Why the EU ETS should worry (a lot) about coal phase-outs

One of the constant features of any discussion about EUA supply and demand trends in the next few years is the phase-out of coal-fired power generation and what measures EU states will take to deal with the demand destruction for EUAs after coal plants have closed.

As we know, Germany has a plan to cancel EUAs that coal plants would have needed for compliance. We know how the cancellation process might work, but it’s not clear exactly how many EUAs will be cancelled.

On the one hand, the German treasury ministry won’t be happy at losing millions each week from sales revenue but on the other, leaving these EUAs floating in the supply pool will do nothing good for the price.

But what is more worrying is that precisely none of the other 13 EU member states that have also committed to shutting down all their coal units, has announced anything about what they plan to do with their surplus EUAs after coal is removed from the demand side.

A reminder: those thirteen countries are Finland (2029), Austria (2025), Greece (2028), France (2022), Netherlands (2030), Italy (2025), Spain (2030), Portugal (2023), Ireland (2025), Sweden (2022), Slovakia (2023), Hungary (2030), Denmark (2030).

Together with Germany, coal plants in these countries represented demand for approximately 373 million EUAs in 2018 (that number will probably be more than 10% lower when 2019 data is published in May).

Seven EU states are already coal-free: Belgium, Cyprus, Luxembourg, Malta, Estonia, Latvia and Lithuania.

The remaining six – Poland, Croatia, Bulgaria, Romania, the Czech Republic (2050) and Slovenia (2050) – have not announced a deadline within the foreseeable future. Demand for EUAs from coal plants in these countries was about 209 million tonnes in 2018.

Data from the European Commission, www.beyond-coal.eu

Of course this whole surplus EUA business is not simply a matter of adding up all the coal-related EUAs and then cancelling them – countries have to take into account what sort of fuel will replace the lost coal generation and make sure there are enough EUAs available for any new fossil generation.

And it's also true that industrial installations don't often get 100% of their emissions in free EUAs any more. They too, have to buy in the auctions.

But with all the research and investment in renewables, battery storage, flywheels, energy efficiency and even green hydrogen that’s going on, it’s very difficult to make a half-decent estimate of how much gas will replace the lost coal, so let’s deal in gross numbers to make it easy.

I’ve made some estimates of the dates of closure for 138 coal-fired plants in those 14 countries and at a very rough guess, the total lost demand for carbon allowances from coal phase-outs in all of Phase 4 could be something like 2.4 billion EUAs. That’s more than one year’s total supply to the market...

Here’s a guesstimate of how many EUAs could be “released” into the market without a coal-plant buyer over Phase 4 (The data is based on a study I did with Carbon Market Watch last year, but I’ve updated the numbers to reflect 2018 verified data).

Emissions data from www.beyond-coal.eu; estimated dates of plant closures are my own.

If these estimates end up anywhere near reality, a lot of work will need to be done by the Market Stability Reserve as well as by member states to soak up the wave of unneeded EUAs that’s coming. And some of these plants will be coming off-line in the next two years..

And it's not as if these EUAs will be withdrawn as soon as the plants shut, either. The process for EUA cancellation that Germany has outlined is pretty complicated. When any plant shuts, the lost demand is not statistically apparent until the following year, but EUAs aren't cancelled until up to two years later. Here's my take on the process:

Let’s say Plant A closes in the summer of 2021. The European Commission calculates the size of the market float each May (the Total Number of Allowances in Circulation) based on the previous calendar year's data. So in May 2022, the total supply data will reflect the fact that Plant A stopped buying EUAs halfway through the previous year, and the MSR’s 24% withdrawal will adjust for that additional market supply from September 2022.

But when that cut takes effect in September 2022, only 24% of Plant A’s demand will have been removed from circulation. Germany will have to do the rest. So Berlin has to calculate how much 76% of that plant’s demand was, and cancel the equivalent EUAs. But it can only do that at the start of the next full year’s allocation, i.e. January 2023.

(Remember, we're dealing in gross figures here. Obviously the cancellation won't be 100% because some gas capacity will be needed to replace the lost coal output.)

But because the MSR does its TNAC calculations on the basis of the previous calendar year, it too will account for the remaining 76% of Plant A’s supply in its 2023 TNAC – unless Germany asks it not to because Berlin will be removing EUAs from its own auction reserve at the start of 2023. (I am assuming that this will happen, naturally.)

So a plant closure in mid-2021 is only fully accounted for by early 2023. And of course, we don’t have certainty yet that Germany will cancel the full amount. (By the way I would welcome any corrections to my interpretation of the process.)

Now multiply this process by another 13 member states. Argh.

How will the EU and governments deal with the surplus? Member states will not be happy or willing to cancel EUAs that are such a welcome revenue stream for them. So it will probably fall to the EU to do this, probably by boosting the Market Stability Reserve intake rate to something like 30% or even more. But it won't happen without a fight.

In conversation with traders I’ve made the point that EU member states, and the market, are behaving a little like the Titanic approaching an iceberg when it comes to the implications of the coal phase-out. If EU countries don’t cancel the equivalent of 100% of lost demand, then we could see total Phase 4 supply increase by anything up to 10%.

I’ll end this with another bit of data. The chart below shows that the UK has auctioned 535 million EUAs between 2013 and 2020. Meanwhile, emissions from its coal plants have fallen from 112 million tonnes to just 14.5 million tonnes. And over the same period emissions from all other combustion plants have fallen from 30 million to 25 million tonnes. The chart shows the scale of the UK’s auction surplus (before accounting for any industrial demand), and what’s waiting for the rest of the EU ETS if countries don’t get their act together.