First published in June 2021 by ABHA Foundation (https://www.abhafoundation.org/)
Carbon pricing gains traction
Around the world, climate change policies are tightening, and carbon pricing [JS1] is playing a big part of that. Once carbon pricing systems are in place, countries can apply pressure to emitters at will – representing the stick part of any energy transition policy, alongside the carrot of possible subsidies and guarantees for cleaner options. New carbon markets have recently been introduced in China, the UK and elsewhere, while prices on the well-established European market have surged as credits are reduced and countries toughen climate change commitments. As prices rise, lower carbon options become more commercially attractive as high emitters incur additional costs.
After testing carbon credit trading at regional level since 2011, China launched a nationwide carbon market for its power sector on February 1st – although initial allocations are free, with prices only expected to be introduced slowly and cautiously to protect investors in the coal sector (by late July, prices were around $7-8/t – Ed). The move is part of China’s efforts to reach net-zero emissions by 2060, and expected to cover over 4 billion tons of greenhouse gas emissions, making this the world’s largest. China’s power sector is only responsible for about 30% of the country’s total emissions, and industries such as cement, metals, and petrochemicals will be added over time. Verified company-level emissions must be disclosed to the public, but unlike Europe, only direct exchanges and no carbon financial derivative products will be allowed initially – which some suggest may hamper liquidity and price discovery.
The obligation to buy carbon credits [JS2] will favour gas-fired (as well as renewable) generation in China – at least in the short to medium term – because the main competitor is coal, which emits about twice the carbon that gas does. However, right now, China’s priority remains meeting surging energy demand – coal supply shortages due to strong post-pandemic economic growth, a ban on Australian imports, and a hot start to summer have sent demand and coal prices soaring, which is having far more impact on costs than a modest carbon price. Among generators, a recent survey suggested the carbon tax was welcomed, but only at low levels, with expectations averaging just 71 yuan/tCO2e ($11.1/t) in 2030 and 140 yuan/t by 2050 – well below current European levels.
European prices see sharp gains.
In Europe, where the Emissions Trading System (ETS) has been in operation for power and industry since 2008, prices have risen sharply in recent months (see figure 1) as climate pledges among European member states have toughened, which is now having a significant impact on investment decisions. EU prices for December 2021 hit an all-time closing high of €56.65/tCO2e on May 14th – although they have dropped back a little following the launch of a new UK post-Brexit market, as UK long positions were transferred across.
Figure 1. ETS EUA prices (ICE Dec 21 contract)
In Europe, higher carbon prices may initially accelerate coal to gas switching, expanding the gas market, but in the mid-to-long-term natural gas will begin to lose out to lower or zero carbon options. This latter stage has already been reached in the UK market, where all coal has now been removed thanks to higher overall carbon prices – and rising wind output is now squeezing the call on gas. Since 2014, the UK has added another £18/t Carbon Price Support (CPS) charge to the EU ETS carbon price in its power sector.
The UK’s new post-Brexit carbon market is also trading at a slight premium (see figure 2). On its first day (May 19th) the December 21 contract opened at £50.23/t ($71.13/t) – which was almost £5/t higher than the EU ETS at the time (largely due to 5% tighter initial allocations). This meant the cost of emitting carbon for energy intensive industries (including oil and gas) in the UK moved slightly above that in the EU – and much higher for onshore power producers, which (with the CPS added in), would pay over £68.23/t if UK ETS prices stayed at that level – the highest carbon price in any major economy.[JS3]
Rising carbon prices and expanded coverage have implications for trade, as it will add costs to many areas of business, putting them at a disadvantage to competitors that have a lower or no carbon price. The EU has discussed defending its industrial energy users with a border carbon adjustment (BCA) mechanism, which would be imposed on imported products with embedded carbon from jurisdictions with lower or no carbon price. It is conceivable that this could extend to natural resources such as gas.
Figure 2: UK ETS prices (ICE Dec 21 contract)
Record price squeezes carbon in UK
In the UK, gas is now largely confined to the times when renewables are not available, and a high carbon price will provide an added incentive to replace it even here, with alternative lower carbon dispatchable sources – such as batteries, hydrogen or biogas – or by adding Carbon Capture and Storage (CCS) to gas-fired plants. That is the plan at several CCGTs in the UK, normally in combination with hydrogen supply plans for nearby refineries and industrial clusters. These include the Shell-led Acorn CCS/hydrogen project in Scotland, and BP’s H2Teesside hydrogen/CCS project, which has a carbon price assumption of $50/t for 2021-2025, rising to $100/t in 2030. S&P Global Platts said in May that a carbon price of about €70/tCO2e was needed for parity between blue and grey (produced in refineries without CCS) hydrogen, and the European Commission put the figure at €55-90/t in 2020.
