• Alessandro Vitelli

What does the current price of EUAs actually represent?

(This article was originally published on September 8 on Carbon Pulse).

Despite all the excitement around EUA prices topping €60 for the first time and moving on to a new record above €63.19 this week, let’s remember that coal-fired power generation is actually more profitable in the near term than natural gas.

Wait, what? How did *that* happen?

Back in the good old days of 2019 and 2020, it all looked so easy. Carbon prices were rising steadily from the mid-€20s to the low-€30s, coal-fired power was being marginalised by the clean dark spread, and governments were happy to commit to phasing out all coal-fired generation.

Look at the beautiful chart below. It shows the clean dark and clean spark spreads for calendar 2021 (forward) baseload power generation in Germany in 2019 and 2020.

It’s a textbook representation of how a rising carbon price should work: higher carbon prices mean coal plants are squeezed until their margins go negative and they are replaced by more profitable and cleaner gas plants.

Now look at the clean dark/clean spark spread for calendar 2022 generation over the last 36 months:


Something’s gone very wrong here. The last nine or ten months have seen gas margins nosedive, while coal has suddenly started becoming significantly less unprofitable.

One interpretation of the change in generation margins is that carbon prices aren’t high enough to continue forcing a switch away from coal to gas – in fact, they’re positively encouraging gas generation to stop and for coal to run. Look at the near-term clean spreads:


And look at the price of carbon that is required to switch from coal to gas today. To switch from a 42% efficiency coal plant to a 54% efficient gas plant to generate power next month, you’d need an EUA price of more than €100:

Carbon is presently something like €40 below the highest fuel-switching level, so it would seem fair to argue that if coal plants are starting up again, then carbon prices aren’t high enough to continue to reduce emissions.

However, a lot of this has to do with unusually high natural gas prices, and it raises some awkward questions about Europe’s resilience to future gas squeezes.

It also suggests that the rate of decarbonisation may slow down dramatically when the easy gains – *permanently* shutting coal plants – have been made. And that hints at much higher carbon prices in the future.

Here’s the development in energy prices this year:



That calendar 2022 gas price has more than doubled. Carbon is up about 85%, and German calendar 2022 baseload power has risen 77%.

I looked at the up-ending of European generation economics earlier this summer, when one analyst described it as a “crisis of confidence” in carbon prices.

You can argue that the current gas market situation represents a “perfect storm” of sorts, with tight supply, high prices, and a market that needs to price gas *out* of the power generation merit order so that it can rebuild storages before the winter. But that’s the subject for another column.

Once that short-term gas price problem is solved, we will return to the issue of how Europe progresses to the next level of decarbonisation. If we don’t have the easy gains of switching off coal, where does the next tranche of reductions come from?

The EU has already said that carbon prices need to reach around €90 by 2030 in order to enable green hydrogen to replace fossil fuels in some industrial applications, and considerably higher than that to bring hydrogen into pure energy applications.

In short, practically and politically, the carbon price isn’t high enough at the moment. It *was*, but the matrix of energy prices has moved fast and EUAs haven’t kept up.

Yet at the same time, prices may well be too high for the fundamental demand/supply that they are supposed to represent.

Given that the European Commission calculated that the market’s Total Number of Allowances in Circulation (TNAC) represented a surplus of more than 1.5 billion allowances in 2020 – more than one year’s emissions from the entire market – the rising price of carbon may not necessarily reflect the market’s intrinsic supply/demand balance.

And that EUA surplus increased between 2019 and 2020, from 1.385 billion to 1.579 billion. Yes, blame COVID for that, but the fact remains that there are more extra EUAs swilling around the market today than there were in 2019, and yet the price has more than doubled.

Here’s what analysts polled by Carbon Pulse have predicted for current-year EUA prices at the start of each year since 2017, compared to the market oversupply:

Year *

Mean forecast

Median Forecast

End-year price

Full-year average

Prv. year TNAC

2017

€6.00

€6.10

€8.18

€5.84

2018

€9.60

€9.50

€25.01

€15.94

1.654 bil

2019

€25.00

€24.25

€25.48

€24.92

1.655

2020

€27.55

€27.75

€32.86

€24.82

1.385

2021 **

€35.20

€35.00

€62.35

€47.15

1.579

* Forecasts for 2017-19 are end-of-year, while for 2020-21 they are full-year averages.

** 2021 price data is for year-to-date as of Sep 8. Forecasts published in January of each year. Source: Carbon Pulse

Some might suggest that the EUA price increase is a consequence of speculative investors, who’ve taken large positions in EUAs in anticipation of those future price rises. Their buying has driven prices beyond the levels justified by the oversupply of EUA, the argument might say.

Others will counter that this is perfectly rational behaviour, that the market will implement temporal efficiencies to smooth out the price over time.

And that brings us back to today’s price which, after all of the above, still seems to occupy some no-man’s-land between supply-demand fundamentals and the level required to decarbonise Europe’s industrial complex today. Temporal efficiency would even suggest the price should be higher, but it’s not.

The EU ETS is a market that is always looking at the longer term, a market that is planned many years into the future. A lot of investors (as opposed to traders) won’t be looking at returns this year, or even next. They’ll be looking further ahead, anticipating a tighter EU ETS cap when the Fit for 55 package is approved, or even thinking about Phase 5 (assumed to be 2031-40).

Perhaps the lesson of all this is that we shouldn’t focus on the near-term, as traders do in the power and gas markets, but keep an eye firmly on the end goal, the 2030 target, the overall cap, and the slow steady grind of the MSR.

So we will continue to have episodes like the current mismatch between climate ambition and carbon outcome, but it’s somewhat comforting to look at generation spreads further into the future to see that normal service is likely to be resumed:



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