Carbon pricing is being increasingly mentioned in both our own and other wholesale market reports as a driver of UK power and gas pricing and we’re seeing the results of high carbon pricing in action. The UK grid recently ran for over a fortnight without burning coal and in this calendar year alone, has had 80 coal-free days in the transition to a cleaner grid. This lack of coal on the grid is being driven by the UK Government’s clear policy drive, but more importantly by higher carbon prices.
The UK Government introduced the Carbon Price Support scheme and the Emission Performance Standard as part of Electricity Market Reform in 2013 to stop new-build coal and provide pricing pressure to coal plants to improve emissions. These schemes paved the way to the currents aim to end the unabated burning of coal by 2025 by only allowing coal generators that meet a carbon intensity level of 450 gCO2/kWh and mandating maximum annual load factors. However, the Government recognises the effects of the wholesale markets, which have clearly been a dominating factor in the past year since the rise in the carbon price.
While policy can move slowly, largely impacting the grid of the future, markets have provided the key pressure to start pushing coal from today’s generation stack. At the time of writing the Dec-19 EU Allowance (EUA) contract is offered at 29.00 €/tonne, not far off of 11 year highs. To give this price more context, even a year ago the Dec-19 contract was almost €13/tonne (45%) lower than present and whilst we won’t discuss why the carbon price has increased in this article, we will comment on the effect of higher prices.
The carbon price is important because for every kWh of electricity produced by a thermal generator, fuel must be burnt that releases carbon dioxide, which costs the generator the EUA price/tonne emitted. Therefore, not only do generators have to consider the cost of fuel when setting their generation strike price, the cost of carbon must also be included in this decision. In a functional market, more efficient power plants that produce less carbon will be able to produce electricity at a lower price and hence will generate more often, increasing their profitability. Because gas-fired plants generally have higher efficiencies than coal plants and burn natural gas, which has a carbon intensity almost half that of coal, their carbon output is lower. This means that in a high carbon price setting gas plants will be more likely to be able to generate at market power prices, assuming the spread between gas and coal prices aren’t too large to negate this effect. This is the theory behind ‘fuel switching’.
In the UK the impact of fuel switching is evident. The impact of a cleaner grid led to a 6% reduction in the UK’s total carbon emissions in 2016, driven by increased renewable penetration but more so by fuel switching due to an effective carbon price and policy effort. A higher carbon price has also led to more interest from a range of market players, not only those looking to take physical delivery of EUAs, such as generators, but also of commodity trading houses and hedge funds looking to take profits from carbon positions. This surge in interest has led to increased volatility in the carbon markets, causing more swings in already volatile gas and power pricing.
Brook Green Supply offers live energy complex pricing including power, gas, carbon and oil, as well as risk management and wholesale expertise. Hiro Flash is the firm’s commodity pricing portal and shows live and historical pricing from a suite of commodity contracts, as well as notes of interest and market reporting in the research section.