EXCLUSIVE: Rising EU ETS emissions point to urgent need for a dynamic pricing paradigm -Andurand

Published 14:49 on January 28, 2022  /  Last updated at 16:33 on January 31, 2022  /  Conversations, EMEA, EU ETS, Views  /  No Comments

With high energy prices dominating the political agenda and politicians in certain EU member states training their sights on the bloc's carbon market, there is one salient fact being missed in all the hubbub: ETS emissions likely increased by 6% in 2021, and are set to rise further again this year. Self-evidently, this means that the price of EUAs is not yet high enough to drive structural decarbonisation, write Pierre Andurand and Mark Lewis in an exclusive piece for Carbon Pulse.

By Pierre Andurand and Mark Lewis

With high energy prices dominating the political agenda in the EU over the last few months and politicians in certain EU member states training their sights on the EU carbon market, there is one salient fact being missed in all the hubbub: emissions in the EU Emissions Trading System (EU ETS) likely increased by 6% in 2021, and are set to rise again this year.

Self-evidently, this means that the price of European carbon allowances (EUAs) is not yet high enough to drive structural decarbonisation.

When the official numbers for 2021 are published in May we expect to see a bounce-back in industrial emissions driven by the recovery from the pandemic combined with higher emissions from power generation as record-high gas prices made coal the cheaper option over the second half of the year.

We forecast an absolute increase of 80 Mt to 1,330 Mt versus 1,250 Mt in 2020 (the 2020 number is a like-for-like number adjusted for the UK’s exit from the scheme).

But it gets worse. We then expect a further leg-up of at least 50 Mt this year as Germany’s 4 GW of nuclear shutdowns combined with France’s recently announced extended nuclear outages compound the impact of continuing high gas prices by forcing even more coal into the mix, thereby outweighing the impact of new renewable capacity coming onstream.

And with the final 4 GW of Germany’s nuclear capacity coming off at the end of this year, 2023 will then see a further 30 TWh of nuclear output lost that will need to be replaced, at least in part, by fossil-fuel output.

All of this means that on our projections we do not get back down to the 2020 level of ETS emissions until 2025. Under a system expressly designed as the cornerstone of the EU’s net-zero policy framework, emissions are currently rising when – if we are to hit the 2030 target and get on track for net zero by 2050 – they are meant to be falling by 4.2% per year from 2021 onwards.

To put this into context: to align with the Commission’s proposed new 2030 cap of 795Mt (excluding aviation), emissions will have to fall twice as fast over the next eight years as they have over the last eight – by 73Mt per year over 2022-30 compared with the 30Mt per year that will have been achieved over 2014-2022 on our numbers (again, excluding aviation and having adjusted the historical numbers to account for Brexit).

Against this backdrop, how should the market and policymakers be thinking about the pricing framework for EUAs from here? The short answer is: policymakers need to let the market develop a new pricing paradigm based on optimising the dynamic efficiency of the ETS and leave behind the one based on optimising static efficiency that has dominated carbon pricing in the ETS since its inception in 2005.

In simple terms this means we need a carbon-price that incentivises the building of new low- or zero-carbon generation and industrial infrastructure for structural decarbonisation over time towards net zero by 2050 rather than one that simply solves for minimising the emissions of the existing power plants and industrial installations already in operation today.

In other words, we need to move from a short-run marginal cost (SRMC) based pricing system for carbon to one based on the long-run marginal cost (LRMC) of abatement.

Until now, the market price for EUAs has generally tracked the so-called fuel-switching price between existing coal- and gas-fired power plants, with the price signal thus indicating the level at which emissions in the power sector can be minimised and the static efficiency of the system thereby optimised.

What we now need – and arguably what is in fact already starting to happen – is a dynamic carbon price that provides an incentive to invest in the right infrastructure for both the power sector and heavy industry (steel, cement, chemicals, and oil refining) such that we move on to an emissions trajectory consistent with total decarbonisation by 2050.

For the power sector, this means a carbon price high enough to incentivise the new gas-fired generation capacity that will be required to back-up renewables over the next 15 years as nuclear, lignite, and coal capacity is retired across Europe.

Germany alone will need 25-30 GW of new gas-fired capacity that can then be converted to burn hydrogen in the 2030s. Assuming a long-run gas price of €25/MWh (the current forward price in 2025), we calculate the carbon price needed for a new gas-fired plant to displace the most efficient existing lignite plant in the merit order – in other words, the LRMC of fuel-switching – at €90/t.

(In passing, it is worth noting that this is considerably higher than the minimum carbon price of €60/t that the new German Government has proposed for German installations covered by the EU-ETS, but then the €60/t level is presumably based on a lower assumed long-run gas price than the €25/MWh we have now. Indeed, if the €60/t level proposed by the German Government were understood as the German Government’s best estimate of the LRMC of fuel-switching, it would imply that they are assuming a long-run gas price of €15/MW. This would have been a fair assumption 12 months ago, but given the sharp rise in EU gas prices across the curve over the last six months it now looks way too low. And if anything, even after this recent unprecedented rally in EU gas prices, the risk from here is still more to the upside than the downside given that any military action by Russia against Ukraine would delay the start-up of the Nordstream-2 (NS2) gas pipeline indefinitely.)

For heavy industry, the LRMC of decarbonisation is the carbon price needed to make green hydrogen competitive with grey hydrogen. This price again depends on assumptions made about the long-run price of gas – the main cost input for grey hydrogen – and the cost of producing green hydrogen (currently €5-6/kilogramme, but with the EU targeting €2/kg by 2030).

Assuming €25/MWh again for the long-run price of gas, and that the cost of producing green hydrogen can be reduced to €3/kg by 2026, we calculate a LRMC of carbon of €150/t.

In short, the dynamic pricing signal we need for the EU power sector and heavy industry to deliver long-term decarbonisation consistent with both the legally binding 2050 net-zero target and the interim 2030 objective lies in a range of €90-150/t.

Interference with the market for short-term political reasons can only lead to either much higher prices than this significantly above the upper end of this range in the future as the market scrambles to make up for time lost today or, ultimately, the failure of the EU to reach the decarbonisation targets that it has made a defining feature of its identity.

EU policymakers should therefore let the market lean into this new paradigm as the sooner EUA prices enter and rise steadily up through this €90-150/t range, the smoother the pathway to full decarbonisation will be.

Pierre Andurand is Founder and CIO and Mark Lewis is head of climate research at Andurand Capital Management.