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2019 shortfall 'unlikely to be cleared by switching'

London — EU carbon prices fell back in early January, reflecting the growing potential for coal-to-gas fuel switching this summer in continental Europe and on-going caution around the Brexit process.

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EU Allowance futures contracts for December 2019 delivery fell as low as Eur21.36/mt January 10 from as high as Eur25.73/mt January 2.

The weaker carbon prices came as natural gas prices fell relative to coal. This was illustrated in German clean dark and spark spreads, with profit margins for lower efficiency coal plant falling below those for the most efficient gas plant over the summer quarters.

German fuel spreads

A key driver of this has been the decline in summer 2019 Dutch TTF gas prices, linked to healthy gas storage levels and strong LNG deliveries into Northwest Europe. At the same time, the carbon price penalty on coal-fired margins has remained relatively stable.

Although higher coal-to-gas switching is bearish for EU Allowance demand, some analysts think a shortfall in 2019 EUA supply could drive carbon prices higher, in order to trigger even more coal-to-gas switching and so narrow the supply-demand gap.

The carbon market had an aggregate surplus of 1.655 billion mt in 2017, which can be used for compliance purposes in any year up until 2030. The Market Stability Reserve will reduce this aggregate supply by 24% per year from 2019 to 2023, which translates into a cut of up to 40% to auction volumes in 2019.

Taking 2019 in isolation, the MSR's impact on supply indicates a yearly shortfall of up to 300 million mt across the system. To clear this shortfall in 2019, utilities would need either to use up part of their surplus held from previous years, or buy enough allowances in the market to fill the gap.

In particular, what matters for the carbon price is: how big that short is; whether coal-to-gas fuel switching will be enough to cover that short; and to what extent utilities have already hedged their positions for 2019 and beyond.

Societe Generale utilities analyst Lueder Schumacher estimates that the EUA supply/demand shortfall will be 305 million mt in 2019 and 279 million mt in 2020. The total coal-to-gas fuel switching capacity in Europe is 70-80 million mt/year, according to Schumacher.

If more than 20 million mt of fuel switching is required, the fuel switch on average power plant efficiencies would become more relevant, and this would require a carbon price of Eur35/mt, Schumacher said.

Analyst Trevor Sikorski at research group Energy Aspects agreed that coal-to-gas fuel switching could be too little to clear the market short in 2019, meaning CO2 reductions would have to be found elsewhere, or prices would have to rise to a point where those with surplus volume are willing to sell it.

Tighter EU carbon market set to prompt more power fuel switching in Europe

2019 is set to be the year that coal-to-gas switching in power generation takes off in continental Europe. Carbon prices supported by the new market stability reserve cutting supplies, coupled with potentially lower gas prices, could prompt unprecedented C2G switching volumes.

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"Even exhausting the fuel switch is unlikely to balance the EUA market, requiring some net draw from the credit inventory in the market," he said in a research note January 7.

Berenberg bank utilities analyst Lawson Steele is even more bullish on carbon prices this year, based on a view that the market will be structurally short in 2019, forcing prices to rise to higher levels.

"Full abatement can save no more than 180 million mt absolute max. And that is against a 400 million mt deficit. Those that cannot buy permits face a Eur107/mt penalty price and have to buy a permit on top for delivery the following year," Steele said January 3.

The extent of the supply-demand gap in 2019 is also influenced by the Brexit outcome.

Carbon prices rallied Wednesday and Thursday after the UK parliament voted against the government's proposed EU withdrawal agreement. EUA futures contracts for December 2019 delivery on the ICE Futures Europe exchange rose as high as Eur23.97/mt Thursday, compared with Eur22.62/mt at the close Tuesday.

This likely reflects a perception in the market that a delay to Article 50 is looking more probable, even though a no-deal Brexit is still a possibility. Agreement on a withdrawal deal would be expected to see UK plants stay in the EU ETS until 2020, which would be bullish for EUA demand, while no-deal would see them exit the EU ETS on March 29 unless an extension is agreed.

A poll of six analysts by S&P Global Platts in December indicated an average carbon price forecast of Eur27.50/mt in 2019 and Eur33.17/mt in 2020.

--Frank Watson, frank.watson@spglobal.com

--Fabio Reale, fabio.reale@spglobal.com

--Edited by James Leech, newsdesk@spglobal.com