Industry Trend Analysis - ETS Reform To Fall Short Of The Mark - DEC 2017

BMI View: Planned reform of the EU's emission trading system will be insufficient to raise the price of carbon to the level needed to drive wholesale coal to gas switching in Europe ' s power sector. This feeds into our relatively muted forecast for gas demand in the region.

The European Parliament and EU member states are negotiating for reform of phase four (2021-2030) of the EU emissions trading system (ETS). In its current form, the ETS has been broadly ineffectual in driving the shift away from more carbon-intensive production and consumption. The main problem lies in the over-allocation permits, which has severely depressed prices. From a high of around EUR29.0/mt in 2008, the front month EU Allowances (EUA) futures contract is currently trading at EUR7.3/mt.

No Recovery In Sight
Front Month EU Allowances, EUR/mt
Source: Bloomberg, BMI

The phase four reforms (as proposed by the European Commission) attempt to tackle lower prices by more aggressively removing surplus emissions allowances from the market. Currently, allowances are being reduced by a rate of 1.74% a year; the proposal is to increase this to 2.20% from 2021. This would see emissions decline by an additional 556mn mt over the 10-year period up to 2030. The EC has also pushed for reform of the free allocation system. Free allocations are designed to prevent carbon leakage - the offshoring of production to markets with laxer regulations by companies seeking to evade the added emissions costs. The EC wants to better target them towards the industries where they will have the highest impact and to more closely align the total volume awarded with actual industrial output.

A higher carbon price would have a potentially significant impact on the European power sector, incentivising a shift from coal to gas. In the absence of a sufficiently high carbon price, gas-fired power generation struggles to compete against coal. In most mainland European markets, spark spreads (the margins made on gas-fired generation) are frequently in the red. In contrast, dark spreads (for coal) are often weak but generally positive. The inverse is true of the UK, where power producers incur a higher carbon price, via the Carbon Price Floor (CPF).

Gas-Fired Generation Firmly In The Red
Spark Spreads, EUR/MWh
Source: Bloomberg, BMI

This has fed through into a higher share for gas in the UK's thermal generation mix, compared to other European markets (see chart below). Numerous other factors drive the decision to switch between coal and gas, not least the relative commodity prices, regulatory constraints on coal capacity and portfolio optimisation by individual utilities. However, carbon pricing has a significant role to play.

Carbon Pricing Holds Key For Gas
Natural Gas Share In Thermal Generation, %
e/f = BMI estimate/forecast. Source: BMI, National sources

However, there remain major barriers to progress on carbon pricing reform. Carbon pricing is intended to capture the negative externalities of emissions, but these are inherently difficult to identify and near-impossible to quantify. The issue is also a political one. While higher prices are needed to incentivise change, they also risk damaging the competitiveness of domestic industries in the short-to-medium run. Governments sensitive to potential economic losses or unemployment will be reluctant to enact polices that risk spiking up the carbon price.

Based on the current futures curves for power, gas and coal, the EUAs would have to be priced at around EUR20.0/mt to incentivise coal to gas switching in 2020. The EUA futures curves currently puts prices at around EUR7.6/mt that year. While the futures curve may be a poor predictor of the future price of emissions allowances, it is strongly indicative of the scale and persistence of the oversupply in the market. It is, in our view, unlikely that the phase four reforms will be sufficient to incentivise wide-scale coal to gas switching and to more aggressively drive up the share of gas in Europe's thermal generation mix.

This is one of the reasons behind our comparatively reserved outlook on gas demand growth in Western Europe. We forecast demand across the region to increase by 32.7bcm by 2026, representing growth of just 7.8% over the 10-year period, less than 1.0% a year.

Demand Struggling To Recover
European Gas Demand, bcm
N.B. Emerging Europe includes Russia and the Caspian. f = BMI forecast. Source: BMI, EIA