The future of coal in Europe
The recent increase in European coal consumption has upended the long-held believe that European coal fired power generation would inexorably decline. Experts and international agencies predict a rising appetite for coal in developing countries, while developed countries will see a strong decrease in coal consumption. In its World energy outlook 2012, the International Energy Agency (IEA) predicted a 45% decrease in coal consumtion in the European Union by 2020. However, recent data suggests a resurgence of coal for power generation in Europe is going on at the moment. The question arises whether coal can pose a real and long-term threat for the already troubeled gas fired power plants in Europe. In this paper, Sia Partners provides an overview of the main drivers behind this phenomen, looking deeper into the role of the EU Emission Trading System (EU ETS) and the boom of shale gas in the US. We calculate how this impacts the profitability of coal fired power plants compared to gas fired power plants and provide an outlook for the future.
Global trends in energy generation
The evolutions in the global energy mix
During the past ten years, coal, gas and oil together accounted for 85% of the increase in global energy demand. Coal alone was responsible for 45% of the increase in energy consumption, as can be seen in Figure 1. This evolution has mainly been driven by rising demand in developing countries. As a consequence, coal production worldwide has almost doubled since 1990, reaching nearly 8 billion tonnes in 2011.
While coal demand in China and India is expected to increase strongly, mainly due to booming economic activity and a growing middle class, the opposite is expected in Europe. Figure 2 reflects this forecast provided by the "New Policies Scenario" in the World Energy Outlook 2012 of the IEA, it illustrates that coal demand in Europe is expected to shrink by 45% by 2020 if current policies are continued. However, the harsh realities of the European energy market prove otherwise. Instead of a decline in European coal demand, recent data shows an increased appetite for coal in power generation, threatening the EU 20-20-20 objective of producing 20% less greenhouse gasses compared to 1990.
The role of fossil fuels in Europe's power generation
When dealing with generation dispatch decisions, generation costs are a primary factor determining the fuel mix for electricity generation. Technology and fuel costs change over time, some energy sources become more economical viable than others. Most of the baseload demand in Europe has historically been supplied by nuclear and coal, given their low variable costs of operation and subsequently, their high position in the merit order. Power generation during peak and intermediate periods of demand is generally supplemented by gas and oil fired power plants. As from 1992 the share of natural gas in power generation began to increase, starting at 8% in 1992 and reaching 23% in 2009. During the same period, the share of coal decreased from 37% to 25%. The share of oil also decreased dramatically, mainly due to high oil prices. These trends are illustrated in Figure 3.
Black clouds at the European horizon?
Looking deeper into the developments within the coal sector over the last three years, Figure 4 illustrates the recent increase in coal consumption in Europe. Indeed, comparing the hard coal and brown coal consumption from the first 5 months of 2010 with the same period in 2011 and 2012, one notices a 7,3% increase in coal consumption in 2011 and a 5,2% increase in 2012. Similar figures are obtained when comparing annual consumption. Coal consumption in Europe went up from 707 million tons in 2010, to 762 million tons in 2011 and 784million tons in 2012, corresponding to an increase of 7,5% and 3% in 2011 and 2012 respectively. Coal has increasingly regain importance as a fuel for power generation in many European countries. Figure 3 illustrates this evolution for Spain, Italy, Hungary and Poland. The reasons for the sudden backsliding on coal dependency are mainly financial: the shale-gas boom in the United States and the low priced carbon permits of the EU Emission trading system.
The Shale gas boom in the United States
Significant discoveries and developments of shale gas have led to record low prices for natural gas in the United States. The shale gas revolution has put a downward competitive pressure on American coal. As a consequence, the American coal industry if forced to export the coal that would normally be consumed in the United States. This in turn has contributed to an oversupplied coal market in Europe and helped to pull down coal prices. Looking at the API 2 index (see Figure 6), a benchmark price reference for coal imported into northwest Europe, one notices that prices have dropped by approximately 30% since summer 2011. In the meantime natural gas grows increasingly pricey in Europe because of the augmenting gas demand in Asia. The combination of both factors results in an increased import of cheap American coal in the EU, making coal a more competitive fuel for power generation in the EU.
The European Emission Trading System
Additionally, the price of carbon permits dropped to prices that make it reasonable to pay for the allowances and to use coal for electricity production. Over the last few years, the impact of the economic crisis has led to a decrease of Greenhouse gas emissions, resulting is a surplus of allowances compared to emissions. By early 2012, the surplus had accumulated to 955 million allowances. Furthermore, the build-up of the surplus of allowances is expected to increase further in 2013. Simple economics suggest that low demand combined with increasing supply result in decreasing prices. Figure 7 illustrates the price evolution of carbon allowances for EU ETS phase 2.
