Carbon policy and electricity prices: how regulation reshapes generation economics

How the carbon market works

To reach decarbonisation goals, governments set caps on carbon emissions from certain heavy-polluting sectors, such as manufacturing and power generation. They receive allowances equalling one per one tonne of carbon that can be sold to other businesses for profit. When permits are restricted, the price of those allowances rises, encouraging the use of cheaper renewable energy. 

Overview of the EU ETS

The European Union Emissions Trading System (EU ETS) places a price on carbon emissions in power production. When the cap on allowances is reduced due to evolving carbon policy, fossil fuel costs rise, reshaping generation economics by pushing wholesale electricity prices in favour of renewables.

Allowance supply and demand dynamics

Generation economics are reshaped by making fossil fuels more expensive and renewables cheaper, encouraging a larger movement towards renewables. When fewer allowances are available, demand from power producers can be higher, sometimes leading them to request borrowing forward allowances from future yearly allowances. When regulators restrict allowances, supply is squeezed, potentially reducing carbon emissions as more expensive fossil fuels become scarce.

How carbon costs affect the generation stack

The effect a heavy carbon-emitting industry can have on the environment is reshaping generation economics through regulatory decisions that apply a price to the environmental damage caused. As the cost of fossil fuels increases, the generational stack shifts. As a result, carbon-intensive energy sources are utilised less and renewables are utilised more.

Emission intensity of coal vs gas.

Carbon policy and regulation reshape electricity generation by making coal’s marginal cost increase, pushing it above cleaner gas-fired plants in terms of cost. Coal produces more carbon emissions than gas and so producers need to purchase more carbon allowances to cover the higher emission intensity.

Carbon-adjusted marginal cost

The marginal-adjusted cost of power plants varies with how regulations shape carbon pricing, as higher carbon pricing increases operating costs. The merit order then changes, pushing coal and gas to the back of the queue for deployment. This usually makes coal the least competitive energy source.

Transmission into wholesale electricity prices

Factors such as Carbon Price Floors (CPF) and Emissions Trading Systems (ETS) reshape generation economics by increasing the marginal costs of fossil fuel producers. The effects of these carbon policies eventually reach wholesale energy prices, which can set the clearing price.

Marginal plant price setting

The lowest-cost plant called on to fulfil demand is what’s known as the marginal plant. Because gas emits around half the carbon emissions, it's often the marginal plant, whose price is set to reflect marginal cost, which impacts the entire wholesale energy market. 

Carbon pass-through mechanisms

Carbon pass-through mechanisms are policies designed to allow power producers to pass on carbon costs to the wholesale market. In regions such as the UK, which are highly reliant on gas-fired plants because of high regulatory penalties on coal, carbon policies have aimed to decarbonise, but in reality, regulatory decisions have led to very high wholesale energy prices.

Regional differences across Europe

With ‘polluter pay’ making high-emission energy sources less desirable, Europe has made inroads towards cleaner energy sources.

The EU Emissions Trading System (EU ETS) is one of the driving forces behind Europe’s carbon policy.

Generation mix differences

Carbon pricing has affected regions differently in regard to how they consume energy. Increases in carbon prices are felt most in Northern and Western Europe, with coal-reliant Germany particularly vulnerable to policy decisions that have raised the overall cost of coal. However, Scandinavia has benefited greatly from policies that have bolstered decarbonisation thanks to its investment in renewables. In Spain and Italy, which are heavily reliant on gas, policies that have raised gas prices have led consumers to absorb a significant share of carbon pricing costs through carbon pass-through.

Fuel dependency variations

France depends more on nuclear energy than other sources of energy, which has meant less carbon pricing on this cleaner form of energy, resulting in lower energy pricing. However, Poland mostly relies on coal, which has caused rising costs due to the effect of EU ETS policies.

Trading and risk implications

Carbon must now be viewed as a commodity, much like coal or gas itself. This requires hedging carbon exposure to avoid price hikes when carbon allowances become scarce and more costly to avoid a stranded asset risk; when an asset becomes too costly to run due to regulatory constraints.

Traders will also need to look at spread trading strategies to keep on top of carbon-pricing-related movements and capitalise on them rather than be penalised by these risks. Two key methods are Clean Spark and Dark Spread Trading, which examine the profit margins of coal and gas-fired plants and require traders to sell energy futures at the same time as purchasing allowances and fuel. Hedging comes into play when when carbon prices increase much quicker than energy prices. Fuel switching is another form of spread trading, which allows traders to profit from price differences between gas and coal plants, exploiting the conditions when coal is the most expensive.