Fuel switching and carbon prices: when gas displaces coal in the generation stack

How the carbon market works

As carbon prices rise, so do the costs of carbon-emitting energy generation. Coal plants emit a lot more carbon dioxide compared to gas-fired plants, so when carbon prices increase, coal prices skyrocket. The operations of gas-fired plants also increase, but less so, meaning that the more expensive coal-fired plants get pushed up the merit order and are last to be dispatched. When these two types of fuel are switched, this is known as fuel switching.

Overview of the EU ETS

The EU Emissions Trading System (EU ETS) is a carbon market that sets a price on carbon emissions, allowing power producers to buy carbon allowances to meet carbon reduction goals.

Allowance supply and demand dynamics

Fuel switching helps to reduce carbon emissions, which then eases reliance and therefore demand on allowances, which can reduce the price. However, the opposite is also true: when gas prices dip, coal is switched to as a preference, which means demand for carbon allowances rises. An increase in demand is also driven by factors such as regulatory changes and the overall fuel mix, whereas regulatory caps tend to reduce reliance on allowances.

How carbon costs affect the generation stack 

As electricity costs vary, carbon prices can directly affect volatility, particularly when coal plants operate at as low as 33% efficiency. When carbon prices are very high, coal plants can’t continue to run, and either have to shut down or peak generation. This shifts coal to the top of the merit order. Gas then becomes the more favoured energy source in the generation stack.

Emission intensity of coal vs gas

Because coal produces higher levels of carbon emissions than natural gas, it becomes the cleaner source with fewer requirements for carbon allowances, which penalises coal. A good example of this is the US, which has seen a huge increase in cheaper shale gas, moving the energy industry away from coal. The carbon-adjusted marginal cost is a calculation we use to determine whether the cost of a fuel source should be increased or decreased by a marginal cost. This is the overall variable cost of power generation, including operating, maintenance, EUAs and fuel costs.

Transmission into wholesale electricity prices 

Wholesale electricity prices are greatly influenced by the behaviour and pricing of fossil fuels and so when coal and gas prices increase due to carbon prices, it’s directly transmitted to wholesale prices. This affects the marginal plant-level pricing of energy sources. Carbon pass-through mechanisms are designed to allow power producers to pass on costs associated with carbon to wholesale energy prices, which the consumer may end up paying. This can make coal a less attractive option than renewable sources as carbon prices rise.

Regional differences across Europe

Different regions experience the effects of fuel switching, depending on factors such as the type of fuel mix in that region, as well as its dependency on coal. For example, the UK introduced a higher-than-average carbon price floor, which penalised coal, causing an increase in gas-fired plants taking the lead in marginal price setting. Italy and Spain are gas-heavy, meaning gas price increases have a great impact on energy prices.  

Generation mix differences

Germany, however, relies on a combination of renewables and coal, meaning that when it has to revert to secure coal sources during renewable shortages, price increases can be expected when carbon prices are high.

Fuel dependency variations

Europe is one of the most volatile regions in relation to fuel switching, which can mean a reliance on coal when gas is at an all-time high, compared to the USA, which relies more heavily on shale gas, signalling a real shift away from coal altogether. As renewable energy increases, however, we expect to see gas eradicated from the energy mix altogether.

Trading and risk implications 

Fuel switching can narrow the gap between the gas and electricity sectors, potentially increasing volatility for traders to contend with. Hedging by investing in carbon to avoid impending price shocks is one strategy for traders to utilise to manage risk.

Hedging carbon exposure

Hedging in a fuel-switching environment is a delicate balance: gas EUAs and electricity need to be risk-managed closely, which increases hedging costs.

Spread trading strategies

Some traders will opt for spread trading, which allows them to manage risk by selecting spreads that factor in carbon costs early on. The two types that apply to the gas and coal industry are Clean Spark Spreads (CSS) that apply to the profit margin of gas plants, which traders will go long on in the instance of coal or gas prices falling and Clean Dark Spread (CDS) that apply to the profit margin of coal plants, which traders will go short on.