We often see terms like “coal-to-gas” differentials and “fuel switching” when discussing EUA price movements. While these may sound complex, they're not as complicated as they seem.
We often see terms like “coal-to-gas” differentials and “fuel switching” when discussing EUA price movements. While these may sound complex, they're not as complicated as they seem.
For simplification purposes, we can imagine that producing electricity only requires paying for the primary energy source, and paying for the EUAs that correspond to the CO2 released by the combustion of those sources.
Electricity producers often have the flexibility to switch between coal and gas for electricity generation. When making this decision, they compare the cost of using gas to that of coal. However, the choice also considers the cost of EUAs.
Despite coal potentially being cheaper than gas in absolute terms, it may not always be more profitable for electricity generation. Coal is more carbon-intensive than gas, meaning it pollutes more and therefore requires the purchase of more EUAs to offset its emissions. The CO2 intensity of burning natural gas is around 0.18 kg/kWh-th, whereas it reaches around 0.37 kg/kWh-th when relying on coal.
So, in their decision-making process, industries calculate the cost of their primary energy source, factor in the cost of EUAs needed to offset emissions (which is typically higher for coal than for gas), and then decide which fuel to use.
The fuel switching price corresponds to the implicit price of the EUA so that the production costs of electricity from coal and gas are equal.
This implicit EUA price helps financial institutions decide on their behavior. The logic is very theoretic, but here is what stands behind it.
When clean spreads are negative, it is a message that “the cost of producing electricity is higher than the revenue from selling it”. This situation implies that utilities will stop electricity production (and stop using coal or gas as a result). Instead, it is better for them to purchase electricity from elsewhere and resell it, rather than producing it themselves.
So, it is expected that CO2 emissions will decline in such a scenario, leading to a decrease in demand for EUAs.
Over the past few months, energy prices have surged due to a macroeconomic shock. In turn, clean spreads have turned negative, making it “more expensive to produce electricity than to sell it”.
EUA traders have interpreted this as EUAs being overpriced compared to their implicit fuel switching price. This is why they have consistently been selling carbon allowances for the past months. This explains a part of the recent price decline (on top of the RepowerEU added volumes of course).
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