EU ETS price slump yet to boost coal plant margins

Fears over the economic impact of the continued spread of the coronavirus pandemic have left EU emissions trading system (ETS) allowance prices this month on track to record their steepest month-on-month decline since the start of the carbon market's full launch in 2008.

But the European coal market's resistance to the downside seen across global markets so far has meant that the carbon market's slump has done little to improve profit margins for coal-fired plant operators in the coming months.

The EU ETS market's front-year contract dropped below the €16/t of CO2 equivalent (CO2e) mark for the first time since July 2018 during trading earlier today, with the product now having shed more than a third of its value since the end of February. This has left the European carbon market on track to record its steepest month-on-month price decrease since April 2006, which fell in what was just a pilot trading phase for the EU ETS before the market's full launch in 2008.

The market's steep losses have come as the coronavirus has prompted a significant reduction in power demand across Europe this month, amid a general economic slowdown and as governments have encouraged remote working where possible. With this having coincided with an unseasonably mild end to the winter period, the requirement for the most emissions-intensive power stations to operate has been significantly reduced, and this is expected to result in a marked fall in the volume of EU ETS allowances required to cover this month's emissions under the scheme.

German coal and lignite-fired power output have averaged only about a combined 12.9GW in March so far, compared with 15.5GW in the same month last year.

Weaker economic conditions are also expected to result in a decline in European industrial activity over the coming months, further limiting related demand for EU ETS allowances, while the coronavirus outbreak has also prompted both governments and airlines to roll out extensive limitations to air travel that are expected to result in a sharp drop-off in aviation-sector emissions under the European carbon market this year.

Further price losses for EU ETS allowances in the coming weeks will risk completely wiping out the historic gains recorded over the past two years. Market values more than tripled over an 18-month period that began in early 2018 and peaked when front-year delivery permits under the scheme reached highs of close to €30/t CO2e last July.

The market's strength has played a significant role in reducing the profitability of coal-fired power production in Europe over this period, helping swing generation economics in Germany in favour of gas-fired facilities that produced more electricity than coal-fired units for the first year on record in 2019.

Lower carbon prices seen this month have raised fears among some environmental groups that a rise in power-sector coal burn may be triggered.

But while the carbon market's losses this month have allowed projected profit margins for German coal-fired generators to widen narrowly, spreads remain at levels that are unlikely to result in any resurgence in production in the near term, with front-quarter spreads still virtually unchanged from where they ended in February.

The expected base-load clean dark spread for a 38pc-efficient German coal-fired unit in the third quarter of this year was calculated at minus €7.65/MWh at yesterday's close, compared with minus €7.55/MWh at the end of February, while the projected year-ahead spread at this efficiency remains at only about €0.55/MWh.

This has come as the effect of the carbon market's losses for clean dark spreads has been offset largely by resistance in European coal swaps values, which are now up marginally on the month. The API 2 contract for the second quarter of this year ended yesterday at $50.25/t, which was about $1.65/t higher than where it stood at the end of February, bucking the trend seen across global energy markets amid support from the physical coal market ahead of an expected production strike in Colombia.

The coal market's resistance means that, at current price levels for European power and fuels markets, the EU ETS front-year contract's value would need to fall by roughly half again from current levels to about €8/t CO2e to take a 38pc-efficient coal-fired unit above a gas-fired plant of 55pc-efficiency or lower in the expected German base-load power sector merit order for next year.

With there appearing to be limited near-term fundamental support for the carbon market as the end of winter approaches, market participants have said the spread of the coronavirus will continue to be the predominant price driver for the foreseeable future, with a period of sustained weakness looking likely.

But the EU ETS continues to sit against a backdrop of potentially supportive supply-side factors in the longer term, including German government plans to cancel a share of allowances alongside coal-fired plant closures, a planned review of the effectiveness of the scheme's market stability reserve (MSR) next year, and the EU's review of its 2030 emissions reduction target later this year, meaning that long-term prospects for the market do remain positive.

If market prices are unable to recover from the price falls early this year, the EU could feasibly opt to accelerate the MSR's supply absorption rate or tighten the market's overall supply cap in an effort to provide support and return values to the levels that would be required to deliver any new 2030 emissions cut goal that is set.

By Jonathan Sims

EU ETS front-year price €/t CO2e

German year-ahead spreads €/MWh

German front-quarter spreads €/MWh