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EU CO2 prices to average Eur35-40/mt to 2023: Carbon Tracker

London — EU carbon dioxide allowance prices are likely to average Eur35/mt to Eur40/mt (about $40-$46/mt) over the period 2019-23, accelerating coal-to-gas fuel switching in the power generating sector, UK-based non-governmental risk analysis group Carbon Tracker said in a report Tuesday.

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As the supply of allowances tightens due to regulatory reforms to the EU Emissions Trading System, higher carbon prices will prompt power generation fuel switching in EU countries with latent gas capacity, questioning the rationale for keeping old coal and lignite power plants running, Carbon Tracker said.

In the short term, European carbon prices are forecast to continue rising to Eur25/mt by the end of the year, up from Eur18.49/mt at the close Monday, after reforms set to kick in next year have already seen the carbon price quadruple within 18 months to reach 10-year highs, the group said.

"The report finds that the carbon allowance supply squeeze caused by the Market Stability Reserve over 2019-23 will leave the power and aviation sectors with a [approximately] 1.4 billion mt carbon deficit," the group said in a statement accompanying the report.

"To reduce this deficit, power generators will need to bid up carbon allowance prices to i) facilitate their own transition from coal to gas so they need fewer allowances, and ii) incentivize the sale of surplus carbon allowances currently held by industry and speculators," it said.

"We conclude that in order to achieve the level of fuel switching required to eliminate that carbon deficit in 2019-23 it will be necessary for combined cycle gas turbine plants with a thermal efficiency rate of 45% and above to displace coal plants with thermal efficiencies of 38% and below," said the report's author Mark Lewis, Carbon Tracker's managing director and head of research.

"With the fuel switching price very sensitive to efficiency rates, this will require higher EUA prices than we were previously assuming," he said a statement.

EU carbon prices could trade as high as Eur50/mt for limited periods in the winter of 2020-21 and 2021-22, the report found.

"During this period, the supply squeeze on generators will be at its peak and in winter months gas prices are at their seasonal highs. However, prices are effectively capped at around Eur50/mt," it said.

"Bullish as the outlook for EUA prices looks to us, it is important to remember that the EU ETS is ultimately a political construct," said Lewis.

"In our view, if prices were to exceed Eur50/mt for more than a couple of months at any point within the next two to three years, this would likely lead to pressure for countervailing measures, especially in Eastern Europe," he said.

The four European countries where fuel switching could occur at scale over the next five years are Germany, Italy, Spain and the Netherlands, the report found, with up to 46 TWh extra gas output in Germany and 42 TWh extra gas output in Spain.

"This fuel switching, alongside efficiency savings accounting for a third in total reductions, could reduce CO2 emissions by up to 60 million mt in 2019, 90 million mt/year between 2020-22 and 70 million mt in 2023," it said.

"Over 2024-30 the picture is less clear. This is because the cost of both renewables and energy storage technology are expected to fall significantly over the next decade," the group said.

"Furthermore, the impact of coal phase-out policies across a number of EU member states could be greater than currently anticipated, especially if Germany implements a coal and lignite phase-out by the middle of the next decade," it said.

EU carbon prices have rallied as high as Eur18.60/mt in August, compared with Eur4.40/mt in May 2017.

The rapid rise in carbon prices over the last 16 months is quickly overtaking previous calls for carbon floor prices among individual EU member states, which originated at a time when carbon was trading in euro single digit prices.

Carbon floor prices involve countries setting unilateral policies to establish a minimum price for carbon, for example by imposing an additional tax on CO2 emissions on top of the EU carbon price.

If EU carbon prices continue to rise in line with some analysts' forecasts, this is likely to make calls for carbon floor prices redundant.

However, Carbon Tracker said uncertainty over long-term carbon prices could maintain some calls for carbon price floors.

"We think it is an open question as to whether or not fuel switching will actually be required over the second half of Phase 4 [2021-30] at all, given that these trends will lead to a structural decline in the power sector's emissions in any case," said Lewis.

"This raises difficult questions about the visibility of EUA prices beyond 2024, which in turn explains why a debate over a carbon price floor is unlikely to go away," he said.

Jeff Berman, director of emissions and clean energy at S&P Global Platts Analytics, said additional plant retirements could take place if there is a new expectation of higher carbon prices in the coming years.

However, the upside for carbon prices could be limited if gas prices come in lower than expectations.

"Any future EUA price level derived from coal-gas switching will depend on upcoming gas prices," Berman said Tuesday.

"Under an EUA pricing model based on power sector coal-gas switching costs, higher gas prices should lead to higher EUA prices. As a result, if strong European gas prices fail to materialize in the 2019-2023 period, then neither will high EUA price gains from power sector fuel switching," he said.

--Frank Watson,

--Edited by Maurice Geller,