European carbon allowances will average €5 through all of the fourth phase of the EU ETS (2021-2030) under the bloc’s current climate targets, meaning prices won’t be high enough to incentivise Europe’s biggest utilities to shift towards burning cleaner fuels until after 2030, Barclays said in an analyst report Monday.
“The key assumption in our base case is that the EU’s current 2030 emissions reduction target – as manifested in the cap on EU ETS emissions over 2021-30 – is not sufficiently tight to make the EUA price an economic constraint on coal and lignite-fired generators,” the analysts wrote in the 121-page report, which examined German utilities E.ON and RWE.
“Our estimate of the EUA price that would be necessary for a 50%-efficient gas plant to displace a 36%-efficient coal plant … [is] €23 in 2016, rising to €29 by 2019,” they added.
“This means that in our base case projections the merit order for fossil fuel generators remains unchanged, with lignite and coal running ahead of gas all the way out to 2030 and lignite and coal generators simply buying EUAs in the market to cover excess emissions.”
Dirtier lignite and coal have remained atop the merit order for utilities in most EU countries over the past five years due to falling coal and carbon prices in relation to gas.
Coal-to-gas fuel switching is currently only being witnessed in countries such as the UK, where unilateral measures have been taken to further increase carbon or coal costs, forcing coal-fired generation down the merit order.
The findings, along with estimates from other analysts forecasting a prolonged period of depressed carbon prices, could push some EU governments to consider following Britain’s lead and implement their own price floor or domestic tax on carbon or coal, or to legislate a phasing out of dirtier generation.
Barclays said they are forecasting an average EUA price of €5 and an average German baseload power price of €28/MWh between 2020 and 2030, both expressed in real 2019 terms.
The EU is targeting emissions reductions of at least 40% below 1990 levels by 2030 – a goal that most observers forecast will be easily met.
In light of this, pressure is increasing from some member states, as well as businesses and green groups, for the EU deepen its target, especially in light of the climate agreement reached in Paris in December.
The bloc is already on track to overachieve its 2020 goal to cut GHGs by 20% below the same baseline.
“We assume that no change in the fossil fuel merit order will be required in order for the German utilities to comply with their ETS obligations out to 2020, and given the sheer size of the EU ETS balance we make the same assumption out to 2030 as well,” Barclays said.
In addition, the analysts said that when the Market Stability Reserve launches in 2019, they expect it to initially remove 1.3-1.4 billion allowances out of an estimated surplus of around 2.6 billion units in 2020.
They then forecast that around 150 million units will be withdrawn per year until the mechanism’s threshold of 833 million allowances in circulation is hit, which triggers it to stop vacuuming up permits.
“As a result, our conclusion is that the EU ETS supply-demand balance will not be sufficiently tight to create meaningful price tension until at least 2025, if not 2030,” the analysts said.
They added that this situation will be exacerbated by the annual 2.2% linear reduction factor in the ETS’ phase 4 emissions cap being mostly absorbed by continuing emissions reductions from more renewable power capacity and improved energy efficiency.
“This means that in the absence of further policy intervention on the part of the European Commission, and based on the current outlook for coal and gas prices, we do not see EUA prices recovering to levels that make internal abatement in the power sector via fuel switching from coal to gas a cheaper option.”
A senior Commission official last week said that no further measures will be proposed by the bloc’s executive to address low carbon prices or the EU ETS oversupply until after the MSR has been given a chance to work.
However, Barclays noted that the picture changes drastically in a scenario where the EU pursues emissions reductions consistent with keeping global temperatures from rising by 2 degrees C above pre-industrial levels – an aspirational goal that was enshrined in last year’s Paris Agreement.
“There is not much difference between the existing 2020 target and the implied 2020 target under 2C, but the 2030 numbers are very different,” the analysts said, noting that the energy sector’s emissions reduction in 2030 under the more ambitious scenario would need to be 23% lower compared to the -40% trajectory.
“On our analysis, this means that the CO2 price would have to be high enough to incentivise an average of 240TWh per year of gas-fired output to run ahead of coal across the EU over 2021-30 [in addition to that seen under our base case]. This means that a 2C trajectory would require an average EUA price of at least €45 in  real terms [over this period].”
“Given that total gas-fired generation across the EU in 2013 was only 507TWh, 240TWh per year is a large number, and would in our view require the older, less efficient gas plants on the system to run ahead of coal much of the time. In short, we think the level of coal-to-gas fuel switching required under a 2C scenario would dictate that the least efficient CCGT plant on the system (i.e. gas plant with a thermal efficiency of only 45%) would have to displace some of the most efficient coal plant (i.e. plant with thermal efficiency of 38% or higher) much of the time.”
The report notes that Germany’s domestic targets of a 40% cut in CO2 below 1990 levels by 2020 is already more ambitious than what would be required from Europe’s largest emitter towards a 2C world.
“Even for 2030 the difference is not that great: under a 2C scenario we estimate that Germany would have to reduce emissions to 509 million tonnes (a 59% reduction against 1990 levels), while under its existing target it is already committed to reducing emissions to 563 million tonnes (a 55% cut against 1990).”
But Barclays highlighted that the German government’s most recent projections estimate 2020 emissions of 837 million tonnes under its current policy measures, translating into a 33% cut below 1990.
“This means that while Germany is on track to achieve its EU-burden sharing target of 819 million tonnes (-34% versus 1990), it will almost certainly fall short of its own 2020 target of 750 million tonnes (-40% versus 1990).”
The analysts added that in a 2C scenario, RWE’s portfolio of fossil fuel generation assets would halve in value to €800 million compared to BAU, while E.ON’s younger fleet of more efficient gas-fired plants would be worth €2.7 billion compared to €1.5 billion under the EU’s current targets and Barclays’ other assumptions.
Both companies are due to report their latest earnings this week.
By Mike Szabo – firstname.lastname@example.org