Analysis: How would soaring carbon costs impact gas demand?
As analysts forecast a sharp rise in the price of carbon emission allowances towards the end of the year, the question is how this might impact on gas demand from British power producers with flexible generation portfolios.
Britain and Spain are the two sole countries in Europe with potential for significant fuel switching in the power sector. These are the only two countries possessing big enough fleets of both gas-fired and coal-fired plants for generators to be able to respond to shifts in dark and spark spreads (the profit made by burning coal and gas respectively in order to produce power). Investment bank Deutsche Bank estimates Britain could avoid around 40 million tonnes of carbon emissions each year by maximising gas-fired production instead of coal – but current EUA prices are not giving the market the right signals to do this.
Gas-fired profits catching up with coal
At present, British generators make almost twice as much selling power from coal-fired plants than they do from selling power from gas-fired plants with delivery in 2009. This is because NBP front summer gas prices have shot up much faster than ARA coal prices. Since the start of the year, ARA Summer ’09 coal has risen by around 40% in value, compared with more than 150% for NBP Summer ’09 gas. Front summer prices for CIF ARA coal are now quoted at just below $190/tonne (EUR 128/tonne).
During August, the clean spark spread – which takes into account the cost of carbon – have been stable around £10-11/MWh, up around 30% from the start of the year. Clearly, profit margins from British gas-fired generation are rising. The problem is that margins from coal-fired generation are rising at a faster pace, up more than 80% for Summer ‘09 since the year started.
The UK Summer ’09 clean dark spread currently stands at £16.95/MWh, compared with a clean spark spread of £10.28/MWh for the same period. The relative attractiveness of burning coal rather than gas has been increasing for most of the first half of 2008, with the clean dark spread rising from a premium of, on average, around £2.00/MWh in January, to around £10.00/MWh in May, June and July (see graph).
Carbon prices would have to more than double from their current levels in the over-the-counter market before it would become more profitable for power generators to burn gas instead of coal to generate power under prevailing market conditions.
According to ICIS Heren data on clean dark and spark spreads, power generators would make £4.72/MWh burning gas and £4.23/MWh burning coal at current fossil fuel prices, if the cost of carbon rose to EUR 40.00/tCO2e.
Carbon price hikes forecast
Some carbon analysts say EUA Futures are likely to do that. Deutsche Bank and Société Générale forecast that EUA prices will recover from a current slump of around EUR 20.00/tCO2e to around EUR 30.00/tCO2e or even 40.00/tCO2e by the end of the year for the most liquid carbon contract, EUA Futures with maturity on 1st December 2008 (EUA Dec’ 08). This should in turn drive up prices for the next year, EUA Dec ’09, by a similar percentage, as an EUA can be used for compliance at any time during the current emissions trading phase (2008-2012), or even the next (2013-2020).
What would be the reason for carbon prices to shoot up to that extent? In a recent report, Deutsche Bank suggested that large utilities obliged to surrender EUAs for compliance purposes might just not have started buying all they need yet.
After all, most power generators received up to 75% of their allocation of emission allowances for free. If the carbon market behaved rationally, this would not matter, since released data on actual emissions implies the British power sector would definitely suffer a shortfall of allowances over the trading period.
But while these free allowances are to hand, will utilities actually come to the market to buy their future shortfall? Deutsche Bank says power generators’ internal hedging systems simply fail to flag up the need to buy emissions allowances, since most have started the new trading phase in an EUA long position. Sooner or later, this would have to change. However, recently published results from Centrica and Drax show that carbon costs have soared at both companies, indicating they are already actively sourcing emissions allowances in the market. And some traders say they struggle to see bullish fundamentals for the carbon market, apart from policy – which is not yet finalised. EUR 40.00/tCO2e was described as “over-cooked” by some.
Coal the new price setter for electricity?
Meanwhile, Coal supply has been kept tight by varios problems in South African and in Russia, while demand from China is pushing freight rates up. Demand is growing rapidly in both India and China, with Far East suppliers struggling to keep up. Analysts from investment bank Citigroup now say coal could become the fuel determining British power prices, not gas. “With international coal prices seemingly holding up better than oil, there is the prospect of further contractions in the dark spread,” the Citigroup analyst said. “Should the spark spread cross with the dark spread, then the UK’s generation merit order would flip over, with coal going to the margin and becoming the price setter for electricity.”
Other Related Stories