How carbon prices shape power markets

The carbon cost mechanism affects generators by making their energy either cheaper (if renewable) or more costly (if fossil fuels), which is how carbon prices translate into wholesale electricity prices.

The role of carbon pricing in electricity generation

Carbon pricing is modelled on several different trading systems. We take a look at different variations and their effect on electric generation. 

• Define emissions trading systems (ETS): cap-and-trade introduces a cap that limits how much carbon a company can emit; it allocates a set number of allowances for carbon production, then trades on a carbon market. 

• Historical context: the EU ETS (Emissions Trading System) was launched in 2005 and aimed to reduce greenhouse gases emitted by 62% by 2030. The UK's divergence from the EU ETS, with different targets, carbon pricing and sectors, is emerging in line with British policies. 

• Covered sectors, compliance cycles, penalties: the industries included in emissions trading systems tend to be high emitters, such as manufacturing, aviation, and maritime. From 2027, ETS will evolve into ETS2, which will also include road transport, fuels and buildings. Reporting and submission are hacked by a third party annually, with penalties in the EU ETS starting at €100 per excess tonne of carbon emissions.

How emissions costs influence the merit order

Carbon emissions directly influence emission certificates to cover excess emissions. 

Add carbon cost per tonne to plant marginal cost (€/MWh)

A calculation is used to determine the cost per tonne added to a plant's marginal cost. The carbon costing per MWh is multiplied by the carbon price to obtain the emissions intensity. This number is then converted from tonnes to kg by dividing by 1,000, and it is added to fuel and variable operations and maintenance costs to find the updated marginal cost.

Clean spark and clean dark spreads explained

Clean spark and clean dark spreads are used to calculate the profit margins of fossil fuel plants. Clean Spark Spread (CSS) takes into account carbon emission allowances and the cost of the raw material used to fire a gas plant: gas. Clean Dark Spread (CDS) accounts for carbon-emission allowances and the cost of the raw material used to fire a coal plant: coal.

How rising carbon prices push coal out of the merit order

These CDS metrics measuring the effect of carbon prices can push coal out of the merit order because coal plants become no longer a commercially viable source of energy, pushing them down the merit order ranking. This makes lower-emissions plants more desirable, as they rank higher in the merit order as cheaper fuel sources.

Carbon cost pass-through to wholesale power prices

The extra cost must be accounted for somewhere.

How much of the carbon price is passed through

But how does carbon pricing go on to affect consumers of energy? Pass-through refers to how the carbon price affects consumers: if the carbon price rises, how much of that increase is 'passed through' to consumers. Usually, a full pass-through of pricing to energy consumers does not occur, and many sectors absorb the cost to remain competitive. 

Regional differences

Depending on the location of the fuel sources, the fuel mix may vary regionally. For example, in countries with abundant wind, wind energy may tilt their energy mix. In contrast, others may lean heavily on coal or oil because those resources naturally occur in those regions. Interconnection can also be affected by location; for example, in Central or Eastern Europe, there are fewer sophisticated interconnected networks, meaning the energy choices for those regions are smaller than in Western Europe. Policy can also vary region to region, with differing levels of renewable support and incentives available, as well as variation in government-supported infrastructure roll-out.

Market behaviour: hedging, abatement, and switching

Generators hedge EUA exposure through forward contracts, which allow market participants to lock in a future price. Industrial and power sector abatement responses have so far included low-carbon fuels such as hydrogen, as well as carbon capture, utilisation, and storage (CCUS), offering carbon reduction solutions for hard-to-abate industries. Switching triggers may cause the market to switch to a favoured fuel method, depending on the coal vs. gas breakeven, which compares the price of coal to natural gas and the cost of greenhouse gases. Depending on which is cheaper at that time, gas or coal may be in favour. 

Future outlook for carbon and power price interaction

Carbon costs are now a core component of power prices, impacting dispatch, investment, and decarbonisation alike. The Fit for 55 initiative in Europe aims to reduce carbon emissions by 55% by 2030, with the  Carbon Border Adjustment Mechanism (CBAM) being a crucial part of this package. CBAM combats' carbon leakage', which prevents companies from operating the heavy carbon emissions elements of their businesses in countries with less strict carbon reduction targets. It does so by applying a carbon price to imports entering countries with higher carbon-emission reduction targets.