The UK Government may decide to go even further. In early June, the Bank of England increased its carbon price forecast to $150/t for 2030. It said this was necessary if the country were to meet its 2050 net zero target, and warned banks that they would suddenly be faced with stranded assets if they failed to prepare now. The number is up sharply from an upward revision to $100/t by 2030 a few months ago. That was the same level as BP’s latest internal assumptions, and close to the recommendations put forward by economists Joseph Stiglitz and Nicholas Stern in 2017, of at least $40–80/t by 2020 and $50–100/t by 2030 to achieve the Paris Agreement goals. Carbon credits may also become a welcome source of income for governments, shifting the tax burden towards polluters.
The UK says it wants a link with the EU ETS, and most believe this will be arranged at some point in post-Brexit negotiations. In the meantime, the European system is being expanded to cover emissions outside industry and power, and the UK plans to do the same. Carbon from flights within Europe is the first new category to be added, bringing coverage up to just under half of all EU emissions. Adding road and rail transport, shipping, and heating, will bring it up to over 90% (although road transport is already taxed heavily in most European countries: In 2018, an OECD study found that in 34 of 42 countries at least 90% of road transport emissions incurred taxes equivalent to a carbon price of more than €60/tCO2e).
Worldwide expansion.
Away from Europe and China, there are also carbon prices in Canada and parts of the US, including California, where prices are around $17/t. There had been talk of a nationwide tax under the new US administration, but so far nothing has been agreed. Canadian prices are set to rise quickly up to C$50/t ($40/t) in 2022. South Korea is also introducing a system, and about 70% of all global aviation emissions are also due to enter a UN emissions-trading program this year. Nevertheless, most of the world remains uncovered. Many expect significant progress by the conclusion of COP26 in Glasgow this November, with the recent successful international deal at the G7 on corporation tax suggesting a similar approach for carbon taxes may be proposed.
Written in June 2020, first published in Natural Gas World. https://www.naturalgasworld.com/carbon-markets-to-get-a-shake-up-ngw-magazine-80235
The UK announced in May that it would impose a new carbon pricing system to replace the European Union’s Emissions Trading System (EU ETS) once it leaves the EU. The EU itself is also planning changes, including a revision of the ETS to cover new fuel such as green hydrogen. At the same time, the scope of emissions covered by these schemes is set to expand from just power and heavy industry to include heating and transport, while carbon prices are expected to rise significantly over the next decade.
Brexit gives the UK the chance to apply a revised approach, avoiding the ETS’ perceived flaws, while co-operating with the EU ETS or its successor. The UK had already adapted the ETS to include a price floor of £18 ($22.3)/metric ton CO2, which kept UK carbon prices well above those elsewhere in Europe until summer 2018, in the process reducing coal-fired power generation (see graph). The UK government says the new system will be even more ambitious than previous versions, including an immediate reduction of the existing emissions cap by 5% by tightening the availability of credits. It will ensure the UK is aligned with its commitment to reach net zero by 2050.
Although few other details were revealed, the government said the new scheme also aims to provide a transition for businesses as the UK leaves the EU at the end of 2020, as well as offering greater flexibility “to work in the best interests of the UK”. Once the programme is up and running, the emissions cap may be revised downwards again, tightening supply and so pushing prices up. Energy minister Kwasi Kwarteng said: “The UK is a world-leader in tackling climate change, and thanks to the opportunities arising as we exit the Transition Period, we are now able to go even further, faster… This new scheme will provide a smooth transition for businesses while reducing our contribution to climate change, crucial as we work towards net zero emissions by 2050.”
EU ETS to be expanded, adapted
In the EU, as part of its ‘green deal’, the European Commission (EC) is expanding the ETS to include emissions from areas other than power generation and heavy industry, which are more difficult to measure and control. Carbon from flights within Europe is the first additional category to be included, bringing coverage up to just under half of all EU emissions. The next step, according to the EC president, Ursula von der Leyen, is to extend the scheme to road and rail transport, shipping and heating, which would increase coverage to over 90% of emissions. This is despite the fact that fuel is already taxed heavily in most EU countries. In 2018 an OECD study found that in 34 of 42 countries at least 90% of road transport emissions incurred taxes equivalent to a carbon price of more than €60/mtCO2, which is more than twice the ETS market price late in June.
