A Comeback for old King Coal?

The introduction of the EU Emission Trading Scheme (ETS) in 2005 has brought about a new and profound uncertainty in the European wholesale electricity market. There is now a cost penalty on carbon-based generation, which is increasing the cost of power generation and promises to shift generation patterns. These additional carbon costs are being passed through in higher power prices, and power generators have seen a surge in their profits.

Under the EU ETS power stations and other large point-source emitters of CO2 are required to back their emissions with allowances — in other words they must have a ticket to pollute. The great bulk of these allowances are issued free of charge on the basis of previous emissions under so-called grandfathering arrangements, with a token share auctioned. Clearly, for the scheme to work effectively there must be less allowances issued than the total amount emitters would require on a business-as-usual case. The greater the scarcity, the higher the allowance price.

EU Allowance (EUA) prices have traded at between €6 and €30.50/t CO2, with prices starting low and increasing almost €30/t in July 2005, slipping back, and then recovering to a new peak in April 2006. Prices collapsed in late April as data emerged showing emissions were less than the market had expected. Prices appear to be settling around €15/t (see chart on page 30).

In theory the price of allowances is determined by the options available for emitters for saving carbon (what economists call the marginal abatement cost) and the amount of carbon that needs to be saved (that is, how tight the emissions cap is).

In the short run the main scope for saving emissions comes from fuel switching. Fuel switching may involve physically changing fuels at a power or boiler plant, but more typically means turning down low-cost (dirty) coal plants and running high-cost (clean) gas plants harder. The costs at which these trade-offs are made will in turn be influenced by relative prices of gas and coal.

If gas prices are high it costs more to save carbon than when gas is cheap. The implication of this is that (volatile) fuel prices will feed through to the cost of saving carbon and hence carbon allowance prices. The range of carbon values implied from observed coal and gas prices in the last 18 months is €20-80/tCO2. For most of the time this implied carbon price has exceeded the market price.

The amount of carbon that needs to be saved is equally difficult to tie down. This reflects the fact that emissions of CO2 are themselves influenced by economic activity, weather (through its affects on electricity consumption, hydropower and wind generation) and nuclear power plant performance (the largest source of carbon-free generation).

The situation has been compounded by uncertainties regarding what the starting level of emissions was, and the propensity of national governments to alter rules regarding the allocation of allowances. All these uncertainties are summarised in the emission-to-cap measure — which reflects the tightness of the emission cap versus business-as-usual emissions.

This interplay between emission-to-cap and relative fuel prices suggests that carbon prices are likely to remain volatile and difficult to predict. In the meantime the immature state of the carbon market, where many of the 14,000 installations are at best passive players, introduces its own complexities.

Given a longer period, emitters will be able to invest in new plant and equipment that reduce emissions, often at lower cost than most fuel-switching options. This suggests that the marginal abatement curve will shift towards the right: more savings will be available for the given price. On this basis, one would expect carbon prices to fall over time. However, the required level of emission savings is likely to increase. Whether future carbon prices will be higher or lower depends on which of these two forces is the stronger.

How carbon affects power generation costs... and prices

Carbon’s impact on generation costs depends on a plant’s overall efficiency and the carbon intensity of the fuel. For a typical UK coal station each €1/tCO2 will add €1/MWh to generation costs, while for a modern combined-cycle gas turbine plant (CCGT) running on natural gas the cost addition is just €0.4/MWh. The cost here is what economists call opportunity cost: it reflects the forgone value of allowances used to back generation, that otherwise could have been sold. In theory, irrespective of whether the allowance has been purchased or provided free, the opportunity cost of carbon should be factored into emitters’ decisions about how to run their plant and the prices at which to sell. A generator that decides not to pass on the opportunity cost is reducing its short-term profitability.

In practice, though, generators with downstream arms may take the view that passing the carbon costs through to their customers will reduce their retail market share, reducing long-term profitability.

In some countries, such as Italy and Spain, tariff controls restrict the extent of cost pass-through, while in others, for example Germany, dominant generators have chosen not to pass through the full opportunity costs in order not to provoke regulatory authorities from taking a tougher stance on the regulated parts of their businesses.

In the UK it appears that stand-alone generators — those without downstream supply business — are passing through the whole opportunity cost, while the big vertically integrated generators are passing through around 75%.