Profitability of coal- and gas fired power plants
The market conditions described above are changing the European landscape for power generation from fossil fuels. At the current low coal and carbon allowance prices, coal has resurrected as an economically interesting input for power generation in Europe. This trend is illustrated by the additional 50GW of coal fired power plants that are currently proposed, being developed or under construction across the EU, according to Platts. Natural gas, meanwhile, remains expensive in Europe, turning coal into the more competitive fossil fuel for power generation. This is illustrated by the rate at which European utilities are shutting down gas fired power plants. One way to investigate the profitability of coal- and gas fired power plants is by calculating the clean dark spread (CDS) and the clean spark spread (CSS) respectively. The spread is the theoretical gross margin of a gas-fired power plant from selling a unit of electricity after buying the fuel necessary to produce it. This means that all other costs (maintenance, capital etc.) have to be covered from the spread. In the clean spread, also the cost of carbon dioxide is included (EU Emissions Trading Scheme). Figure 8 shows that the economics of power generation in
Belgium have turned in coal's favour since the beginning of 2011. In 2012 this trend even worsens, the theoretical gross margin from selling electricity after buying gas required to produce it and the right to emit the carbon dioxide becomes negative as from then, meaning that the gas needed to fuel a power plant costs more than the electricity produced. The negative clean spark spread means that operators are unable to cover the investment- and operating costs of the gas fired power plant. On the other hand, the clean dark spread for coal fired power plants is much higher and increasing. Under these circumstances it is much more interesting to build and operate a coal fired power plants from an economic point of view.
In long-term, will coal regain its crown?
Will the supply of cheap coal continue?
Whether coal will keep the competitive edge over natural gas depends largely on the price evolution of both fuels in Europe. Given the unwillingness of the US to export cheap shale gas in order to safeguard their competitive manufacturing advantage, the unlikeliness of the EU being able to produce shale gas themselves anytime soon and the growing demand for natural gas in Asia it is unlikely that natural gas prices in Europe will drop any time soon. Obviously, rising coal prices might also steer the odds in favour of natural gas. The planned nuclear phase-out in many European countries and growing coal demand in Asia might indeed drive up coal prices. However, given the current gas and CO2 prices, the price of coal would need to rise by approximately €50 per ton in order to restore competitiveness to gas for power generation. With coal currently priced around €70 per ton this represents an increase of 70%, which is realistically not achieved anytime soon.
The future of the EU Emission Trading System
The cumulative surplus of allowances will continue to grow in 2013, mainly due to three sources: the selling of left-over allowances in national phase 2 new entrant reserves, early auctioning to meet sector hedging demand and the forward selling of phase 3 allowances to generate funds for the NER300 programme by the European Commission (EC). These sources are expected to generate an additional surplus of 500 million allowances by the end of 2013. In the meantime, emissions in 2013 are not expected to change significantly. This will result in a total surplus of approximately 1,5 - 2 billion allowances by the end of 2013. As from 2014 the surplus is expected to fall slowly at a rate which depends on economic growth and the measures the EC takes in order to fix the growing supply-demand imbalance. At the 16th of April 2013, the Members of the European Parliament (MEPs) rejected the so-called backloading proposal by the EC, an initiative to raise the price of carbon by delaying the auctioning of emission allowances intended to be allocated in 2013-2015 until 2018-2020. The proposal was intended to be a quick short-term solution to increase the carbon price while more structural solutions are developed. Right after the vote, the price of emission permits fell to a record low of €2,46 per ton.
Currently, the future of the EU ETS is highly uncertain and depends strongly on the next steps the EC will take. As the MEPs voted to reject the backloading proposal but also voted to send it back to the environment committee the proposal is not completely dead but it is expected that it can't be saved before 2015, well after the backloading was meant to take place. Given the political difficulties associated with raising the carbon price at a time when Europe is trying to emerge from recession it is widely believed that there will be no changes to the current system until 2020. This might result in Member States each legislating their own national policies, thus 27 different carbon prices, coal taxes and carbon taxes.
The "switching price", an indicative CO2 allowance price which indicates when a switch from natural gas to coal or from coal to gas is economically advantageous for power production, provides an indication of the profoundness of the current situation. The "switching price" can be interpreted as the fictional price of CO2 that would equal the clean dark spread and the clean spark spread. Figure 9 illustrates, for the average gas price of € 24,83 per MWh in 2012 and in function of the coal price, the required CO2 price the EU ETS needs to achieve in order to make natural gas equally competitive as coal for power generation. For the 2012 average coal price of € 72,00 per ton, the carbon allowance price would need to be as high as € 35,67 per ton, a price that has never been reached during the 8 year existance of the EU ETS, herbeby illustrating the difficulty of the measures to be taken.
The recent economic advantage of coal over natural gas for power generation poses significant issues for the already troubled gas fired power plants and the EU which wants to see a shift from coal-fired power generation to towards renewables and gas, which sends fewer greenhouse gasses into the atmosphere than power generated from coal. The rise of coal is mainly due to two factors: the shale gas boom in the US leading to decreasing coal prices in Europe and the record low carbon prices due to an imbalance between supply and demand. The direction in which this trend will evaluate depends largely on global price developments and whether the EU will be able to come up with new measures to restore the EU Emission trading system.
Yannick Schuermans - Sia Partners