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Aligning EU ETS with Paris deal would push CO2 price to Eur55/mt

London — Aligning the EU Emissions Trading System with the United Nations Paris Agreement on climate change would push carbon allowance prices as high as Eur55/mt -- high enough to undermine even the highest efficiency coal-fired power plants in Europe, financial analysis group Carbon Tracker said in a report Thursday.

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EU CO2 allowance prices (Dec 2018)

"EU carbon prices are set to double by 2021 and could quadruple to Eur55/mt by 2030 if the European Commission ultimately legislates to align the bloc's emissions targets with the Paris climate agreement," the London-based group said in a statement.

In order to put EU CO2 emissions on a path consistent with international climate targets, the price of EU Allowances under the EU ETS "would have to rise to levels that would make even the most efficient coal and lignite power plants unprofitable," the group said.

Carbon prices have already trebled since May last year, rising from Eur4.40/mt ($5.36/mt) to well over Eur13.00/mt in April, as market participants anticipate cuts through the Market Stability Reserve (MSR) to the supply of allowances to be auctioned in 2019, linked to recently-passed legislation that overhauls the market's rules.

Even without additional measures, EUA prices are "on course for Eur25-30/mt by 2020-2021 as reforms squeeze out surplus supply," Carbon Tracker said.

EU governments in March formally asked the European Commission to draw up a proposal for a long-term emissions reduction strategy in line with the Paris Agreement within a year.

EU ETS CO2 emissions and annual CAP vs EUA price

"This sets in train a process that could potentially lead to a cap on the number of allowances dealt on the EU ETS [being] aligned with the objective of keeping global warming 'well below 2 degrees C'," said Mark Lewis, Carbon Tracker's managing director and former head of European utilities research at Barclays.

The EU's existing goal is to cut economy-wide CO2 emissions by 40% from 1990 levels by 2030, but this would need to increase to 55% to align with the Paris deal, according to Carbon Tracker's calculations.

"Life is about to get much tougher for EU coal-fired plant generators. Higher carbon prices will eat further into operating margins that have already been severely eroded by the growth of renewables, forcing less efficient coal plants off the grid altogether," said Lewis.

Under a Paris-aligned EU ETS, carbon prices would need to reach a sustained level of Eur45-55/mt to drive coal and lignite plants out of the market, he said.

This is likely to see a major switch from coal to gas in Italy, Spain, Germany and the Netherlands, the report found.

There would be less impact in the UK, which has largely phased coal out of the electricity mix through the Carbon Price Support -- a tax on CO2 emissions from power generation in addition to the EU carbon price.

Electricity generation 2017

"High carbon prices are also likely to accelerate the development of large-scale energy storage, smart grids and demand-side response, where energy users shift consumption away from peak periods," the report said.

As the supply curbs get nearer, EUA prices could reach Eur15/mt in the second half of 2018, Eur20/mt in 2019 and Eur25-30/mt in 2020-2021 "as the supply squeeze really starts to bite," it said.

The MSR is set to remove about 3 billion mt of allowances from the market by 2023 -- about two years' worth of CO2 emissions across the 31-nation system.

Aligning the EU ETS with the Paris Agreement would require removing an additional 1.6 billion mt, forcing a much greater shift to clean energy, the report found.

The MSR will have the equivalent effect of reducing the EU ETS cap on annual emissions by 2.65%/year from 2020 to 2030, from 1.8 billion to 1.2 billion mt.

However, to align the cap with the Paris deal, it would need to be reduced by 4%/year to just over 0.943 billion mt by 2030.

Even the base case of no additional ambition for the EU ETS emissions cap, significant fuel switching in power generation will likely be required to plug the carbon supply gap created by the impact of the MSR from 2019 onwards, the report found.

"As such, we think that fuel switching between [gas-fired] CCGT plants with efficiency rates of 50% and above and coal plants with efficiency rates of 36% and below will likely be sufficient to clear the EU ETS over 2019-21," it said.

This would mean least-efficient hard-coal units being pushed out of the merit order in favor of the most efficient gas -fired CCGT plants and renewable energy systems, which provide a growing share of power on sunny and windy days in Europe.

Germany's lignite plants, which tend to run 24/7, providing baseload power, would still be profitable even with much higher carbon prices of Eur25/mt, which are likely under the baseline scenario with no further climate ambition, Lewis said in an interview with S&P Global Platts on Thursday.

Since lignite-fired power plants tend to be sited next to mining facilities, the operators face negligible fuel transport costs, making them cheap to run compared with other generation capacity.

"It's only when you get to those higher carbon prices of Eur45-55/mt that it starts to push lignite out of the market," he said.

Lewis also acknowledged the political difficulties the EU faces in ramping up the ambition of the EU ETS to align with the Paris goals.

"This is going to be a very difficult, contentious issue for the EU to deal with. But the European Commission has been given a mandate by the EU Council to come up with a plan within 12 months [to set emissions targets in line with the Paris Agreement]," he said.

The EC may even publish a proposal in November ahead of the UN climate talks in Katowice, Poland, in December, he said, although this has not yet been announced.

A European Commission spokeswoman told Platts that the Commission is working on a long-term strategy to align EU emissions targets with the Paris deal, as per the request from the European Council in March, although the timing has not yet been confirmed.

Carbon Tracker's study assumed that the balance of emissions reductions would stay the same between the EU ETS sectors -- power, heavy industry and aviation -- and the non-traded sectors such as surface transport, agriculture, buildings and waste.

"I've assumed the EU ETS taking the same share of the overall burden that it does today," he said.

For its analysis, Carbon Tracker used a study by the Netherlands Environment Assessment Agency and the International Energy Agency's implied carbon budget for the EU power sector under its Sustainable Development Scenario.

Carbon Tracker is a non-profit financial analysis group that seeks to align capital markets with a transition to a low-carbon economy.

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