The implication of all this is that carbon uplift on wholesale prices is less than the full opportunity-cost pass-through would suggest. Customers are therefore being spared the full price hike, albeit by incumbent electricity retailers looking to defend their long-term profitability.

It is probable that should generators have to buy the bulk of their allowances in auctions, rather than be granted them for free, they would pass through the full carbon opportunity cost.

The fact that generators are already passing through such a large element of the opportunity cost, even though most of their allowances are granted for free, means that Europe’s power generators are currently earning large windfall profits. Indeed it is the presence of these windfall profits that is stimulating calls from consumer lobbies to move towards full auctioning. This raises the question as to how generators would respond if the EU adopted an auctioning solution. In order to protect their profitability, generators would need to increase the margins on generation (so called clean spark spreads), which would feed through to yet higher electricity prices (see Chart above).

Pattern of generation

Despite carbon prices averaging well over €20/t for long periods, there has been little impact on power generation patterns. Coal generation last winter (2005/06) was higher than in previous winters. This reflects the comparatively high price of gas versus coal and the fact that the current emissions cap is not severely constraining. It is clear that as the emissions cap is successively tightened, coal and lignite generation will be substituted by efficient gas-fired generation, then less-efficient gas generation and ultimately, should the emissions cap become very tight, by oil-fired generation.

While existing coal plant will be squeezed to the margin by tight emissions caps, they will nevertheless be required to meet peak demand, and so will demand an appropriate reward. If they fail to earn an adequate return there is the prospect of coal stations being taken offline, which raises concerns regarding security of electricity supply.

In the longer term the market will have time to respond by bringing on new carbon-free, or low-carbon generation plant, meaning that the expensive substitution options, such as running oil-fired plant, will only be called upon in crises. In practice, substitutions tend not to be as smooth as the economists’ models predict: take-or-pay fuel obligations, technical constraints on plant operation and acid-gas emission caps all tend to make generation systems exhibit lumpiness in their behaviour.

Investment decisions

Carbon is also likely to impact on generators’ investment choices. To the extent that carbon pushes up overall power prices this will improve the profitability of new renewable and nuclear plant. In practice, however, renewables are either resource or network constrained, while nuclear financing remains problematic and development lead-times are protracted.

This means that in meeting the need for capacity before 2015 the real choice is between gas and coal. For most of the last 15 years European generators have favoured gas-fired CCGT. However, the hike in gas prices in the last year has meant that coal now provides the least-cost new generation option, even factoring in carbon at €15-20/tCO2.

That said, anyone investing in coal plant in Europe in the next few years will want to ensure that the plant has sufficient space and access for fitting carbon-capture equipment should the need arise post 2015. Carbon capture involves separating out CO2 and pressurising and transporting it for final disposal in deep geological structures.

Of course, gas prices may fall and carbon prices may rise sufficiently to bring CCGT back into favour. However, as carbon prices increase they will reach a point at which it becomes more cost-effective to build coal plant with carbon-capture capability. While this may be done on a pilot basis before the first Kyoto period ends (2012), the large-scale deployment of carbon capture and storage requires that huge regulatory hurdles regarding disposal of CO2 in geological structures be overcome and that a CO2 pipeline infrastructure is built.

Conclusions

Carbon has become a key component in Europe’s electricity markets which developers, lenders and regulators need to understand. The early indications are that it promises to be a volatile element and the knife-edge nature of fundamentals underlines this. Power generators have responded pretty much as the economic textbooks predicted and passed through the great bulk of the opportunity cost of carbon. Generation patterns have yet to shift, but this will happen as emissions caps tighten, probably before 2012.

With regard to new generation investment, it appears that even with carbon at €15/t advanced coal plant offers a lower-cost option than CCGT at current forward prices for gas and coal. Most generators are still leaning in favour of gas: evidently they expect gas prices to weaken or carbon to rise.

However, in a severely carbon-constrained world we would expect coal with carbon capture to be the plant of choice, assuming that the EU approves of disposing CO2 in geological structures, and the necessary pipelines are put in place.

Dr Guy Doyle is Chief Economist, Energy, at Mott MacDonald, a leading international engineering and management consultancy. He can be contacted on +44 1273 365 171, guy.doyle@mottmac.com