High carbon prices prompt coal-to-gas fuel switching

The soaring price of European Union emissions permits is encouraging more utilities to switch to natural gas from carbon-heavy coal to generate electricity in Germany, potentially speeding up its phase-out of the highly polluting fuel.

The EU's Emissions Trading System (ETS), its main tool for curbing greenhouse gas emissions, charges power plants and factories for each tonne of carbon dioxide they emit.

As the cost of emissions permits rose 28% last year, power generation from hard coal in Germany fell 6% and output from brown coal slid 11%. While that in part reflected a pandemic-related drop in demand, generation from gas remained broadly flat.

The benchmark price of EU carbon allowances in the scheme has risen a further 45% since a December meeting when EU leaders agreed a more ambitious emissions cut target this decade.

That prompted a scramble for permits among speculators betting lawmakers would extend the need for carbon offsetting, pushing prices to record highs of 45 euros a tonne.

The higher carbon price has increased the cost of operating hard coal plants, making them less profitable to run compared to gas equivalents. Some generators have switched to gas, which emits less carbon dioxide when burnt.

For those not able to switch fuels or operate at a loss, permit costs are passed on to the consumer through higher power prices.

In the German power market, the difference between the so-called "clean dark" and "clean spark" year-ahead spreads - which effectively measure the cost of operating coal-fired and gas-fired plants respectively - has widened since last November.

The cost gap between fuels and carbon has also hit brown coal, or lignite, plants in Germany, which are dependent on a usually cheaper fuel source than both gas and hard coal.

In early March, forward contracts for power produced by lignite plants built pre-1995 - the least carbon efficient - went into a deficit cost for the first time.

The rising carbon price has caught a lot of industrial players off guard, as its low price relative to other fuel sources had made many see lignite as a "safe bet" in the short to mid-term, said ICIS analyst Marcus Ferdinand.

For coal and lignite to stay competitive in the several EU countries where it remains a main fuel source, operators would need to see the price of the fuel drastically drop in comparison to gas in order to tighten the spread, he added.

But when gas prices recovered after the summer months in 2020, coal prices also soared due to high demand in China during the recovery from the pandemic, reaching a near two-year high in January. They remain about $10/tonne higher year on year.

Some analysts see rising prices eventually leading to a faster phase-out of coal and lignite power sources, which are currently due to come offline in 2038 in Germany and in 2040 in Poland.

If hard coal plants shut down at a faster pace and there are no alternatives in place to meet power demand normally assured by conventional supply, there could be a supply squeeze further down the line.

"As we are moving away from coal, and with unknown or risky outlooks (for) building gas-fired plants, we expect many countries to run into security of supply problems," said Espen Andreassen, an analyst at consultancy Volue.

(Reporting by Forrest Crellin; Additional reporting by Vera Eckert in Frankfurt; Editing by Nina Chestney and Jan Harvey)

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