Greenhouse gas emissions trading scheme and energy markets: how does one affect the other?

Energy prices do have an impact on EUA prices, but this has not always been the case. And it will not always be the case for the future. Yet, it is important to understand what stands behind the EU ETS carbon allowance price correlation with the energy markets that we have seen recently. 

The price of allowances from the greenhouse gas emissions trading scheme is influenced by factors such as weather, economic conditions, and energy markets… Fuel switching, especially from coal to natural gas, plays a significant role in reducing emissions due to the lower CO2 output of natural gas. Energy prices in turn impact this switching; lower gas prices promote gas use, reducing emissions and permit demand, while higher prices have the opposite effect. There are expectations that gas prices will remain repetitively high in the remaining months of 2024. With the current levels of correlation between GHG emissions allowances from the ETS, we expect this to drive EUA prices on the rise. 

• Greenhouse gas emissions trading schemes, a reminder 
• Fuel switching, greenhouse gas emissions and energy markets
• Are energy prices important for fuel switching ? 
• What are the effects on greenhouse gasses emissions volumes from fuel switching? 
• How are greenhouse gasses emissions trading prices affected by energy markets? 
• What to expect from gas markets and greenhouse gasses emissions trading prices

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Greenhouse gas emissions trading schemes, a reminder 

What is a greenhouse gas emissions trading scheme?

As a reminder, a greenhouse gas emissions trading scheme is a market-based mechanism designed to put a price on CO2 emissions. As the price increases, companies that emit greenhouse gas have an economic incentive to reduce these emissions. 

It operates by setting a cap on the total amount of emissions allowed within a certain jurisdiction, and then allocating or selling permits to emit specific quantities of greenhouse gasses. Participants in the scheme can buy, sell, or trade these permits, incentivizing emission reductions by using the free market forces. 

It is a compliance mechanism, in the sense that it is set up by a jurisdiction and target sectors have the obligation to comply. 

What drives the price in greenhouse gas emissions trading schemes?

As previously discussed in our articles, carbon prices are driven by different elements like weather patterns, macroeconomic conditions, trading behaviors, and the dynamics of energy markets. Let’s now delve into how energy and gas markets specifically impact the pricing of greenhouse gas emissions trading schemes.

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Fuel switching, greenhouse gas emissions and energy markets

What is fuel switching in energy markets? 

Fuel switching refers to replacing one type of fuel with another for energy generation or industrial operation purposes. This process is often done in response to changing energy market conditions, regulatory requirements, technological advancements, or environmental considerations. It often means transitioning from fossil fuels such as coal, oil, or natural gas to renewable energy sources like wind, solar, hydroelectric, or biomass, or vice versa. Fuel switching aims to optimize energy production or consumption while minimizing costs, emissions, or other environmental impacts.

What is an example of fuel switching in energy markets? 

An example of coal to gas fuel switching for power generation. Many countries have been transitioning from coal-fired power plants to natural gas-fired power plants - in this way, they have reduced their greenhouse gas emissions and improved air quality. For instance, in the United States, several coal-fired power plants have been retired or converted to natural gas-fired facilities due to stricter environmental regulations, such as the Clean Power Plan. 

What is the effect of coal to gas switching on greenhouse gas emissions? 

Switching from coal to gas as a fuel source implies an important reduction in carbon emissions associated with the combustion. 54% of the energy in methane (CH4), the primary component of natural gas, stems from its hydrogen atoms, which burn into harmless water vapor upon combustion. The chemical structure of coal makes its combustion way more polluting. 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.

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Are energy prices important for fuel switching ? 

Here are some examples from different parts of the world on what the historical cost of switching from coal to gas has been. Dynamics proper to the country and its macroeconomic situation make the coal-to-gas switching price different from one place to another. 

