Paradoxical effects abound in Europe’s deregulated electricity market, in particular. Governments are trying to cut carbon emissions using a mixture of EU action and national policies, but these measures often have unexpected outcomes. Some have less effect than intended; others succeed beyond expectations, sometimes provoking a backlash and policy U-turn.
Moody’s published a series of reports this week on Europe’s electricity markets, exploring the likely market dynamics over the next decade, and the effects on the credit outlook for the utilities it rates.
The big surprise over the past six months has been the carbon price. The price of one EU Allowance (EUA) — the permit to emit one tonne of CO2 — has never been high enough to really drive companies to cut greenhouse gas emissions, but since 2012 it has been dire. The economic contraction since the financial crisis has worsened the glut of EUAs left over from previous years, when more new credits were issued than industry needed.
“In past years we have assumed, based on our expectations of a persistent surplus, that the carbon price was going to be low, stable and pretty immaterial from the perspective of affecting generation power prices,” said Graham Taylor, vice-president at Moody’s in London. “We said ‘how about we assume €5-€10?’” That has been the rough level of the EUA price for five years.
But in November, there was a breakthrough, after two years, in political negotiations on reforms to reduce the huge surplus of EUAs, which makes them almost worthless.
Countries agreed to raise the speed at which the number of new EUAs issued each year is reduced; cancel some EUAs ; and transfer others to a market stability reserve — essentially, parking them outside the market.
So far, the changes have worked. The price has more than doubled, to €17. Moody’s is now forecasting a price of €10-€20 over the next four years.
Pain leads to pleasure
Everyone who is concerned about climate change will be pleased the carbon price has risen. But it will not automatically lead to keener incentives for emissions cuts.
The first surprising result is that power generators, which will have to pay more to emit carbon, will actually enjoy the higher price. “It’s remarkable how emphatically positive it is for substantially all the generators we rate to have a high carbon price,” said Taylor.
With power freely traded in Europe, the electricity price is effectively set by the marginal cost — the price of the next watt of power that is needed.
In all EU countries, the same pattern prevails — a good part of the baseload may be provided by nuclear or renewable energy plants, which have lower emissions. But the marginal supplier that can produce extra power if called on is a higher carbon source, typically gas or coal.
A higher carbon price pushes up the cost of generating power for that marginal supplier and hence raises the general power price. The consumer pays more — but it is good news for the generators, which can sell their electricity for more money. Those with lower carbon power stations than the marginal supplier will suffer a smaller increase in costs and hence enjoy a fatter profit margin.
A €1 rise in the carbon price costs EU consumers about €1bn a year, of which perhaps €400m flows to generators’ pre-tax profits.
Little to celebrate
But the news for the environment is not so good. There is more hope now of a tight carbon market occurring, but it is far from certain.
Above a price of about €18, gas starts to become price-competitive with newer hard coal power stations and above €20 it starts competing with lignite in Germany. But the price would need to get into the €30s to really drive generators to change fuels.
The future path of the EUA price remains clouded. “The analysis is now very sensitive to a number of things taking place or not taking place,” said Paul Marty, senior vice-president at Moody’s in London. “The surplus could shrink quite rapidly because aviation emissions are retained within the ETS mechanism.”
Aviation was added later to the six high-emitting sectors covered by the ETS, which include power and heat generation, metallurgy, cement, glass and paper. Airlines use more allowances each year than they are allocated. The deficit is only 30m tonnes, which set against total emissions of 1.75bn is small, but it can be an important swing factor. Aviation is expected to grow, and depending on policy decisions, it could start eating into the EUA surplus quickly and push up the price.
However, although a high carbon price ought to raise incentives to decarbonise, the nature of the system is that if successes are achieved in cutting emissions, the carbon price quickly falls again.
This is partly because of the ETS's inflexibility. As an international agreement, it is necessarily slow to change, and it also has to give countries and companies stability over several years, so cannot be constantly tinkered with. This makes it an unwieldy tool for controlling emissions.
| Most countries are likely to meet or exceed 2020 emissions targets, but the renewable energy and energy efficiency targets appear more challenging | |||
| EU targets for 2020, compared with 2005 base year | |||
| Effort-Sharing Decision (greenhouse gas emissions outside ETS) | Renewables as % of gross energy consumption | Energy efficiency (primary energy consumption, in Mtoe) | |
| EU 28 | -9% | 20% | -13% |
| France | -14% | 23% | -16% |
| Germany | -14% | 18% | -13% |
| Ireland | -20% | 16% | 1% |
| Italy | -13% | 17% | -13% |
| Poland | 14% | 15% | 10% |
| Portugal | 1% | 31% | -10% |
| Spain | -10% | 20% | -10% |
| UK | -16% | 15% | -19% |
| Colour coding as per European Environment Agency assessment | |||
| Roman = exceed or meet target, bold = expected to miss target | |||
| Sources: Moody's, European Environment Agency | |||
Other games in town
Furthermore, it is not the only policy being used. By far the biggest share of cuts in the emissions covered by the ETS since 2005, about 40%, has been achieved by the UK, because it used other policy measures to drive the power sector towards renewables and promote energy efficiency. Since 2013, those have included a UK carbon price support mechanism that has pushed the local price to €35.
Coal has now almost ceased to be burnt in UK power stations, while across the rest of the EU coal and oil still provide a quarter of power . This has contributed to keeping the EUA price low and underlines the pattern that substantial emissions cuts can occur at times of low carbon prices.
“The more aggressive your environmental policies, the less effective the carbon price is as a driver of change,” said Taylor.
The UK has harvested much of its low hanging fruit. Tougher national policies being introduced in other countries — notably Germany, which is behind with its EU targets to move away from coal and lignite — could generate an environmental boost, and downside risk to the EUA price. But Moody's is not forecasting this.
Depressingly, Moody’s expects the pace of reduction in emissions from burning fuel to fall, from 3.1% a year in 2013-17, to 2.3% in the next five years and 1.5% in 2022-30.
“The slower pace of emissions reduction from now on is because a large share of the reduction came from the UK, and that is not going to happen again in the next few years,” said Marty.
Although the EU as a whole is well on the way to meeting its own 2020 targets of cutting emissions 20% from 1990 levels, getting 20% of energy from renewables and using 20% less energy, this is far from being ambitious enough to keep global warming to 2C — even if the rest of the world did the same.
“At this pace, the EU would not meet its Paris Agreement targets," said Marty. "The ETS might struggle to incentivise such a reduction in emissions. If the Paris target is met, the carbon price in the ETS would collapse. To get there, countries might have to have different overlapping policies, in addition to the ETS.”