CO2 prices: EUA price vs implied fuel switch cost

As you will have seen from my posts I have spent the last week thinking about CO2 emissions. It is perceived wisdom that the price of CO2 reflected in the price of the EU Emissions Trading Scheme (ETS) allowances (EUAs) is too low to compensate for the cost of abating CO2 emissions in the power generation sector.

A standard methodology for finding out the marginal abatement cost is to work out the cost of generating a MWh of electricity from coal and gas, and then calculating the implied cost of reducing CO2 emissions by one ton by switching generation from dirty coal to cleaner gas.

I have carried out my own calculations (which are still only provisional) for the last two and a half years and as you can see I find that the cost of abatement from switching fuel types has been very volatile, in some instances being even negative. The cost is negative when generating electricity from gas is cheaper than generating it from coal, which appears to have been the case on a number of ocassions, including during the last three months.

In conclusion, I find that EUA prices are not too low at the moment - if anything they are too high because gas is currently so cheap compared to coal that it is cheaper to generate electricity from the cleaner fuel.

Other reasons why the EUA price is not too low:

(1) The ceiling for EU emissions during 2008-12 has been set at an annual average 3% lower than emissions in the benchmark year of 2005. As my previous entries on global and US emissions state, if the early 1980s are anything to go by we can expect a fall in emissions in the next few years simply because of the recession. In the case of the EU, if emissions were to follow the same trend exhibited between 1979 and 1985, 2008-12 annual average emissions will be 7% lower than 2005 emissions, implying that overall emissions will fall substantially below the target and therefore Phase II EUAs will be worthless.

(2) Direct subsidies to renewables (e.g. through Germany's feeding tariffs) are already generating CO2 emission reductions that reduce the need to generate these reductions elsewhere, thus depressing the value of EUAs.

(3) Finally, in the calculations on the switch cost I have used the standard assumption of 49.13% thermal efficiency for natural gas. Yet, technological improvements mean that the most modern Combined Cycle Gas Turbines (CCGT) can deliver thermal efficiency as high as 60%, thus reducing the marginal cost of reducing emissions by switching fuels even further.