EU ETS allowance price stability and fuel switching during the coronavirus crisis

The coronavirus pandemic has been a shock to many aspects of society, and its impact on the energy system is no different. In Europe, demand for energy and electricity has decreased as the economy slows down and people stay home, in addition to the usual springtime drop in demand for fuel and electricity for heating.

As a result, wholesale electricity prices have been depressed, and many power companies are producing at a loss. This crisis comes at a time when the power sector in Europe has already been experiencing structural changes, much due to the increased pressure from high carbon prices in the European Union’s Emissions Trading System (EU ETS). However, the EU ETS has not responded well to economic shocks in the past, and the current downturn will be a test of the many reforms that the system has gone through in recent years. While it remains to be seen what impact the coronavirus will ultimately have on the EU ETS and the European power sector, I hope to present some ideas that can inform our evaluation of the crisis going forward.

Economic shocks can greatly destabilise the functioning of the emissions trading market in an ETS. The EU ETS experienced this issue during and after the financial crisis of 2008. The downturn decreased emissions naturally, resulting in an oversupply of emissions permits. Supply far outpaced demand, and the price per allowance crashed. Low carbon prices, under 10 €/tCO2, persisted throughout the 2010s. EU policymakers felt that allowance prices needed to be raised in order to promote emissions abatement and incentivise low carbon technology development, so they created the Market Stability Reserve (MSR). The MSR, which became operational in January 2019, banks unallocated and excess allowances in order to tighten the market. It can also release excess allowances if a shortage occurs. After its implementation, prices began to rise in the EU ETS, reaching nearly 30 €/tCO2in July 2019.

However, as markets have faltered in recent weeks, the EU allowance price has also fallen. This crisis may be the first true test of the MSR. The mechanism functions free from political influence – it is triggered by the quantity of allowances in circulation, and it adds or removes supply automatically. If the coronavirus results in a sustained economic downturn, demand for allowances will likely trigger the MSR to constrict the supply of permits in the market to prevent wild fluctuations in the price. The European Commission (EC) publishes the number of allowances in the market by 15 May  each year, so we should soon have a picture of the current market situation. However, there is still the potential for great change in the next few months that would not be picked up by this year’s adjustments. Current projections for the EU allowance price in 2020 are around an average of 22 €, a 32% drop from the price projections in January.

Depending on the efficacy of the MSR and the resulting fluctuations in the EU allowance price, two questions arise. First, more generally, is a high allowance price desirable during this time? Second, how might changes in the price affect the choice between gas- and coal-fired power generation?

Fundamentally a market-based mechanism, an ETS allows for market conditions to influence the price of emissions. Without any price controls, an ETS allowance price should adjust downward to alleviate the pressure on companies facing hard times. However, as we saw after the 2008 recession, the carbon price did not recover with the economy. The MSR may help to prevent this outcome, but it may also leave companies with less room in their budgets during the economic downturn. European policymakers will have to decide how to react if this occurs – will any industries get emergency allocations or relief from emissions targets, or will the EC take advantage of any natural drop in emissions to push forward with their environmental targets?

Furthermore, coal-fired power plants have lost a significant amount of market share to gas within the past two years. This shift was heavily impacted by the rising EU allowance price starting at the end of 2018. With the advent of higher carbon prices, gas has begun to outcompete coal due to the lower carbon intensity of CCGT plants, especially compared to Europe’s many subcritical coal plants. However, this trend is not guaranteed to continue; fuel switching occurs not only based on the carbon price margin but also the cost of fuel. With plummeting fuel costs caused by the coronavirus slowdown, and lower carbon prices, the dynamics of the electricity market may shift again going into the 2020s. It will be important to monitor the energy mix going forward in order to determine the effect of this crisis.

We do not know yet how the coronavirus will ultimately affect the global economy, but the current situation suggests that the impact will be large. Such exogenous shocks pose a major hurdle for emissions trading systems; the impact of the 2008 economic recession on EU ETS demonstrates their susceptibility. While the EU has implemented reforms that are meant to address such conditions, it has yet to face a disruption of this magnitude. It is worth watching to see how the EU ETS reacts to the current crisis and whether it accelerates or shifts the energy transition in Europe in any way.