How do gas markets influence the EUA prices trends and forecasts ?

Carbon emissions allowances prices are driven by various factors including weather conditions, regulatory decisions, trading behavior, and energy markets. In this article, we will examine this last element through the relationship between gas prices and carbon allowance prices.

We will start by defining what fuel switching is, and then use this concept to establish logical connections - how do gas prices affect CO2 emissions and demand for European Union Allowances (EUAs)? This relationship between gas prices and fuel switching has implications for the volumes of emissions released in the economy. Gas combustion produces lower carbon emissions compared to coal , so an increase in gas usage due to lower prices leads to lower overall emissions. This in turn leads to reduced demand for carbon allowances, eventually putting downward pressure on EUA prices. 

Understanding this relationship is important for making european carbon allowances price forecasts. We will go through the high correlation between gas prices and EUAs during the carbon allowance prices during the recent market fall. We will finish by advancing our projections on the expected correlation between EUA prices in the future and gas markets.

• How do gas prices affect EUA prices?
• Why did carbon allowance prices decrease recently? 
• What are the emissions price forecasts and how do they depend on the changes in gas markets?
  

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How do gas prices affect EUA prices?

What is fuel switching? 

As explained in our previous article, fuel switching refers to the practice of changing from one type of fuel to another, for example from gas to coal or vice versa. This is usually done either to save money (by choosing the least costly energy source), or for environmental reasons (by choosing the least carbon-intensive energy source). In this article, when we refer to fuel-switching, we talk about the change from coal usage to gas. Essentially, when the price of gas decreases, industries tend to transition from using coal to utilizing gas as a fuel source. They choose the more economical option, but in this case this is also good news for climate - gas is also less carbon-intensive than coal.

How does fuel switching alter carbon emissions volumes? 

Fuel switching impacts carbon emissions by substituting high-carbon intensive coal (which emits approximately 205-228 pounds of CO2 per million British thermal units - lb CO2/MMBtu) with the lower-carbon alternatives of natural gas (which emits approximately 117-130 lb CO2/MMBtu). This substitution results in a significant reduction in CO2 emissions per unit of energy produced or consumed - it is an important transition for mitigating climate change. Policy interventions and technological developments play a role in facilitating and incentivizing such fuel switching practices.

How do gas prices influence emission allowances prices?

When gas prices decline, industries increase their usage of natural gas, leading to a decrease in their carbon emissions (as discussed above). In turn, industries anticipate a reduced need for European Union Allowances (EUAs) to offset their emissions. This expectation of lower demand for EUAs puts downward pressure on EUA prices. At the end of the day, carbon markets use the laws of the free market. Just like for any other financial asset, a decrease in expected demand leads to lower prices.

How does carbon pricing affect energy prices? 

The costs associated with electricity production differ in a system with and without carbon pricing. Electricity producers have the option to use gas or coal for their operations. The combustion of those sources emit CO2 volumes that are matched by equivalent volumes of carbon allowances. This shift in the balance sheet of electricity producers due to the price they pay for EUAs is reflected in the end-consumer price. For instance, a study by the European Union indicated that from January 2021 to September 2021, the EU ETS price rose by approximately €30/tCO2. This increase translates to a cost hike of about €10/MWh for electricity generated from gas (assuming a 50% efficiency) and about €25/MWh for electricity generated from coal (assuming a 40% efficiency).

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Why did carbon allowance prices decrease recently? 

Why have gas prices been falling after the summer of 2022?

The conflict in Ukraine in 2021 led to a surge in gas prices in Europe as the bloc heavily depended on Russian gas. This drove prices upward - there were concerns about supply shocks because of the reliance on Russian imports. However, the energy crisis appears to be resolving now. Europe has diversified its supply sources, particularly through increased shipments of liquefied natural gas (LNG) from the US and the Middle East. Currently, mild winter temperatures have further dampened gas demand, with February figures 23% below seasonal averages. Gas storage levels are reaching record highs. 

What are the forecasts for gas prices from 2024 on?

Analysts expect continued gas price decreases in the medium term due to ample storage levels and global oversupply. Some gas price expert forecasts were revised downwards, for example Goldman Sachs commodities analysts have changed their anticipations to €31 from €41 previously for the end of 2024.

What is the correlation between European carbon allowance prices and gas prices? 

There is a link between gas prices, gas usage, carbon emissions, demand for EUAs, and eventually, EUA prices. This relationship has been evident in recent months, with the correlation between gas prices and EUAs being higher than usual. Historically, the correlation between gas prices and EUAs has been low, around 0.12. However, recently we have seen a stronger association between the two. In October 2023, the 5-day rolling correlation between gas prices and carbon allowances prices reached 0.9. As discussed in our previous article, participants have displayed a market myopia - they were only focusing on short-term elements like the weather and gas markets. 

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What are the emissions price forecasts and how do they depend on the changes in gas markets?

Will fuel switching keep on forever? 

Fuel switching may cease even if gas prices keep falling because there is a limit to fuel switching. What if all installations that technologically can make this power switch have already done so? In this scenario, even if gas prices continue to decrease, there would be no more emissions reduction. In turn, expected demand for EUAs will no longer be affected either. So, the downward pressure on EUA prices may no longer persist even in a world where gas levels go down further.

Will gas markets lose their influence on EUA prices?

Carbon markets are fascinating because of the multitude of price drivers, each affecting EUA prices to a different degree. This influence shifts over time, with certain drivers taking precedence at some points in time - this depends on market sentiment, macroeconomic factors, and what most preoccupies investors at that moment (extending beyond the confines of carbon markets). 

A 2023 - 2024 example of EUA price drivers and their influence 

For instance, during the gas crisis, energy markets were at center stage of all talks. Those had a greater impact on carbon prices at the time. On the other hand, ahead of the EU Commission's announcement of the 2040 climate targets, everyone was looking forward to learning about the level of institutional climate ambition. Indeed, in January, just before the commission’s announcements, carbon allowances prices exhibited less correlation with gas prices - it fell to 0.47. At the time, the political aspect (with the added supply volumes from the RepowerEU package) was the primary driver.

Refocusing on the core fundamental drivers for carbon market prices

Soon, market participants will likely shift their focus towards market fundamentals. As previously mentioned, the RepowerEu program caused a temporary supply shock by increasing volumes in 2023 and 2024 (drawing from “the future carbon budget”). However, this imbalance will be compensated by a sudden fall in supply volumes in the years to come. Furthermore, the phasing out of free allocations and the inclusion of new sectors into the system are expected to drive prices upwards. Once market players begin to prioritize these dynamics, we can anticipate a more pronounced decoupling from gas prices.

A bullish EUA price forecast for the future

2024 as a promising opportunity for investment in carbon markets. The end of 2023 and the beginning of 2024 witnessed market downturns driven by factors such as energy markets, q decrease in economic activity, and regulatory adjustments (as a response to the gas crisis stemming from the conflict in Ukraine). However, we anticipate a return to market fundamentals in the near future. Supply and demand dynamics are expected to tighten up, leading to a forecasted recovery in prices.

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Key Takeaways

• Gas prices impact carbon emissions volumes in the EU, affecting demand for EUAs and their price levels.
• Fuel switching from coal to gas, driven by lower gas prices, reduces carbon emissions, leading to decreased EUA demand and downward pressure on prices.
• Recent decreases in carbon allowance prices are partially due to falling gas prices.
• Correlation between EUA and gas prices has strengthened recently, with a 0.9 correlation observed in October 2023.

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