(The author is a Reuters market analyst. The views expressed are his own.)
By Gerard Wynn
LONDON Oct 9 A new British carbon price floor may increase gas demand as rapid price rises eat into profits from burning coal, but the impact on power prices could affect political will to implement the policy.
Margins from coal-fired power generation are currently far more attractive than gas, reflecting the relative price of the two fossil fuels and a very low European carbon price. The result is a tilt towards burning coal in Europe.
Britain introduces its carbon price floor (CPF) next April, with the aim of providing certainty for low-carbon investment through a clear schedule of rising carbon prices, which will favour nuclear and renewable energy as well as gas.
This is intended to counter the volatility and recent collapse in the price of EU allowances (EUAs).
It works by topping up the EUA price where this falls below the CPF price target. This is implemented with a tax on gas and coal purchases by power plants.
Chart 1 shows how the CPF is intended to rise in a straight line from 15.70 pounds (19.45 euros) per tonne of CO2 emissions in 2013 to 30 pounds in 2020.
These numbers have to be adjusted for inflation, however, showing a much faster rise from 19 pounds in 2013 to about 43 pounds in 2020, assuming an inflation rate of between 3 percent and 4 percent.
That implies a near trebling of carbon prices in Britain next year, compared with a 2013 EUA forward contract of about 8 euros.
The rapid rise in the British carbon price implies an increasing carbon cost on power generators, which will make gas increasingly competitive, potentially driving demand higher.
CARBON PRICE IMPACT
Britain's finance ministry calculates the CPF tax as the required level to top up the EUA price to the desired British carbon floor price.
The tax starts at 4.94 pounds per tonne of CO2 for the financial year from April 2013, as the government announced in its November 2011 budget.
The tax was calculated as the difference between the nominal CPF target for the financial year 2013/14 and the average traded price for the EUA 2013 contract from March 2010 to February 2011.
Chart 2 shows that European carbon prices have halved since that calculation period.
As a result, without a sharp recovery in EUA prices the tax will be inadequate and Britain's carbon price next year will fall short of the CPF target.
Looking ahead to 2014/15, the CPF inflation-adjusted target is about 19.70 pounds, while the EUA 2014 forward contract traded at an average price of 12.30 pounds from March 2011 to February 2012, Thomson Reuters data show.
As a result, the UK treasury should announce next month a tax in the financial year 2014/15 that takes the difference between these two, at about 7.4 pounds per tonne of CO2, a little more than the indicative rate of 7.28 pounds that the government published in 2011, since when EUA prices have fallen sharply.
Assuming that utilities pass on this cost, wholesale power prices would rise by at least 5 percent, potentially decreasing UK competitiveness.
In that context, it is unsurprising that Britain has been more ambitious than any other EU country in calling for the bloc to increase European carbon prices by cancelling surplus EUAs, thereby narrowing the EU-UK differential.
The relative prices of gas and coal at present mean that it is far more profitable to burn the latter.
But as the price of CO2 emissions rises, the relative economics shift in favour of gas, which emits roughly half as much carbon as coal.
The carbon price at which gas becomes competitive with coal is called the fuel switch price.
Chart 3 show the average fuel switch price in Britain falling to about 40 euros per tonne of CO2 over the next five years, but for the most inefficient coal plants it is about half that, according to Point Carbon.
Such analysis suggests that from 2014 or so the British carbon floor price may be high enough to drive switching from the most inefficient coal plants, and that effect will become more widespread as the price rises to more than 40 pounds at the end of the decade, all else being equal.
Britain has a higher potential for fuel switching than many European countries because of a diverse grid that includes gas (40 percent of generation, with 28 gigawatts of installed capacity) and coal (30 percent and 20 gigawatts).
Meanwhile, higher power prices could prompt higher imports of electricity through Britain's 4 gigawatts of interconnector cables from Ireland, France and the Netherlands.
UNCERTAINTY AND CRITICISM
An important caveat to the impact of the CPF is uncertainty over its rollout and criticism that could force the government to scale back implementation, especially beyond 2020.
The government has only assured a price floor out to 2020.
It has suggested a price of 70 pounds per tonne of CO2 in 2030, but that would be contingent on other countries following suit. "This estimate is subject to the progress of international negotiations," the government said in its overview of the policy in March 2011.
The plan appears to have additional uncertainty built in because the top-up is announced at each annual budget, implying that the finance minister may have some discretion in calculating the level.
The CPF, meanwhile, has drawn criticism as a unilateral policy that will raise British wholesale power prices compared with those in Europe, and for a perceived limited environmental benefit.
As a unilateral action within a much wider EU emissions cap, the concern is that those reduced emissions will simply be taken up by higher emissions and greater EUA purchases in the rest of Europe, an effect known as carbon leakage.
As a result, political risk threatening full implementation of the scheme beyond the end of the decade already looks high. (1 British pound = 1.24 euros)
(Editing by David Goodman)