Carbon prices and power markets: understanding the coupling mechanism

Carbon pricing can have substantial trading and risk implications, therefore it’s crucial that traders understand how carbon prices interact with electricity markets and influence power price formation. It’s also key for power traders, portfolio managers, analysts and energy economists to understand vital cross-commodity trading signals. We'll touch on this in the following article, as well as explain how carbon prices are transmitted into power markets and provide actionable insights for traders.

How the carbon market works

Cap-and-trade schemes allow decarbonisation goals to be met by creating allowances that can be traded between companies that need to lower their overall emissions and those that produce excess carbon credits. The EU Emissions Trading System (EU ETS) limits the number of carbon credits through a cap that shrinks each year. Demand for these credits is motivated by fuel switching and demand power generation preferences.

Allowance supply and demand dynamics

These caps that shrink annually create a scarcity of allowances, for example, in 2024-2027 the EU ETS reduced by 4.3% thanks to regulatory factors. Higher demand for fossil fuels drives greater demand for carbon allowances, as green alternatives are much more expensive at that time. Operational costs increase when free allocation is switched to auctioned allocations, which increases compliance costs, making carbon prices increase in line with increased demand for allowances in auctions.

How carbon costs affect the generation stack

When carbon pricing increases, fossil fuels become less competitive with renewable sources, making natural gas a much more affordable alternative.

Emission intensity of coal vs gas

Because gas and coal are non-renewable, carbon-intensive sources of energy, carbon pricing is more expensive for these types of sources. While gas tends to emit less carbon than coal-fired sources, it also depends how efficient and modern a power plant is to determine how much a plant will get penalised by carbon pricing.

Carbon-adjusted marginal cost

Carbon-adjusted marginal cost is the cost of carbon dude to fuel costs. So, for example, high carbon pricing can result in lower profit for a power generator because they experience a higher cost when carbon pricing increases, while a renewable energy alternative will remain unaffected.

Transmission into wholesale electricity prices

Wholesale prices and carbon pricing are closely entwined, with areas that rely heavily on fossil fuel markets driven heavily by this relationship. When carbon prices increase, the operational costs of a fossil fuel plant also increase. This in turn increases the supply curve, or merit order. When coal becomes more expensive than gas to consume, it changes the marginal plant. This marginal plant price setting, also known as uniform price setting, ranks plants from the cheapest to the last, most expensive plant required to meet demand levels, which is usually a coal plant.

Carbon pass-through mechanisms allow power producers to envelope costs associated with carbon allowances into energy offers. This can range from high pass-through rates, e.g. 100%, to incomplete pass-throughs which don’t include all of the carbon allowance costs. An incomplete pass-through occurs when government regulations prevent all of the costs from being put on the consumer. Opportunity costs allow generators to include the profit they may have made from selling and an allowance on it instead of using it, even if that allowance was free.

Regional differences across Europe

On the European wholesale market, a marginal pricing mechanism couples European energy markets and carbon pricing. The most expensive source sets the price for all energy producers. Factors that can affect this coupling include the mix of energy types, timing and fuel dependency.

Generation mix differences

Different markets experience different coping relationships for example, in the UK, the region operates its own UK ETS, distancing it in price from the EU ETS. It's highly sensitive to regulatory policies thanks to a Carbon Price Support (CPS) tax. Northwest and central Europe rely heavily on coal, which means they’re subject to price increases driven by rising carbon prices, whereas the Nordics utilise hydropower, which is renewable, so they are less affected by wholesale price changes.

Fuel dependency variations

The coupling mechanism relies on the relationships among gas, coal, and carbon prices. In the UK, Spain and Italy, natural gas prices have the biggest influence on marginal pricing. However, if these prices become too high, many will switch to cheaper coal sources, which increases carbon emissions and in turn, the price of carbon. High prices in one country can also affect entry prices in a neighbouring country.

Trading and risk implications

Carbon coupling is key to decarbonisation, but its complexity requires sophisticated approaches to trading to succeed. Energy prices are closely tied to carbon price volatility, which can prompt traders to use targeted strategies, such as hedging carbon exposure or incorporating spread trading.

Hedging aims to mitigate the risk of trading in this environment by hedging exposure to rising costs, forward hedging, dynamic hedging, or using hedging tools such as forwards or options to fix emission allowance costs.

Spread trading strategies to consider might include clean spark spread, utilising the profit margins of gas-fired plants, or spray spread trading, which focuses on locking in a margin on a power sale. Fuel switching is another trading strategy that exploits the spread between clean spark and clean dark.