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Carbon pricing in Europe: a new game for analysts and governments

Library of Congress

The European emission trading scheme for carbon emissions was designed in the early 2000´s and has been around for years. It is a unique tool, the world’s first carbon pricing system. Moreover, it is the EU´s premier tool to incentivize a shift from fossil to renewable energy. It is an extremely important tool, almost everyone with insights in how to design effective incentives for reduction of CO2 keeps pushing for an increased carbon emission cost. 

Unfortunately the ETS system has had very little success as an investment influencer. The price for the ETS allowances has simply been very low with insignificant impact in comparison with e.g. the global price volatility of oil and gas. Why care about single digit cost impact when there is double digit impact caused by other far more important factors? But now, maybe, the ETS system seems to have taken a few steps towards being the real investment incentive it was designed to be. The ETS allowance price has gone up, up and up for two years. Two weeks ago it hit the level of EUR 30/t, which should be compared with EUR 8 in the beginning of 2018. That´s quite an increase. But why is this?

This price development is partly caused by the EU reforming the system (after realizing it did not work as an investment incentivizer) and introducing a market stability reserve in order to cut surplus allowances. There are more reforms coming up. From 2021 and onwards, the number of ETS value will decrease with 2,2% per year inevitably leading to a price increase. Moreover, the final price gain happened following German environment minister Svenja Schulze announced that her department will back a recommendation to cancel a proportional share of ETS allowances to offset the reduction in demand following Germany´s closing of coal and lignite fired power plants. Clearly this German measure can’t be described as anything else than a political market intervention to boost the carbon price. As such it is an extremely interesting phenomena. Individual European governments can obviously ensure a certain floor level for the ETS price or even push for an increased price of carbon emissions in general without having to through the tedious process of achieving reforms by agreeing with everyone else in the commission and parliament. Will we see the governments of e.g. France, Denmark, Sweden and the Netherlands follow suit and abolish ETS allowances?

Clearly this German measure can’t be described as anything else than a political market intervention to boost the carbon price.

Another interesting thing: despite knowing about both the political ambitions of Germany as well as the structural reforms of the ETS system, carbon market analysts have been shooting far too wide at the target when forecasting the ETS allowance price. The leading analysts a few years ago predicted the 2019 ETS allowance price to be around 8-10 EUR/ton. Now it´s three times as high! Such unexpected price development may be good stuff for hot headlines and articles. But there is a backside to it. This bearish forecasting causes a major problem. It erodes the function of the ETS as a climate policy tool by effectively limiting the capital being invested in renewables. Why is that? Well, as utilities and industries evaluate their investments in new energy they will want to understand the long-term price scenarios- including the values of the ETS allowances. They then turn to the expert analysts for advice. If such analysis indicates the ETS allowance value to remain low then the bottom line of the investment calculation scenarios will indicate high ROI for fossils and low ROI for renewables. Guess which ones will be realized? Not only are investments in renewables not being realized. It is painful to correct such decisions afterwards. Remember, this is the capital-intensive energy industry. Investments are long-term and plant installations are assets that are supposed to be there for decades. Reversing an erroneous investment decision is almost impossible.

This bearish forecasting causes a major problem. It erodes the function of the ETS as a climate policy tool by effectively limiting the capital being invested in renewables.

I am not saying it is easy to predict the energy market, but how many thousand tons of CO2 emissions would have been avoided if the leading carbon analysts had done better in 2015-2017?

But let´s look forward. Obviously the Germans are committed to having an ETS system that really matters. The question for the future is where this will take us. Last year oil giant Shell concluded that the world needs a carbon price of 50 USD/t by 2030 (and close to 100 USD/t by 2040) if the Paris Agreement goals are to be met. Such carbon price levels completely changes the economics of any renewable vs fossil investment decision. Has the stellar development of the ETS allowance price in the last two years been the first promising steps to the right level?

 

Niclas Davidsson's picture

Thank Niclas for the Post!

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Matt Chester's picture
Matt Chester on Aug 16, 2019 12:35 pm GMT

I am not saying it is easy to predict the energy market, but how many thousand tons of CO2 emissions would have been avoided if the leading carbon analysts had done better in 2015-2017?

This is one of many 'what ifs' in the energy and climate arenas-- which is why looking critically at forecasting and predictions is important and not a haphazard exercise

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