Since the start of the year, EU carbon has doubled in value, raising the possibility of coal to gas switching in power generation. This analyst note reviews the implications of higher carbon prices for EU fuel margins.
Summary
- The EU power mix has been both volatile and increasingly bullish in 2018. EU carbon has doubled in value since the start of the year, raising the possibility of coal to gas switching in power generation. Since April, EU coal, gas and power prices have also increased by around 20%, due to gas storage concerns and robust economic growth in China and the EU.
- All else being equal, EU carbon prices will need to increase another €12/t (to €28/t) to engender coal to gas switching en masse. From 2012 to 2015, the EU ETS did not generate prices high enough to promote coal to gas switching at scale. Despite EU carbon prices being at levels not seen in seven years, prices will need to increase another €12/t (to €28/t) for gas to run ahead of coal in the merit order. The extent of gas storage concerns will likely determine the potential for coal to gas switching in 2018. All else being equal, if gas prices decline to 2018 lows, the EU ETS would put gas in the money.
- Currently, around 75% of EU coal units are cash flow negative based on long-run marginal costs. While short-run marginal costs govern dispatch decisions and thus should promote coal over gas for the time being, long-run margins affect the bottom line and will continue to drive coal retirements, as most unit operators will still find it extremely difficult to cover fixed O&M costs. As of May 2018, around 75% of EU coal units are cash flow negative based on long-run marginal costs.
The EU power mix has got off to a volatile and increasingly bullish start in 2018. Gas storage concerns and strong economic growth in China and the EU have helped support gas, coal and power prices. Since April, EU coal, gas and power prices have increased around 20%. The moves in gas, coal and power, however, have been dwarfed by EU carbon, which has doubled in value since the start of the year. EU carbon prices are now trading at around €16/t, raising the possibility of fuel switching in power generation.
EU carbon, coal and German power in 2018 (January 2018 = 100)
Source: Bloomberg LP data, Carbon Tracker analysis
Fuel switching and gas prices
An expected outcome of the EU ETS was to increase the short-run marginal cost of coal to allow gas to occupy the front of the merit order. Most of the time coal generation has been cheaper than gas in the EU. Therefore, if only short-run marginal costs are considered, it has been cheaper for utilities to burn coal instead of gas for power generation.
Since gas has a lower carbon intensity than coal, if the carbon price gets high enough it can become more profitable to burn gas than coal. This level is termed the fuel switch price. Due to years of overinvestment in the 2000s, EU power systems have significant levels of spare gas capacity, and thus carbon pricing can lead to a change in dispatch decisions among unit operators. Most of the EU’s spare gas capacity is situated in Italy, Spain, Germany and the Netherlands.
As shown in the figure below, by taking average hard coal and gas plant efficiencies for Europe, it is possible to identify the average carbon price required to incentivise fuel switching from coal to gas. By comparing the most inefficient hard coal units with the most efficient unabated gas units, it is also possible to identify a low fuel-switching price range, and vice versa, for the EU.
From 2012 to 2015, the EU ETS engendered virtually no coal to gas switching due to (i) low carbon prices from structural oversupply following the global financial crisis and to a lesser extent the EU debt crisis; (ii) high gas prices due increased LNG demand after the Fukushima disaster; and (iii) low coal prices from lower than anticipated demand from China. Since 2016 there has been some fuel switching as gas prices declined due to low oil prices and surplus LNG capacity.
Coal to gas switching in 2018 will depend to a large extent on gas prices. Power assets exposed to wholesale power have a strong indirect exposure to gas, as they set power prices across Europe. If storage facilities are not filled by the end of summer, the market for gas could be tight in winter. To close the arbitrage and divert LNG volumes from Asia, EU gas prices would have to increase significantly which would likely keep coal to gas switching out of reach. Nonetheless, all else being equal, if gas prices decline to 2018 lows, the EU ETS would put gas in the money.
Theoretical EU coal to gas fuel switching from 2010 to May 2018 and the delta between the mean coal to gas switch price and front-year EUA in 2018
Source: Bloomberg data, Carbon Tracker analysis
Notes: based on front-year API coal and month-ahead TTF gas futures contracts. Mean plant efficiencies: hard coal, 36%; gas, 49%. Low-range plant efficiencies: hard coal, 32%; gas, 60%. High-range plant efficiencies: hard coal, 46%; gas, 32%. Readers should note, the author has used this figure in previous reports at Sandbag, IEA and Carbon Tracker.
Long-run coal margins and the RWE carbon hedge bluff
Does this situation mean some respite for EU coal generator margins? While EU power prices have increased due to fuel costs, these rises have been more than offset by increasing carbon prices. According to Carbon Tracker analysis, around 75% of EU coal units are cash flow negative based on long-run marginal costs. Short-run marginal costs include fuel, carbon and variable operations and maintenance (O&M) costs, while long-run marginal costs also include fixed O&M costs.
While short-run marginal costs govern dispatch decisions and thus should promote coal over gas for the time being, long-run margins affect bottom line and will keep coal units under sustained financial pressure for two reasons: (1) as detailed in Carbon Clampdown, this situation could push carbon prices even higher, as the market will likely need to get abatement from fuel switching or industrials who tend to hold onto their surplus in a benign economic climate; and (2) as detailed in Lignite of the Living Dead, we find that falling renewable energy costs, air pollution regulations and rising carbon prices will continue to undermine the economics of coal power in the EU, making units reliant on lobbying to secure capacity market payments.
Gross profitability of the EU coal fleet based on long-run marginal costs
Source: Bloomberg data, Carbon Tracker analysis
Much has been made about RWE fully covering its carbon liability out to 2022, but we believe this is overdone. The hedging strategy detailed in their May 2018 company presentation replaces power price risk with outright spread risk. Instead of hedging their exposure to the outright power price RWE is opting to hedge their exposure to the outright spread. RWE defines fuel spread defined as: power price – (pass-through-factor carbon × EUA price + pass-through-factor coal × coal price + pass-through-factor gas × gas price). This is why RWE states their carbon position is “financially hedged” to 2022, because it is based on a fuel spread proxy. While the term financially hedged is a great investor relations strategy in the face of steadily increasing carbon prices, it is misguided to assume RWE has fully hedged its carbon liability allowances out to 2022.
Conclusion
The EU energy mix has got off to a supercharged start in 2018, owning to reforms to the EU ETS, gas storage shortage concerns and robust economic growth. Despite the significant rises in EU carbon prices, coal to gas switching looks tantalisingly out of reach until the market has further insight on the EU’s gas shortage issues. All else being equal, if gas prices decline to 2018 lows, the EU ETS would put gas in the money.
Matt Gray – Analyst (Power & Utilities)
