Robust Carbon Prices Accelerate EU’s Power Sector Decarbonization

in Japanese

The European Union (EU) power sector is a decade away from becoming carbon free. This major achievement will protect the EU from imported fossil fuels price volatility and supply disruptions, which are significant threats to economic prosperity and energy security. This is of utmost importance as global geopolitical instability worsens. A pillar of the EU power sector decarbonization is the EU Emissions Trading System (ETS). With a carbon price of €65 per ton of carbon dioxide equivalent (/tCO2eq) in 2024, existing coal and gas power plants are twice more expensive than new solar photovoltaic (PV) and onshore wind projects. Carbon pricing also makes more funding available for decarbonized technologies and enables these technologies to be more profitable. This encouraging progress should inspire Japan to take courageous action in favor of carbon pricing, as the country remains dangerously dependent on fossil fuel imports.

Basics of the EU ETS functioning¹

All EU Member States, as well as Iceland, Liechtenstein, and Norway participate in the EU ETS. The EU ETS was launched in 2005, and it was the world’s first carbon market. The fourth phase of the EU ETS began in 2021 and will end in 2030.

The sectors covered in the first phase of the EU ETS (2005-2007) were electricity & heat generation and industrial production. Aviation was added at the end of the second phase (2008-2012), and maritime transport in 2024. These four sectors account for around 40% of the EU’s total greenhouse gas emissions (GHG).

From 2027, another EU ETS “ETS2” will start and separately cover GHG emissions from buildings and road transport.²

The EU ETS is based on a “cap and trade” principle. The cap refers to the limit set on the total combined amount of GHG that can be emitted by all participating countries under the scope of the system. The cap is expressed in emission allowances with one allowance giving the right to emit 1 tCO2eq. This cap is reduced annually in line with the EU’s climate targets (i.e., carbon neutral by 2050, 55% GHG emissions reduction by 2030 compared to 1990), ensuring that emissions decrease over time (Chart 1).

Chart 1: EU ETS – Emission Allowances Cap for Electricity & Heat Generation, Industrial Production, and Maritime Transport 2013-2024

Allowances are primary traded on a common auction platform, the European Energy Exchange, where auctions are organized several times a year. Bilateral trade is also possible. The price of allowances is determined by the law of supply and demand (Chart 2).

For example, in 2022, widespread outages at nuclear reactors in France, the phaseout of nuclear power in Germany, and droughts across Europe caused drops in electricity generation from nuclear and hydro power. This decrease in decarbonized electricity resulted in an increase in electricity generation from coal and oil, contributing to higher allowance prices (from €53/tCO2eq in 2021 to €80/tCO2eq in 2022).

Some companies receive free allowances such as industries considered to be at significant risk of carbon leakage (e.g., iron and steel, chemicals). The volume of free allowances is decided depending on each industry’s exposure to the risk of carbon leakage. Free allowances are being phased out as the Carbon Border Adjustment Mechanism (CBAM) is gradually introduced (its definitive regime will apply from 2026).³ The objective of the CBAM is to ensure that the carbon price of imports is equivalent to EU ETS price.

Chart 2: EU ETS – Emission Allowances Price 2013-2024 (as of December 10)

Under the EU ETS system, companies must monitor and report their emissions on a yearly basis and surrender enough allowances to fully account for their annual emissions. The use of offset credits is not allowed. If these requirements are not met, heavy fines are imposed: a fixed penalty of €100/ton of CO2eq emitted for which no allowance is surrendered on time, to be added to the market price of the allowance to be surrendered.⁴

As of April 1, 2024, 24% of global GHG emissions were covered by carbon pricing instruments (i.e., ETSs and carbon taxes).⁵ More than three-fourths of these emissions were covered by ETSs, making this instrument the most popular one for carbon pricing.

In 2023, the EU ETS was the world’s second largest ETS in terms of GHG emissions covered, behind China and ahead of South Korea (Table 1).

These ETSs all use exchange platforms to trade allowances (while South Korea ETS also allows bilateral trade, China ETS does not allow it).

In 2023, the price of allowances in the EU ETS was 9-11 times higher than in China and South Koreas ETSs. Higher allowance prices reflect more stringent allocation of allowances (i.e., while most allowances are allocated via auctions in the EU ETS, all or almost all allowances are allocated for free in the China and Korea ETSs). Higher prices are more powerful to incentivize emissions reduction.

