon experts to share experiences from emissions trading systems and pave the way for greater alignment of carbon markets worldwide. Both countries are looking to scale up existing cap and trade systems. China, the world’s top emitter of carbon dioxide (CO2) emissions, officially launched its cap and trade system covering the power sector in 2017. Mexico, the world’s tenth largest CO2 emitter, is planning to launch a pilot cap and trade system in 2019 with a view to start trading carbon on a national level in 2022. This will operate in tandem with a carbon tax launched in 2014.

Untested mechanism

But the newly introduced mechanism in the EU remains untested and whether EUA prices will keep rising simply because of the elimination of excess emissions permits remains unclear. Testament to this is the volatility of carbon prices due to external risks. The UK government’s statement on 12 October 2018 that failure to agree a deal on Brexit, the UK’s departure from the EU planned for March 2019, would lead to its exit from the EU ETS, fuelled market fears of an additional surplus of permits, pushing EUAs down to around €17 a tonne. Phil Macdonald, managing director at climate change think-tank Sandbag, believes such fears are unfounded, though this will not necessarily stop the market reacting in a similar way in future. “The [European] Commission would quickly stop new auctions or free allocations to the UK, so there would be few extra spare allowances,” he says.

Higher gas prices

The gas industry remains hopeful that gas will take up a role as a transition fuel and displace coal as carbon prices continue to rise. But other factors at play are pushing up gas prices, in turn bolstering electricity prices, and making a coal-to-gas switch less attractive in the foreseeable future. As European gas markets are becoming increasingly interconnected, gas prices across the continent have been rising faster than coal prices due to higher oil prices and low gas inventories for the coming winter. The prospect of reduced production from the UK and the Netherlands in the coming years is also having an effect. The volatility is making the switch to gas-fired generation a moving target. Credit agency Moody’s estimated earlier in the summer of 2018 that an EUA price of around €20 a tonne would be needed to start triggering some coal-to-gas switching for highly efficient gas-fired plants. “Our analysis is still valid,” says Paul Marty, vice-president at Moody’s. “Commodity prices [including oil and gas] have gone up, therefore the range at which switching starts to occur has moved as well. To have more widespread switching you probably need a price of more than €30 a tonne,” he says. Liquified Natural Gas (LNG) remains a viable supply alternative to reduced indigenous gas production in Europe and to help keep a lid on the price. Whether it gains a foothold remains to be seen, given the risks inherent in global LNG trading. Increasingly, European buyers are having to compete with Asian buyers to attract LNG ships their way. “Things look somewhat flawed. The question is if you keep pushing European gas prices higher, at what point would Asian gas buyers stop taking LNG and maybe switch back to coal,” says Trevor Sikorski, lead analyst at consultancy Energy Aspects. “If there’s not enough gas around [in Europe], then no matter what the carbon price does, you’re not going to get more gas into the power mix. But it is unclear what the gas price needs to be before you get that type of demand elasticity impact,” he adds. Gas-fired generation, it seems, could keep struggling to compete with unabated coal-fired power stations. The share of coal in the power mix in the UK rose by 12.4% on an annual basis in September 2018, having fallen annually by 36% in August and 65% in July. This trend is expected to persist through the following winter because of the higher cost of gas-fired generation, even if in the grand scheme of things, the proportion of coal as a power fuel dropped from 34% in 2007 to 6.7% in 2017, following the introduction in 2013 of the UK carbon price support tax of €18 a tonne, which acts in addition to the EU ETS price.

• The EU ETS was adopted in July 2003.
• Using a cap and trade approach, the system puts a limit on overall emissions from installations included under the ETS umbrella and the limit is lowered each year. Below this limit, companies can buy and sell emission allowances as needed.
• The EU ETS covers approximately 11 000 power stations and manufacturing facilities in the 28 EU member states plus Iceland, Liechtenstein and Norway, and aviation activities in these countries.
• In total, around 45% of total EU greenhouse gas emissions are regulated by the EU ETS.

Low carbon winners

The higher cost of producing electricity from gas-fired power stations is benefitting other low-carbon generators, notably wind and solar technologies whose falling costs are making them increasingly competitive with fossil-fuel based generation. Sandbag stated in August 2018 that with European carbon prices hovering around €20 a tonne, coal and gas prices make new onshore wind and solar more economic than the short-term generation-plus-carbon price of electricity from existing coal and gas stations. The think-tank cites figures for 2017, showing how in Germany, where coal-fired generation accounted for 37% of electricity production, coal and gas generation prices had risen respectively by 72% and 43% to €46 and €49 a megawatt hour (MWh). In contrast, recent auctions of contracts for new wind and solar projects saw bids as low as €38/MWh. In this context, Sandbag argues, gas may be missing the bandwagon as a so-called transition fuel, with economics encouraging a direct shift from coal to cleaner technologies, especially in countries in eastern and central Europe such as Poland where coal remains dominant in the electricity sector. The recent rally in EUAs prices is just one indicator of what might happen in the coming months and years. The carbon market has been buoyed by the expectation that the surplus of carbon allowances will be removed by the latest reform, encouraging banks and other speculators to increase their investments in EU carbon. This confidence, however, could be dimmed by lingering uncertainties over government policies post-2020 designed to accelerate the reduction of emissions and which could see the carbon market surplus continue. “There is a risk or even a likelihood that emissions fall quite fast irrespective of the ETS and there might be a big surplus [of carbon allowances],” says Macdonald, highlighting that they are far from the only factor driving change. The risk of further price volatility calls for an EU-wide carbon price floor that would give confidence to investors for the coming years, he argues. But more importantly, the need for policy clarity on decarbonising the electricity sector and specific industries will likely translate into greater caution on the part of ETS participants. “Even in the event of a high continuing surplus the [carbon] price could still stay high,” because market participants are recognising that in the longer term many industries “do not have a very clear decarbonisation pathway”, says Macdonald. “They might think they will need the allowances through to 2020 and hold onto them.”

Writer: Fatima Sadouki