Carbon pricing in the EU Emissions Trading System, or ETS market, is entering a new phase, signalling that decarbonisaton is well under way in the energy sector and that reducing industrial CO2 emissions will be next, as the EU moves towards its net zero emissions target for 2050.
Prices of carbon emission allowances in the ETS, the largest and most liquid carbon market in the world, have been rising since the middle of 2020 after the EU announced its net zero plan, aiming to have a legally binding decarbonisation goal for member states in place by this summer.
Year to date, the price has increased by more than 30%, recently setting an all-time high at around EUR 40 a tonne before entering a modest correction. The higher the price of carbon, the greater incentive there is for emitters to “decarbonise” by switching to alternatives in the renewable energy sector.
In fact, pricing the cost of releasing CO2 into the atmosphere is the EU’s main policy tool to achieve its commitment to net zero. The ETS covers roughly 50% of all the emissions in the EU.
It can be seen as a market mechanism that encourages emitters to reallocate their resources in the most efficient way, i.e. to cleaner technologies and products that do not involve production methods incurring a cost for the CO2 emitted.
We believe the carbon market is now looking for a new paradigm with prices being adjusted to much higher levels that incentivise the use of green hydrogen, which is produced using renewable electricity. This energy source is seen as key to enabling the EU to reach its net zero target.
At the same, the EU is working to ensure that its carbon reduction efforts including carbon pricing do not undermine industry’s competitiveness relative to other jurisdictions.
In that context, the EU is looking at ways to limit speculative inflows from financial investors into the carbon market, while also investigating ways to impose a carbon tax on imports from countries without a carbon pricing system at the border to ensure a level playing field.
Is there also a new phase in the bidding for offshore wind capacity and hence the cost (of the energy transition) for consumers and the returns available for investors?
The latest auction of rights to develop offshore wind capacity – in the waters around England and Wales – has thrown up some developments that bear watching closely. For the first time, it included an auction to lease the seabed for 60 years at an annual fee coming to a total GBP 880 million. 
While the extra revenue is welcome to the seller – the UK government – the additional costs of the lease will have to be borne by the consumers of the electricity, the project developer or the offshore-wind industry’s equipment suppliers, or all three. This could boost the average power price by nearly 25% or almost halve the rate of return for the developer.
The UK is currently the largest and most dynamic offshore wind market in the world, with 10 gigawatts (GW) already in operation and a further 29GW under construction or planned. The country is also preparing to host COP26 in Glasgow later this year – the most important UN climate-change conference since Paris in 2015. Accordingly, developments in this market are watched closely.
If the pressure on returns becomes a trend, it could drive up the cost of shifting from fossil-fired electricity to renewables in the wholesale market. The extra cost from seabed-lease options would alter the economics of offshore wind relative to gas-turbine (CCGT) power stations materially. It would also affect the transition from gas to electricity in the retail market. Both shifts are fundamental pillars of strategies to zero carbon emissions in 30-40 years’ time.
The seabed-lease auction raises questions about the ability of the existing leaders in offshore wind – utilities – to continue winning new projects at the rate of return they have done previously.
It also highlights issues around the ability of Big Oil to pivot to green energy at acceptable levels of return. One Big Oil company was part of the consortium making the highest – winning – bid and appeared willing to a pay a significant premium to get a foothold in the offshore wind market, possibly setting a precedent that will force future bidders to be equally competitive.
Big Oil’s apparent interest comes at a time when oil majors are increasingly under pressure to pivot away from fossil fuel exploration and production and change their business models.
Finally, the high price paid points to possible trade-offs between (the need for) government revenues, (affordable) consumer prices, and (attractive) investor returns.
Investors will need to watch whether other governments will copy the new model for awarding seabed leases. Governments might be tempted to seek a higher windfall, but investors will need to press companies to ensure that targeted rates of return and capital discipline match up.
Also listen to the podcast with Mark Lewis
 See Offshore Wind Leasing Round 4 signals major vote of confidence in the UK’s green economy https://www.thecrownestate.co.uk/en-gb/media-and-insights/news/2021-offshore-wind-leasing-round-4-signals-major-vote-of-confidence-in-the-uk-s-green-economy/
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