The impact of carbon regulation on power generation

EU-ETS intended to create a continental market for emissions by attaching an economic value to the carbon externality thereby encouraging power utilities to shift their power generation mix towards less carbon intensive alternatives at the least cost. In practice however, the current EU regulatory framework poses little threat or incentive for utilities to switch away from 'dirty' generation.

Report Highlights
To date, European utilities have gained more than they have 'pained' from European carbon regulation. This is a trend which is likely to continue until and unless auctioning is introduced in the new EU climate package. Until then, and at current prices, a large scale switch from coal to gas appears unlikely, regardless of the pricing rule adopted.

The increasingly positive correlation between gas and carbon prices has been destabilized, in part, by the seasonality of gas. Oil, however, is acting as a positively correlated non-seasonal gas proxy for carbon prices. The dynamics shaping the interrelationship between gas, oil, coal and carbon suggest that carbon prices will rise long-term.

Fossil fuel commercial breakeven without carbon pricing is a function of total energy demand, not fossil fuel switch-off and will increasingly be impacted by the rapid scaling of 'green' energy sources, particularly as carbon policies and peak oil dynamics steepen the fossil fuels supply curve, making clean energy more attractive.
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DATAMONITOR VIEW 1
CATALYST 1
SUMMARY 1
ANALYSIS 2
The current and likely future dynamics shaping the interrelationship between gas, oil, coal and carbon suggest that carbon prices will rise long term 2
The prices of gas and carbon are exhibiting increased positive correlation trends, destabilized mostly by the seasonality of gas 2
Oil is acting as a positively correlated non-seasonal gas proxy for carbon prices 3
In the long term, carbon prices and energy prices are likely to increase 4
Going forward, three likely scenarios will dictate the future correlation between fossil fuel prices and carbon prices 4
Utilities are unlikely to decommission viable power plants unless the variable costs of continued operation exceed revenues 6
Commercial breakeven without carbon pricing or incentives is caused by an inflexion in energy use, not fossil fuel switch-off 6
The rapid scaling of 'green' energy sources will impact the commercial breakeven of all power generation technologies 7
Carbon policies and peak oil dynamics are designed to steepen the fossil fuels supply curve, making clean energy more attractive 8
To date, European utilities have gained more than they have 'pained' from European carbon regulation 9
Power generators have three means of switching to less polluting thermal generation to hedge against the carbon externality 10
An incumbent power utility's decision to switch is generally made on the basis of different decision rules 11
At current prices, a technological switch from coal to gas appears unlikely, regardless of the pricing rule adopted 12
Under the EU ETS, long-term substitutions between coal-fired units and CCGT plants will take place under very restrictive conditions 13
APPENDIX 15
Ask the analyst 15
Datamonitor consulting 15
Disclaimer 15
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Figure 1: The 60-day rolling correlation between gas and EU Allowance (EUA) prices has a long-term mostly positive upward trend 2
Figure 2: The 60-day rolling correlation between Brent spot and EUA spot returns has a long-term upward trend and is largely positive 3
Figure 3: Global cap and trade mechanisms will lead to higher carbon prices as the demand side scenario prevails 4
Figure 4: Without carbon pricing, thermal plant breakeven varies with overall energy demand 6
Figure 5: Theoretical plant commercial breakeven is driven down by (cap and trade) carbon pricing 8
Figure 6: The divergence in '07 and '08 EUA prices has increased the potential and scale of windfall profits in the power sector 9
Figure 7: The threshold carbon price varies depending on the decision rules adopted by power utilities 10
Figure 8: When considering a switch, pricing and decision rules must first be considered 11
Figure 9: Currently, EUA prices appear to be well below all of the power generation switching threshold scenarios 12
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