Emissions rally yet to test European fuel-switching range

Author Edward Bentley

Prices for EU emissions trading system (ETS) allowances have climbed recently, but are still short of the levels required to generate any fuel switching in Europe’s power sector.

Imagine a situation where supply and demand are highly inelastic in the coal, gas and emissions markets, apart from where the two fuels compete in the power sector. And assume that the supply-demand balance is tight in all of those markets.

Gas has to remain uncompetitive with coal in northwest Europe to limit demand, so UK NBP and Dutch TTF prices rise. But there is not enough coal either and API 2 swaps push higher to try to minimise demand from the power sector. Add to that the strong coal demand contributing to emission prices rallying and that results in a similar situation to this summer.


There is little flexibility for European gas supply to step higher. Russia’s Gazprom says it could meet its maximum contractual volume to Europe and Turkey of about 205bn m³ this year. And production from Norway’s flexible Troll field is on course to rise to a new record again this gas year.

Demand cannot be reduced because it is inelastic in the short term, apart from where it competes with coal in the power sector.

The only way to get more supply for the power sector to burn — helping gas and coal markets balance — is for Europe to import more LNG.

But global LNG demand is also highly inelastic, unless it competes with more expensive fuel oil or crude.

Northeast Asian LNG prices have to hold a premium to the NBP wide enough to attract LNG from suppliers close to northwest Europe, such as Russia and Norway, because of strong and inelastic demand. Northeast Asian LNG prices this summer have remained close to the NBP plus the cost of shipping.

This has resulted in European emissions allowance prices lifting the NBP, which raises the cost of gas in China and Japan. And assuming a tight supply-demand balance in global LNG markets, northeast Asian LNG prices need to keep rising until there is a cheaper substitute.

Northeast Asian LNG markets have previously peaked at oil parity, which is just over $13.90/mn Btu based on recent North Sea Dated crude prices. Oil parity could provide a global resistance level for gas being able to displace coal in Europe, assuming that LNG demand in the region is inelastic until it is displaced by crude.

Northeast Asian LNG prices climbing to $13.90/mn Btu would allow the region to turn down LNG imports and take more oil. NBP or TTF prices could rise to $11.50/mn Btu — nearly €34/MWh — and that would be enough to keep Norwegian or Russian LNG in northwest Europe, given recent shipping costs.

The NBP first-quarter 2019 market has already climbed to almost €32/MWh, partly because of the increase in coal and emissions prices over the past year.

But emissions prices would need to climb further to lift UK fuel-switching levels to €34/MWh, even taking into account the carbon price floor.

The UK fuel-switching price has already climbed above €30/MWh, based on a 55pc-efficient gas-fired plant and 39pc-efficient coal-fired unit.


The UK fuel-switching price increasing to €34/MWh could allow the UK to import more LNG and burn less coal, providing that northeast Asia uses less gas and more oil.

But there is still a long way to go for emissions markets to create that outcome. Each $1/t CO2 equivalent increase in the cost of emissions adds just over €0.25/MWh to the fuel-switching price. It would take a further $16/t jump in the cost of emissions to lift the UK fuel-switching price to €34/MWh, assuming coal markets are unchanged.

This is — of course — a hypothetical scenario to show how global generation fuels markets could balance when everything except fuel switching is inelastic in the short term. But it also demonstrates that while Europe could reduce its emissions by burning more gas and less coal with a rise in EU ETS prices, that would mean northeast Asia switching to oil from gas.

And there are medium-term implications, when supply and demand are less inelastic. The rise in European power prices could spur more investment in renewable generation. But firmer coal and gas markets could drive spending on raising fossil fuel-fired generation capacity, particularly outside Europe in countries that have lower emissions taxes or prices.

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