Can carbon prices fire up gas demand in electricity generation?

McKinsey Energy Insights develops an annual Global Energy Perspective (GEP). Using the GEP Power Model, we assessed how carbon prices can shift the power generation mix. We analysed scenarios of multiple carbon price levels in different markets, modelling the effects on the generation mix as well as on emissions and power prices.

We found four key trends in all markets:

• There is a carbon price that maximises gas consumption by being sufficiently high to displace coal and sufficiently low to avoid the displacement of gas by renewables in combination with storage.
• This 'optimal price' from a gas perspective depends heavily on country-specific conditions. For gas consumption, country-specific carbon prices could be advantageous over a global price.
• The optimal price decreases significantly over time as the economics of renewables continue to improve. Gas tends to benefit from higher carbon prices (above US$30/t) until 2025/30, accelerating the shift from coal to gas. Beyond 2030, gas is penalised by (nearly) any level of carbon prices.
• With regards to emissions, the shift from coal to gas is a significant abatement source in most countries. High carbon prices in the short run (until 2020) can shift generation and achieve substantial emission reductions by 2030 (e.g. prices of at least USD30/t after 2020 would reduce emissions in the power sector by over 40% in 2030 for Germany).

Local conditions shape effects of carbon prices on natural gas

Higher carbon prices make coal less attractive, yet the impact on natural gas strongly depends on the local conditions. We uncovered six factors that affected the degree to which natural gas is favoured when carbon pricing is introduced¹:

• The carbon price changes the competitiveness of natural gas in comparison to other sources; as the carbon price rises, gas gains competitiveness over coal, but it also loses competitiveness over RES².
• The existing power generation and capacity mix in the market defines the current market share of natural gas, the other power sources it is competing with and at what relative marginal costs (e.g., coal or nuclear as baseload competition).
• The (future) prevalence of nuclear power defines the role of gas as a baseload or balancing technology in an environment with carbon pricing.
• Age of generation fleet: In a market with old gas plants, natural gas will also tend to be pushed out of the capacity mix earlier.
• The speed of renewable energy expansion driven by declining RES LCOE³s increases the demand for balancing capacities such as gas in the short run; in the long run, RES then outcompete gas.
• The availability and maturity of storage technologies can smooth supply (and demand) fluctuations in most instances in which natural gas would be an alternative.

Three selected countries illustrate the effects from carbon prices

Based on those factors, we can identify three country archetypes that illustrate how country-specific conditions lead to different manifestations of general trends:

1. Increased gas demand with higher carbon prices compared to today due to coal-to-gas switching (e.g. Germany).
2. Marginal impact on gas demand with higher carbon prices compared to today due to RES balancing need after coal was replaced (e.g. UK).
3. Decreased gas demand with higher carbon prices compared to today due to gas-to-RES switching in countries with a high share of gas (e.g. Mexico).

For our analyses, we compared a base case to three scenarios. For the base case, we froze the current local carbon prices in 2017 for the entire period (referred to as 'today'). In three scenarios, carbon prices increase linearly to USD30, 50, or 70/t of CO₂e in 2025. As the UK's carbon price today is already at US$33/t, there is no US$30/t scenario for the UK.

1) Germany: gas demand increases with higher carbon prices compared to today

Exhibit 1: Share of gas power generation mix with different carbon price scenarios

Exhibit 2: Share of coal in power generation mix with different carbon prices

In Germany, higher carbon prices would increase the share of natural gas in the generation mix in the next 15 years. Higher carbon prices increase the share of natural gas in the generation mix by replacing coal. Post-2030, the impact of higher carbon prices on the share of gas declines and it can even have a negative impact on gas as it starts to be replaced by RES.

The resulting shift from coal to gas has an immediate effect on emissions: high prices in the short run accelerate the replacement of coal. A carbon price of US$30/t in 2025 (roughly the UK level today) would reduce emissions by ~50 Mt/yr CO2e or 22% until 2030 and help meet the 2030 target. If carbon prices remained at today’s level (and no other measures are taken), Germany would fail to reach its 2030 targets.

Exhibit 3: CO2 emissions (power sector) 2030

In Germany, the optimal carbon price for gas consumption decreases over time: US$30-50/t until 2025 and US$30/t or lower post 2030.

2) United Kingdom: higher carbon prices compared to today only have marginal impact on gas demand

Exhibit 4: Share of gas in power generation mix with different carbon price scenarios

In the UK, higher carbon prices (~USD33/t) and a reduction in gas prices have already led to a shift from coal to gas. Since 2012, the share of coal in the generation mix dropped—from ~42% in 2012 to ~10% in 2016.⁴

Exhibit 5: Historical share of gas and coal in power generation

Increasing the carbon price beyond US$33/t would only decrease gas consumption by making it less competitive when compared with renewables in combination with storage.

The current carbon price of ~US$33/t (EUA⁵  + £18) has already positioned the UK to reach its 2030 emissions target for the power sector of ~32 Mt/yr CO₂e⁶ . In 2016, emissions in the power sector already fell by 24% compared to 2012 and even by 62% when compared to 1990.⁷

Exhibit 6: CO2 emissions (power sector) 2030

3) Mexico: gas demand decreases with higher carbon prices compared to today

Exhibit 7: Share of gas in power generation mix with different carbon price scenarios

Exhibit 8: CO2 emissions (power sector) 2030

In Mexico, the share of gas could be negatively affected by a carbon price; a carbon price of US$30/t could reduce the share of gas by nearly 50% in 2030.

In the short run (until 2025), a carbon price in Mexico has limited impact on the share of gas (replacing the remaining ~10% share of coal in the generation mix).

At the same time, carbon prices would significantly accelerate the decline of gas after 2025; cheaper RES (and later storage) would outprice gas and reduce the share of gas in generation to 20-30% by 2030.

A carbon price of US$30/t would have a significant impact and reduce emissions by 50% or ~50 Mt/yr CO2e by 2030. Interestingly, any further increase in the carbon price would yield only disproportionally smaller reductions in annual emissions in 2030.

Conclusions

It is clear that higher carbon prices significantly reduce carbon emissions and generally favour gas to replace coal in the short term (until 2025/2030).

Beyond 2025/2030, depending on the country-specific conditions, higher carbon prices help RES replace gas, thereby achieving lower marginal abatement for emissions in 2030.

1. Overall, we assume relatively stable coal prices of around US$12/MWh (t) until 2050, while gas prices increase to a plateau in the early 2020s at around US$23/MWh (t)
2. Renewable energy sources
3. Levelised cost of electricity
4. Meeting Carbon Budgets: Closing the policy gap 2017 Report to Parliament Committee on Climate Change June 2017
5. European emissions allowance (EUA)
6. Estimate based on overall national targets in the 5th carbon budget; Meeting Carbon Budgets: Closing the policy gap 2017 Report to Parliament Committee on Climate Change June 2017
7. Meeting Carbon Budgets: Closing the policy gap 2017 Report to Parliament Committee on Climate Change June 2017

List of Authors

• Frithjof Wodarg
• Bram Smeets
• Jerry van Houten
• Sebastien Leger
• Tristan Swysen

Read the article online at: https://www.hydrocarbonengineering.com/special-reports/15022018/can-carbon-prices-fire-up-gas-demand-in-electricity-generation/