Triggering a fuel switch with the EUA price
The role of emissions certificates in Germany's energy sector has evolved over recent years. Initially, emissions certificates held little sway over fuel choices.
However, with CCGT turbines sometimes generating cheaper electricity than coal, the regulatory goals are beginning to take effect. Still, a permanent increase in the European Union Allowance (EUA) price is essential to achieve a long-term shift away from coal.
How does the EUA influence the fuel mix?
The EU certificate system was introduced in 2005 to achieve climate targets. Despite several reforms, the desired effect of a lower-emission electricity supply did not materialise until 2021, as the price of the certificates remained almost constantly below €30/t CO2. This changed with the price rally to a bit over €100/t CO2. However, the external shock with the result of faster increasing gas prices compared to the coal prices prevented the fuel switch. In the meantime, EUA prices and commodity prices have fallen again, and the effects of the external shock have been overcome. Regardless of past and future external shocks, the EU's long-term goal of decarbonisation remains. This will only be achievable if the fuel mix of the power plant fleet contains a larger proportion of lower-emission technologies. It is therefore time to reassess the situation.
With the market stability reserve, the EU has created an instrument to control the quantity of permits to have a more flexible way of influencing the price of CO2 allowances alongside the other mechanisms. This has proved particularly useful during the pandemic, demand for allowances fell due to lower economic activity and the surplus supply was held back in the reserve to be made available to the market again at a later date. This ensured a certain degree of price stability. Now that the economic situation has stabilised again, this instrument can be used to carry out the fuel switch; the following model explains how this works.
Impact of European Union Allowance (EUA) on Levelised Cost of Energy (LCOE) - a static sample calculation
To illustrate the impact of EUAs on LCOE , the electricity generation costs of fossil fuels were calculated as a function of the price of the front year, the nearest future calendar year contract available, of the respective fuels and the CO2 price. The market under
consideration is the German market. The graph shows the power generation costs as a function of the certificate price. The different gradients in the curves result on the one hand from the higher efficiency of CCGT turbines and on the other through the more efficient emission factors. While the share of CO2 certificate costs in the respective LCOE is 90% for lignite and 60% for hard coal, it is only 25% for CCGT turbines. This puts CCGT turbines in direct competition with coal-fired power plants at the current price level. At the current market situation, hard coal fired power plants are slightly cheaper with 91.7 €/MWh than CCGT power plants with 92.3 €/MWh only lignite-fired power plants are slightly cheaper with 81 €/MWh. If the price of EUA constantly rises above 70 €/t CO2, CCGTs are more favourable and would push coal-fired power plants out of the market.
Figure 1 - LCOE's of different power plant types as a function of the EUA price:
Discrepancies between modelled and actual fuel switch patterns due to market dynamics and procurement strategies
The next step in the analysis is to take a look at the historical development of LCOEs resulting from the model described above. The calculation was done from Q3 2019 until today. Considering the daily settlement prices of the relevant commodities and the EUA price. The respective modelled marginal costs of hard coal power plants and Combined Cycle Gas Turbine (CCGT) power plants are plotted in the graph below. The timeframe to be observed is the end of 2020 to mid-2022, in which coal had significantly higher LCOE’s than CCGTs. This was mainly driven by the increasing EUA price and the lagged price increase of coal respective to gas. If we compare this with the actual generation of energy, we can’t see the clear pattern of the expected fuel switch in the respective time frame. In 2021, the actual generation from hard coal power plants amounted to 46.7 GWh, compared to 51.8 GWh from gas power plants. In the first two quarters of 2022, hard coal power plants generated 26.2 GWh, while gas power plants produced 24.3 GWh. The numbers of 2022 are supporting the thesis, but the numbers of 2021 are contradicting the theory explained. First of all, we can’t distinguish between the generation of gas power plants and CCGT power plants in the data, but this doesn’t explain the contradiction. Two reasons can explain it. The first reason is the market situation at the time, the rapidly increasing power price and the power price volatility made power plants overall more profitable. The second more important reason is the procurement strategy of power plants. They always plan years ahead and are securing their commodity and EUA prices years in advance, so the above modelled LCOE’s aren’t modelling the real LCOE’s of the respective power plant type at that specific time point, because every procurement strategy is a bit different, and prices are secured to different times.
Figure 2: Calculated LCOEs in recent years using the model described above:
Permanent EUA Price Increase: Key to Long-Term Fuel Switch
The question is what needs to happen to trigger a fuel switch with a EUA price increase. To do that the EUA price has to be increased substantially resulting in higher LCOE’s of hard coal power plants than the ones of CCGT power plants and not only that, but it also must be done over at least three to five years. Otherwise, the procurement strategy of the power plant owners can use favourable market situations to secure production. Overall, it remains a complex task for the EU, because a forced increase in the EUA prices is affecting more industries than the energy sector. For market participant it is relevant to study the long-term strategy of the EU regarding CO2 reduction. A smart way to do this is to investigate long term power price simulations and scenarios. In good modelling, the planned EU policy is translated into a time series which, together with the forecast commodity prices, provide a reliable basis for the timing of the fuel switch.
A sustainable fuel switch in Germany’s energy sector hinges on a substantial, prolonged increase in EUA prices. This shift requires careful consideration of market dynamics, long-term procurement strategies, and EU policies on decarbonisation. Effective modelling and scenario planning can help stakeholders understand and prepare for the impacts of rising EUA costs on future fuel choices.
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