Coal phase-out threatens effectiveness of the EU Emissions Trading System (ETS)

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Over the last few weeks, two utilities – SSE and RWE – closed their last working coal-fired power stations in the UK, leaving the country with just four coal-based plants supplying electricity to the grid.

By the end of 2019, coal’s contribution to the country’s power supply had slipped from 70% in 1990 to less than 3%. By 2025 that share will have dropped to zero.

Europe’s largest economy, Germany, is headed in the same direction. A law passed last year will see the country quit all forms of coal-fired power by 2038 at the latest, and analysts believe the end will come well before then.

The coal exit may not be felt by industry or consumers directly if renewable energy, natural gas and nuclear power are able to fill the gap. Indications point towards continued growth for wind and solar power and the potential for back up through grid-scale batteries should they be built in scale.

One area where the loss of coal power will be felt, however, is the climate. In 2010, German power plants belched 369 million tonnes of carbon dioxide into the atmosphere. By 2019, this number fell to 311 million tonnes, helped chiefly by some plant closures but mainly from the shift to natural gas and renewables.

Coal’s share of Germany’s total was 244 million tonnes in 2010, falling to around 165 million in 2019. The coal sector is still the single largest emitter in the country.

An unintended consequence of the German and UK exits from coal, together with government pledges in 11 other EU countries, will therefore be to remove that largest source of demand for EU emissions allowances, and this threatens to undermine the effectiveness of the EU Emissions Trading System.

At present, the vast majority of EU industrial installations receive a large handout of free EU allowances (EUAs). This is to protect them from additional costs that would make them uncompetitive in world markets.

But there is no such protection for the power sector: generators are required to buy every EUA they need, either through daily auctions organised by the EU, or in the secondary market, where prices are currently around €18/tonne CO2 equivalent.

Each EU state has a reserve of EUAs for auction, and we can use this figure as a rough estimate of the power sector’s demand. To be clear, many industrial plants don’t receive 100% of what they need free of charge, and so they also need to buy some EUAs in the market or at auction.

Let’s take the UK as an example. In 2013, CO2 from UK coal and gas-fired power plants totaled 142 million tonnes, while the country’s auction reserve of EUAs was just 107 million tonnes.

By 2018, however, coal and gas emissions had tumbled to 39 million tonnes, while the auction reserve was still 101 million tonnes.

Even allowing for the demand from industrial plants, this represents a significant surplus. And when the last four UK power plants shut over the next few years, the auction, together with the free handouts to industry, would dwarf the market demand.

Germany and the eleven other countries committed to phasing out coal face the same problem. The gradual decline in demand will leave a growing glut of allowances that could push EUA prices back to levels below €10/tonne not seen since late 2017.

The EU has a solution, but it has so far failed to make much of a dent in the existing surplus.

The Market Stability Reserve (MSR) automatically removes 24% of the total market surplus each year, by reducing the number of EUAs each country has in its auction reserve. In 2019, the MSR’s first year of operation, it took 400 million EUAs from the market and according to analysts it may take a similar volume in 2020.

According to a study by Carbon Market Watch published last year, the closure of coal plants across Europe over the next ten years could wipe out an average of 240 million tonnes of demand for EUAs each year. The MSR would find it hard to keep up.

Market observers and lobby groups are calling for reforms to the MSR that would enable it to take a greater volume of surplus EUAs from the market each year, thereby tightening supply, boosting the price and increasing the incentive to cut emissions in other sectors.

Quitting coal is generally seen as a positive move for the climate, but the impact of so-called “overlapping” policies risks the integrity of the EU ETS and calls into question the willingness of policymakers to let the market take the lead in driving Europe’s decarbonization.


Alessandro Vitelli

Alessandro Vitelli is an independent journalist with more than 30 years of experience in energy markets. Since 2004 he has also worked as a journalist and analyst covering global carbon markets and climate policy. He has worked as a journalist for S&P Global, Bloomberg, and as an analyst for IDEAglobal.

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