These moves may have implications for trade, as they will add costs to many areas of business, putting them at a disadvantage to those outside the EU that have no carbon price. Stuart Broadley, CEO of the UK’s Energy Industries Council, said that, in the case of the UK, this competitive disadvantage meant that the UK government should be thinking about including embedded carbon import tariffs on all goods and services in the trade talks being conducted with countries that do not have carbon prices.
Not to do so would put local products at a disadvantage and customers would just keep buying imported high carbon products – which would undermine efforts to become a zero carbon economy in 2050.
“If we are to reach net zero by 2050, this [embedded carbon tariffs] is essential, and Brexit gives us an opportunity to include it in new trade deals,” he said. Only a fifth of global emissions are subject to a pricing scheme or soon to become so, with a current average price of $15/tCO2, according to The Economist.
There have also been calls from EU industry for similar protection – high carbon-intensity industries, such as steel, already receive compensation for paying carbon prices so that they compete with overseas producers on price. Further support, if it comes, is likely to be in the form of “border carbon adjustment” (BCA) mechanisms, which in effect are tariffs on products from countries that are not members of a carbon-pricing scheme.
The EU says it will propose a BCA mechanism next year as part of the expansion of the ETS. In the US, the Democratic Party has also proposed border adjustments to stop climate plans hurting the competitiveness of US companies.
Making room for hydrogen
In addition, as part of the EU’s new hydrogen strategy, the ETS requires further reform in order to recognise the carbon abatement achieved by replacing natural gas with green or blue hydrogen. Meeting in mid-June, ministers from Austria, Belgium, France, Germany, Luxembourg, the Netherlands and non-EU member Switzerland, committed to look at the role of CO2 prices in developing a hydrogen market, as well as taxes, levies and tariffs in sector coupling between electricity and gas.
The UK government is also keen to encourage hydrogen production and the use of carbon capture and storage (CCS), which may affect the design of its new system.
Getting the pricing right
To date, most emissions trading systems work by capping the total amount of greenhouse gases that can be emitted by certain sectors, and after each year, companies must surrender enough carbon allowances to cover their emissions or pay the difference. Carbon allowances can be traded and the overall cap (amount of credits) is reduced over time in order to drive decarbonisation. As more areas come under the remit of carbon schemes, assessing the amount of greenhouse gases that can be emitted becomes more complex. In the EU ETS’ case, this approach has also led to low prices – at least until a tightening of the cap in 2018 – which provide too little incentive to decarbonise.
The answer to both problems appears to be in reform of the EU’s Market Stability Reserve (MSR), which controls the amount of ETS credits issued. This would take the form of a switch to focus on prices, rather than quantities of carbon allowances, making it a Price Stability Reserve, rather than an MSR – and there are calls for this to be done at an upcoming review in 2021. The switch would make it easier for policy-makers to control prices, and avoid the complexity of assessing volume allowances as the range of emissions included widens.
The UK may also opt for this approach, given its focus on ensuring a price floor in the past. In May, the French-German initiative for the European recovery from the coronavirus crisis also recommended the introduction of minimum carbon pricing in the EU ETS.
Carbon pricing gains traction
Carbon pricing appears to be gaining popularity as a policy tool. According to the 2020 Refinitiv Carbon Survey, the EU ETS has overtaken national climate policies and is now widely seen as the most important driver in tackling carbon emissions. In the survey, 43% of respondents said the ETS will have a major impact – a much higher share than the 27% that said national climate policies and other EU-wide climate policies would be major factors. This marks a reversal in opinion from the 2019 edition of the survey, when the EU ETS scored 35% and national climate and energy policies scored 43%.
Outside Europe there are also carbon prices in Canada and parts of the US, including California. Canadian prices are set to rise quickly – from a minimum of C$20 ($14)/metric ton CO2 since January this year, up to C$50/mt in 2022. South Korea is also introducing a system, and China had planned to introduce one for its power sector by the end of the year. In addition, in 2021, 70% of global aviation emissions were scheduled to enter a UN emissions-trading programme which aims to cap them at 2020 levels, although this may be less urgent now given the collapse in aviation miles since the Covid-19 pandemic.
Leading economists say carbon prices need to be in the range of $40-80/mt to be effective (as well as some other interventions), which is in line with what most observers expect in Europe in five or ten years. And it must cover all types of greenhouse gas emissions, including leakage, which is the direction most policies are taking, although there is some distance to go.
Oil and gas companies are increasingly aware that this will affect their operations, prompting European majors to introduce their own zero, or close to zero, carbon targets. Efforts are already underway. For example, last month Total signed a deal with Siemens to develop solutions to decarbonise the production of LNG, while BP, which has made big plans to decarbonise, is counting on a carbon price of $100/mt (or its equivalent) by 2030.