Greenhouse gas emissions and fuel switching prices in the US

In the US, data from the EIA indicates that the average price of coal was $43/ton between 2010 and 2019, representing a very low cost of 0.7 cents per kilowatt-hour of thermal energy (kWh-th). During the same period, the average price of natural gas was $3.3 per thousand cubic feet (mcf), equivalent to 1.1 cents per kWh-th. So, the additional cost of using natural gas was around 0.4 cents per kWh-th - directly substituting coal with gas came at a cost of $20 per ton of CO2 avoided. 

Greenhouse gas emissions and fuel switching prices in Europe

In Europe, the average price of imported coal over the 2010-2019 period was $87 per ton, resulting in a cost of 1.2 cents per kWh-th. At the same time, the average price of gas was $8.2 per mcf, translating to 2.7 cents per kWh-th. This means that there was a premium of 1.5 cents per kWh-th for natural gas. So, directly substituting coal with gas had a cost of $80 per ton of CO2 emissions avoided.

Greenhouse gas emissions and fuel switching prices in Japan 

In Japan, the price of imported gas was even higher than in Europe, they were at $12.2 per mcf between 2010 and 2019. This resulted in a coal-to-gas switching cost of $150 per ton of CO2 emissions avoided. This high cost was driven by the impacts of the Fukushima nuclear disaster, which shut down 300 TWh per annum of Japanese nuclear capacity during this period. As a result, the direct replacement with gas needed significant LNG imports, contributing to over 10% of the tightening in the global LNG market overnight.

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What are the effects on greenhouse gasses emissions volumes from fuel switching? 

Link between fuel switching and greenhouse gasses emissions, a recap 

When gas prices decrease, industries shift towards using more gas instead of coal for their operations due to the cost advantage. Since natural gas produces fewer greenhouse gas emissions compared to coal, this leads to a reduction in the volume of CO2 emissions released into the economy. Therefore, lower gas prices typically correspond to lower emissions, while higher gas prices tend to result in higher emissions as industries may resort to using cheaper but more carbon-intensive fuel sources like coal. 

An example of the link between fuel switching and greenhouse gasses emissions

In a recent report, the International Energy Agency (IEA) confirms the correlation between gas prices and emissions with empirical evidence from 2021. The reliance on coal-fired electricity generation during 2021 was made worse by very high natural gas prices at the time. Operating existing coal plants in both the United States and many European power systems were much cheaper than operating gas-fired power plants for most of the year. This gas-to-coal switching resulted in an increase of approximately 250 million tons in global CO2 emissions. In the United States, emissions from coal-fired plants surged by 17% in 2021, although they remained lower than the levels recorded in 2019. At the same time, the European Union saw a 16% increase, although this rise was smaller than the 21% decline observed in 2020.

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How are greenhouse gasses emissions trading prices affected by energy markets? 

Effect of fuel switching and greenhouse gasses emissions trading prices

As highlighted earlier, lower gas prices lead to decreased emissions, leading to reduced demand for carbon allowances to match these lower volumes. So, this decrease in demand causes European Union Allowances (EUA) prices to decrease as well. The correlation between gas prices, emissions, and EUA prices shows that carbon markets react to changes in energy costs.

An example from 2023 and 2024 of the effect fuel switching and greenhouse gasses emissions trading prices

At the end of 2023 and the beginning of 2024, European carbon allowance prices experienced a decline, driven by dynamics in energy markets and the fuel switching phenomena discussed earlier. Notably, gas prices have seen a decrease, and EUA prices were very closely correlated to it. This correlation has been very strong, almost perfect in the final months of the year.

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What to expect from gas markets and greenhouse gasses emissions trading prices

In March 2024, there was a rise in gas prices. Indeed, LNG plant shortages were observed in different regions of the world, driving the EU TTF Natural gas prices to increase by 18%. This was promptly seen in EUA prices too, gaining 15% over the same period. We expect this to keep occurring in the following months of 2024 - the gas-EUA correlation is unlikely to decrease, and gas prices are expected to remain sustained. This brings us to our expectation of carbon markets EUA price to reach EUR 70 by the end of 2024 - this year offers a great entry point to becoming a carbon investor. 

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