Fuel Switching 2.0

Carbon pricing, whether through trading or taxes, is considered one of the most important policies to reduce emissions. A price on carbon increases the operating costs of high carbon fuels relative to lower-carbon alternatives. This post introduces an index (termed Coal-to-Clean Carbon Price Index - CCPI) for approximating the carbon price required to leapfrog fossil gas and support an electricity system predominantly supplied by variable renewable energy. We hope CCPI will improve information flows and support the urgent changes required to align electricity generation with the goals of the Paris Agreement.

What is the Coal-to-Clean Price Index?

TransitionZero is a climate analytics not-for-profit established to clarify complexity with data transparency. We do this by developing open data and open source projects to support economic and financial decision-making in electricity and industry sectors. CCPI is an open data project that tracks the carbon price required to incentivise fuel switching from existing coal to new onshore wind or solar PV plus battery storage in 25 countries. CCPI is based on a methodology report by TransitionZero and a database of coal plants developed by the Global Energy Monitor. We hope CCPI will be a useful proxy to allow:

• Policymakers to understand how subsidising fuel and energy (both directly and indirectly) can undermine the effectiveness of carbon pricing policies
• Traders and investors to predict zero-carbon fuel switching costs in near-real-time independent of regulatory constraints and non-price barriers
• Civil society shape the debate about the cost-competitiveness of zero-carbon technologies, especially during periods of fossil fuel price volatility

To capture fossil fuel price volatility, CCPI will be updated weekly for Europe and the US and monthly in the rest of the world.

Clean energy comet

Fuel switch costs in electricity have historically been analysed through coal and fossil gas generation prices. Fossil gas has a lower carbon intensity than coal, so if the carbon price gets high enough it becomes more economic to burn gas than coal. This level is termed the fuel switch price.

The problem with this metric is it ignores the transformation required for electricity generation to be consistent with the temperature goal in the Paris Agreement. The IEA’s net-zero emissions (NZE) scenario underscores the urgency of this transformation: virtually no unabated coal or fossil gas generation by 2035 in advanced economies and globally by 2040. Despite this, around two-thirds of electricity generation came from unabated coal and fossil gas in 2020.

We have taken fuel switch analysis a step further, by calculating the fuel switch cost required to leapfrog fossil gas and transition directly to dispatchable renewables. The coal-to-clean fuel switch price captures the difference in cost associated with operating existing coal and new onshore wind or solar photovoltaics (PV) plus battery storage.

The good news is, due to the declining cost of renewable energy and battery storage coupled with the increasing price volatility of gas, we found it is now cheaper to switch from coal-to-clean than coal-to-gas. Based on a global average derived from CCPI, the carbon price required to switch from existing coal to existing gas has so far averaged $235/tCO2 in 2022, while the carbon price to switch from existing coal to new solar PV or onshore wind plus battery storage was just -$62/tCO2. This represents an extraordinary decline of 99% since 2010.

Common but differentiated results

There is considerable regional variation in the carbon price needed to replace existing coal with renewable energy and battery storage. These variations are due to factors on both the supply side and demand side. The price is negative in Europe due to rising carbon prices from policy reforms to the ETS, decades of policy support for renewable energy - and Russia’s invasion of Ukraine, which has resulted in a marked rise in the price of thermal coal. Due to discriminatory regulations and land-use constraints, Japan has one of the highest coal-to-clean fuel switch prices. China and the US are world leaders in renewable energy, but lower domestic coal prices partially offset these cost advantages. Fuel switch costs in Southeast Asia are influenced by the subsidisation of coal and gas, as well as the renewable energy being a nascent industry compared to other countries. Despite this, all regions show a clear deflationary trend in the cost of switching from coal-to-clean. These findings call into question the 615GW of gas and 442GW of coal under construction and proposed globally.

Fossil price volatility

Markets had their first supply scare of the energy transition era in 2021. Economic growth coupled with supply shortages increased coal and gas prices in the second half of 2021. These trends continued into 2022 as Russia’s unprovoked attack on Ukraine has caused energy markets to become increasingly chaotic. As these sanctions extend to energy, the implications of these events are creating extreme price volatility.

While commodity prices will continue to go up and down with investment cycles and geopolitics, supply chain disruptions and dated market regulations have highlighted the energy insecurity issues associated with coal and fossil gas. There are several reasons why this volatility could continue into the future independent of Russian aggression in Europe.

Investment cycles are likely to continue to shorten as producers remain under pressure from investors and policymakers to avoid stranded assets from overinvestment. Trade bans from Indonesia and the EU imply that trade is increasingly used to support energy security and enforce environmental goals. These volatility catalysts are likely to put considerable pressure on consumers, businesses and the balance sheet of governments for the foreseeable future.

Zero-carbon technologies are not immune to supply chain gyrations, but they are unlikely to suffer from the same volatility as fossil fuels due to the fact they have near-zero marginal costs. For this reason, these technologies need to be at the heart of supply-side strategies to reduce the impact of the energy crisis.

Policy reform required

This analysis paints a rosy picture of zero-carbon generation technologies and their ability to outcompete fossil fuel generation. These technologies were competitive with coal and gas even before the recent price spikes - meaning the required carbon price is often low or negative in many markets. However, we believe ‘crowding-in’ investment to deploy these technologies in a manner consistent with the Paris Agreement will likely require three policy reforms.

First, price discovery in regulated electricity markets is distorted by technology-specific power purchase agreements and the subsidisation of coal, gas and end-user electricity prices. These market distortions tend to prevent least-cost outcomes and delay the adoption of competitive technologies, such as wind, solar, and battery storage. Moreover, in regulated markets, especially those with access to domestic coal production, cash-to-close policies will likely be required to align coal generation with the Paris Agreement, due to the scale and time sensitivity of the challenge. Based on our analysis, nearly 3,000 coal units would need to be replaced between now and 2030. Information flows amongst investors, governments and civil society are currently limited and therefore greater levels of transparency will be required to ensure cash-to-close policies are informed by all stakeholders.

Second, deregulated markets tend to suffer from a lack of investment, due to weak demand-side engagement from a lack of product differentiation and inframarginal risks from high capital costs and long project timescales. These barriers often mean zero-carbon originators have to bear not only technology and market risks but those of policy and politics over successive election cycles. Markets, and cost-reflective pricing, are crucial to optimise investor behaviour. But to ensure the efficient allocation of capital, differentiation of policy support is required.

Third, both regulated and deregulated markets need to urgently reform permitting processes. While the political will to deploy more capacity is clear, permitting is a key bottleneck slowing deployment and increasing the cost of zero-carbon sources of electricity generation. According to WindEurope, an industry association, the permitting lead time for onshore wind deployment can take up to 10 years. The permitting reforms required vary by region and technology, but generic constraints include complex rules, slow procedures and inadequate staffing.

We hope CCPI is a useful tool to increase transparency and ensure these policy reforms are made to align electricity generation with the goals of the Paris Agreement.