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COLUMN-UK carbon floor price may boost gas demand: Wynn

(The author is a Reuters market analyst. The views expressedare his own.)

By Gerard Wynn

LONDON, Oct 9 (Reuters) - A new British carbon price floormay increase gas demand as rapid price rises eat into profitsfrom burning coal, but the impact on power prices could affectpolitical will to implement the policy.

Margins from coal-fired power generation are currently farmore attractive than gas, reflecting the relative price of thetwo fossil fuels and a very low European carbon price. Theresult 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 investmentthrough a clear schedule of rising carbon prices, which willfavour nuclear and renewable energy as well as gas.

This is intended to counter the volatility and recentcollapse in the price of EU allowances (EUAs).

It works by topping up the EUA price where this falls belowthe CPF price target. This is implemented with a tax on gas andcoal purchases by power plants.

Chart 1 shows how the CPF is intended to rise in a straightline from 15.70 pounds (19.45 euros) per tonne of CO2 emissionsin 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 43pounds in 2020, assuming an inflation rate of between 3 percentand 4 percent.

That implies a near trebling of carbon prices in Britainnext year, compared with a 2013 EUA forward contractof about 8 euros.

The rapid rise in the British carbon price implies anincreasing carbon cost on power generators, which will make gasincreasingly competitive, potentially driving demand higher.

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CARBON PRICE IMPACT

Britain's finance ministry calculates the CPF tax as therequired level to top up the EUA price to the desired Britishcarbon floor price.

The tax starts at 4.94 pounds per tonne of CO2 for thefinancial year from April 2013, as the government announced inits November 2011 budget.

The tax was calculated as the difference between the nominalCPF target for the financial year 2013/14 and the average tradedprice for the EUA 2013 contract from March 2010 to February2011.

Chart 2 shows that European carbon prices have halved sincethat calculation period.

As a result, without a sharp recovery in EUA prices the taxwill be inadequate and Britain's carbon price next year willfall short of the CPF target.

Looking ahead to 2014/15, the CPF inflation-adjusted targetis about 19.70 pounds, while the EUA 2014 forward contracttraded at an average price of 12.30 pounds from March 2011 toFebruary 2012, Thomson Reuters data show.

As a result, the UK treasury should announce next month atax in the financial year 2014/15 that takes the differencebetween these two, at about 7.4 pounds per tonne of CO2, alittle more than the indicative rate of 7.28 pounds that thegovernment published in 2011, since when EUA prices have fallensharply.

Assuming that utilities pass on this cost, wholesale powerprices would rise by at least 5 percent, potentially decreasingUK competitiveness.

In that context, it is unsurprising that Britain has beenmore ambitious than any other EU country in calling for the blocto increase European carbon prices by cancelling surplus EUAs,thereby narrowing the EU-UK differential.

FUEL SWITCHING

The relative prices of gas and coal at present mean that itis far more profitable to burn the latter.

But as the price of CO2 emissions rises, the relativeeconomics shift in favour of gas, which emits roughly half asmuch carbon as coal.

The carbon price at which gas becomes competitive with coalis called the fuel switch price.

Chart 3 show the average fuel switch price in Britainfalling to about 40 euros per tonne of CO2 over the next fiveyears, but for the most inefficient coal plants it is about halfthat, according to Point Carbon.

Such analysis suggests that from 2014 or so the Britishcarbon floor price may be high enough to drive switching fromthe most inefficient coal plants, and that effect will becomemore widespread as the price rises to more than 40 pounds at theend of the decade, all else being equal.

Britain has a higher potential for fuel switching than manyEuropean countries because of a diverse grid that includes gas(40 percent of generation, with 28 gigawatts of installedcapacity) and coal (30 percent and 20 gigawatts).

Meanwhile, higher power prices could prompt higher importsof electricity through Britain's 4 gigawatts of interconnectorcables from Ireland, France and the Netherlands.

UNCERTAINTY AND CRITICISM

An important caveat to the impact of the CPF is uncertaintyover its rollout and criticism that could force the governmentto 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 in2030, but that would be contingent on other countries followingsuit. "This estimate is subject to the progress of internationalnegotiations," the government said in its overview of the policyin March 2011.

The plan appears to have additional uncertainty built inbecause the top-up is announced at each annual budget, implyingthat the finance minister may have some discretion incalculating the level.

The CPF, meanwhile, has drawn criticism as a unilateralpolicy that will raise British wholesale power prices comparedwith those in Europe, and for a perceived limited environmentalbenefit.

As a unilateral action within a much wider EU emissions cap,the concern is that those reduced emissions will simply be takenup by higher emissions and greater EUA purchases in the rest ofEurope, an effect known as carbon leakage.

As a result, political risk threatening full implementationof the scheme beyond the end of the decade already looks high.(1 British pound = 1.24 euros)

(Editing by David Goodman)

((Gerard.Wynn@thomsonreuters.com)(+44 207 542 2302)(ReutersMessaging: gerard.wynn.reuters.com@reuters.net))

Keywords: COLUMN WYNN/CARBON FLOORPRICE