Carbon decouples from gas market dynamics

Christopher Rene


LONDON (ICIS)–The relationship between the European carbon and natural gas markets has weakened further going into the fourth quarter while coal-to-gas fuel switching incentives remain at extremely low levels.

Carbon market dynamics have oscillated between policy- and gas market-driven moves since the end of the summer with long-term climate strategies at the forefront of traders’ minds in recent weeks.


The German front-month baseload fuel-switching costs, the theoretical EUA price required to trigger a switch from coal to gas, has seen monthly averages range between -€16.9/tCO2e and €247.44/tCO2e since the start of 2020. The month-to-date average is €250.41/tCO2e.

In contrast, monthly average EUA benchmark values have ranged between €19.69/tCO2e and €61.31/tCO2e, with prices slipping below the front-month fuel-switching value since July. The month-to-date average is €63.81/tCO2e.

A long-term uptrend in gas prices has seen coal-to-gas switching incentives transition from multi-year highs to multi-year lows in 2020-2021.

The month-to-date average for ICIS TTF front-month stood at €80.01/MWh on 23 November, 152% higher than January’s average last year.

The explosive gains have been driven by prolonged market tightness with low LNG arrivals a key factor alongside depleted natural gas stocks following the previous cold winter, Russian gas supply uncertainty, and post-pandemic economic recovery.

Consequently, fuel switching costs from an average coal (39% efficiency) to gas-fired power plant (50% efficiency) skyrocketed to €300/t CO2e by 5 October.

By 10 September, even the most efficient gas-fired power plants at 60% efficiency had worse margins for the front-month contracts than a coal power plant at 33% efficiency. For the front-year contract, which is highly relevant for utilities’ hedging, this point was reached by 27 October.

As coal-fired generation became significantly more profitable than its gas-fired counterpart, this had a bullish effect on EUAs, because power producers must adjust the EUA hedge for their higher-emission expectation.

ENTSO-E data indicates that year-on-year power sector emissions by 21 November where about 11% higher compared with 2020 – with the gap to widen further in winter. ICIS Carbon Analytics expects 2022 EU ETS power sector emissions to be about 20% above 2020 levels (excluding 2020 emissions for the UK).

However, the decoupling of carbon and gas prices since September indicates that high emissions in 2021 and 2022 are already accounted for by power producers.


The gas market crunch, and the subsequent boost to power sector emissions amid higher coal-fired output, will force EU ETS power generators to surrender more allowances than previously expected.

However, ongoing developments regarding the revision of the EU ETS and the broader climate strategy for Europe mean that carbon price volatility is elevated beyond the impact of gas market dynamics.

The carbon market is currently running a surplus, with participants holding a calculated oversupply of about 1.5bn allowances of which according to ICIS estimates at least 90% is in the hands of compliance players in the EU ETS via both hedges, speculation, and historically banked volume from previous allocations.

However, the EU ETS’ Market Stability Reserve (MSR) is designed to bring down this oversupply to 833m within the next years by reducing EUA auction volumes.

This leads to a situation where new EUA supply (via auctions and allocation) in 2021-2023 will be lower than predicted emissions across that period.

Rising emissions amid low coal-to-gas fuel switching incentives should erode this surplus at a quicker pace. At the same time this will most likely lead to reduced MSR application in later years. The carbon price upside risk is therefore concentrated in 2021 and 2022.

The ongoing EU ETS reform and discussions about EU’s 2030 climate strategy (“Fit for 55”) present another bullish risk for EU compliance players as it leads to higher market uncertainty and greater difficulty in knowing when to hold EUAs, use them for their own compliance or sell them.

Wide-ranging long-term price expectations highlight the scale of this challenge. ICIS Analytics sees a very broad scenario range of €83/tCO2e – €150/tCO2e by 2030 depending on the conclusions of the EU ETS revision process and strength of political ambition with the base case reaching €90/tCO2e.

Most recently the ICE EUA Dec ‘21 hit new highs, surpassing the €70/tCO2e threshold in the process, amid post-COP26 conference optimism , the European Securities and Markets Authority (ESMA) investigation into speculation in the EUA and derivatives market, as well as technical support.

The policy process is expected to gain traction early next year with EU parliamentary groups and EU member states currently forming their positions.


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