Carbon volatility and power prices: how EUA movements reshape electricity markets

How the carbon market works

The EU ETS features a cap-and-trade model that limits industrial and power-related sectors on the amount of carbon emissions they can emit. This is done via carbon allowances (EUAs), which represent one tonne of carbon and can be bought at auctions or received for free. Companies with excess carbon allowances can be sold to businesses that need to reduce their carbon emissions to meet their reduction targets.

Allowance supply and demand dynamics address how EUA movements reshape the electricity market. As the EU climate targets approach, the total EUA allowance is shrinking annually to remove excess EUAs from the energy market and encourage businesses towards decarbonisation without causing price crashes. Fossil fuel generation combined with industrial output drives demand for EAUs and as renewable energy increases, makes EUAs less vital.

How carbon costs affect the generation stack

High EUA prices equal high fossil fuel prices, meaning that as EUA prices move, so do the prices of gas and coal. By 2026, the generation stack is expected to be affected by these increases, combined with the growth of renewable energy. This change in energy prices due to EUA movement causes a ‘switching’ between different energy sources, depending on which is cheaper to produce. When carbon costs are high, this encourages a switch from coal to gas.

It’s also important to consider the emission intensity of coal vs gas: coal plants tend to emit more carbon, whereas natural gas emits less, which means that when EUA pricing rises, the cost of coal rises more significantly.

We call the combined cost of production of fuel, efficiency and carbon pricing the carbon-adjusted marginal cost. As EUAs tighten up further in the future, we expect the marginal cost of energy to become even more volatile and so we will need to call on flexible energy resources even more crucially than before.

Transmission into wholesale electricity prices

When EUA prices are high, this reshapes market dynamics by increasing the cost of wholesale energy prices, as coal is the most sensitive to EUA rises, making coal the least competitive source of energy.

Marginal plant price setting

This process affects the marginal plant price, the term for the last energy source called on to meet demand. Because renewable energy has increased so much as a source, it is rarely marginal.

Carbon pass-through mechanisms

Carbon pass-through is the scenario where energy producers pass on the cost of carbon pricing to the end market, meaning consumers take on these costs. Some regions don’t allow a full pass-through rate as part of energy regulations. Sharp spikes in carbon pricing also signal a need to invest in storage facilities to avoid passing on those costs to consumers in the future.

Regional differences across Europe

Carbon allowance movement is never linear: EUA volatility can change across different regions. This can be due to regional regulatory differences, technological advancements, grid constraints, or, most crucially, the current and changing energy mix. For example, regarding generational mix differences, in central-western Europe, specifically Germany, there is a reliance on gas and coal, meaning this region is sensitive to EUA-related price spikes. This is also the case in Italy. In Spain, however, EUAs are less relied on, as solar and wind have taken off as key renewable energy sources. The cost of emissions can significantly affect the relationship between enemy and EUA prices, leading to changes in fuel dependency. For example, when EUA prices increase, they affect the pricing of coal-sourced energy, but it can also make it difficult to switch to coal sources when gas prices independently skyrocket.

Trading and risk implications

The carbon allowance scheme is a complex mechanism that requires experienced traders to navigate the content changes and their effect on the energy market.

Spread trading strategies

It's not just risk that both power producers and traders must navigate; it's also regulatory risks that occur in a market where the goalposts for EUA legislation are constantly changing. In 2026, EUA prices will be determined by new regulatory changes.

EUAs can cause volatility in spot prices, with notable differences between longer-term forward contracts and shorter-term spot electricity prices. This means looking at future hedging strategies from a slightly different angle.

 Hedging carbon exposure

Carbon pricing can affect the cost of compliance for suppliers and power producers in a volatile market, so traders will have to incorporate these extra costs into their future trade decisions. Dedicated forecasting tools can help traders predict the effects of movements in EAUs on the market, with modelling software one of the best tools in a trader's arsenal for managing volatility.