For comparison purposes, at approximately $2/tCO2eq (¥289/tCO2eq), Japan’s carbon tax, started in 2012 for fossil fuel importers, is ridiculously low and has a negligible impact.

Table 1: Comparison of the World’s Three Largest ETS 2023

High carbon prices make fossils twice more expensive than solar PV and onshore wind

In the EU from 2021, coal and gas power plants have been confronted with a double insurmountable obstacle: high fuel and carbon costs (Chart 3).

Fuel cost is the main generation cost of coal and gas power plants. Fossil fuel prices started to increase as the world economy recovered from the COVID-19 pandemic in 2021 and skyrocketed when Russia invaded Ukraine in 2022. Since then, they significantly decreased (i.e., they have been divided by 2-3) but they remain high for importers like the EU and Japan.

Carbon cost internalizes the negative externalities (i.e., environmental pollution) from generating electricity from coal and gas power plants, and it is added on top of generation cost to calculate total cost.

Carbon prices sharply rose as the EU ETS emissions cap was steeply tightened from 2021 (Chart 1). Data for 2024 are not fully available yet. So, is difficult to exhaustively describe why allowance prices have decreased this year.

However, preliminary data suggest that strong growth in electricity generation from renewable energy (RE) and a rebound in electricity generation from nuclear power have played decisive roles. This is because higher electricity generation from decarbonized technologies reduces electricity generation from fossil power, lowering the demand for emission allowances, and thereby the price of emission allowances.

Chart 3: EU – Costs of Existing Coal and Gas Power Plants 2019-2024

In 2024, despite much lower fuel cost than in 2022 and 2023, existing coal and gas power are still largely uncompetitive with new solar PV and onshore wind projects, and to a lesser extent with existing nuclear reactors (Chart 4).

This is because in the EU, a carbon price of €65/tCO2eq is sufficient to give a clear economic edge to mature decarbonized electricity generating technologies. Coal is particularly penalized owing to high GHG emissions: 0.83 tCO2eq/MWh, against “only” 0.37 tCO2eq/MWh for gas.

Chart 4: EU – Costs of Key Electricity Generating Technologies 2024

Carbon pricing means more funding and profits for decarbonized technologies

In 2023, the auction revenue from the EU ETS reached €43.6 billion.⁶ More than three-fourths of this revenue directly flowed to the national budgets of participating countries. This revenue must be used to support investments in RE, energy efficiency, and other decarbonized technologies that help to reduce GHG emissions. With this revenue in 2023, participating countries mainly invested in the decarbonization of their power sector (including RE supply, grids, and storage), and public transport and mobility.

Moreover, the revenue from the EU ETS also supports two dedicated EU decarbonization funds: the Modernization Fund and Innovation Fund (in 2023, most of the revenue went to the Modernization Fund – the exact breakdown could not be found).⁷

The Modernization Fund supports the modernization of energy systems and the improvement of energy efficiency in thirteen lower-income EU Member States (i.e., Bulgaria, Czechia, Estonia, Greece, Croatia, Latvia, Lithuania, Hungary, Poland, Portugal, Romania, Slovenia, and Slovakia).⁸

The Innovation Fund supports innovative decarbonized technologies (e.g., hydrogen, carbon capture, utilization and storage…) toward commercialization. It derisks projects by providing grants.⁹

Another advantage of carbon pricing is that it makes decarbonized technologies more profitable.

In the power sector, based on the merit order principle, power plants are ranked in ascending order of marginal cost until supply meets demand, and the power exchange price is set by the power plant with the highest marginal cost. Regardless of carbon pricing, because of their higher fuel cost, coal and gas power plants typically set power exchange prices.

The addition of carbon pricing increases the marginal cost of fossil fuel generators, and thereby power exchanges prices. Higher power exchange prices translate into higher profitability for decarbonized generators. This accelerates the deployment of new solar PV and onshore wind in the EU.

Admittedly, higher power exchange prices are undesirable as they are reflected in retail electricity prices paid by consumers.

On a positive note, these higher prices are only temporary. For example, in 2023, as cheaper new RE replaced existing fossil power (Chart 5), power exchange prices – and GHG emissions – decreased (Chart 6).

Thus, a virtuous economic and environmental circle is set in motion. This is what the EU empirically demonstrates, and the example that Japan should follow.

Chart 5: EU – Electricity Generation from Decarbonized and Fossil Power 2019-2023

Chart 6: EU – Power Sector GHG Emissions and Power Exchange Prices 2019-2023