price substitution effects across energy markets – Bank Underground

Dooho Shin and Rebecca Mari

The Bank of England Agenda for Research (BEAR) sets the key areas for new research at the Bank over the coming years. This post is an example of issues considered under the Financial System Theme which focuses on the shifting landscape and new risks confronting financial policymakers.

Carbon pricing has emerged as one of the main mitigation measures adopted around the world to fight climate change. In the UK and EU, increases in carbon prices in the Emissions Trading Schemes (ETS) work as an incentive to substitute away from emissions-intensive activities and sources of power. Such increases can be a result of direct government policies, but as we explain in this post, changes in carbon prices appear to be also endogenously linked to developments in energy markets. An understanding of the possible transmission channels underlying the relationship between the two is important to assess how climate-related risks are linked to broader macroeconomic developments and thus monetary and financial stability.

Carbon pricing generally consists in the application of a monetary cost to greenhouse gas emissions through either a carbon tax or ETS. In an ETS, generally in the form of a ‘cap-and-trade’ system, the government sets a cap on emission allowances and the market determines the price. Some government policies supporting the transition to net zero focus on increasing carbon prices. These include reducing the supply of emission allowances in ETS. Changes in carbon prices significantly affect the economy, with their effect being larger for more emission-intensive countries and firms. An increase in carbon prices is associated with a negative impact on GDP and equity prices and an increase in consumer prices and interest rates and risk premia in the short run. This is commonly referred to as a short-term trade-off associated to transition at a macro level.

But in practice short-run fluctuations in ETS allowance prices are not just exogenously determined by government policies. Carbon prices exhibit a strong correlation to developments in gas markets, as shown in Chart 1 where UK and EU ETS allowances prices (respectively UKA and EUA spot series) are plotted against UK benchmark gas prices (UK NBP day ahead series). We identify three possible transmission channels behind this historical correlation.

Chart 1: UK and EU carbon prices broadly track each other and gas prices

Notes: 20/5/2021 (start of the UK ETS) to 7/2/2025.

Sources: Bloomberg and Bank calculations.

The first and most important transmission channel relates to substitution effects affecting electricity producers’ choices. When gas prices rise, electricity producers switch from natural gas to coal if the gas becomes more expensive than coal. Coal is more carbon-intensive than gas, so this increases demand for ETS allowances and pushes carbon prices higher. This was observed in Europe during the energy shock in 2022. Coal as a source of power generation rose by 4% compared to 2021 while gas fell by 6%. Market intelligence suggests this has contributed to the higher carbon prices observed over 2022 (Chart 1).

This channel is directly operating in countries producing both gas and coal. Some European countries continue to generate coal power, so higher gas prices could drive up EU carbon prices through the gas-to-coal switch described above. Higher carbon prices, coupled with higher gas prices, would push up electricity prices in the EU, which are partially driven by a combination of gas and carbon prices.

International spillovers through energy markets’ interconnectedness however mean that carbon prices in countries not producing either of the two sources of energy could still be affected. In the UK for instance, despite the closure of the last coal power station in September 2024, a global gas price shock can still affect UK carbon prices through the interconnection with the European wholesale power market. The UK has 9.8GW of electricity interconnector capacity with Europe, which allows power to flow from cheaper to more expensive markets. An increase in electricity prices in the EU such as the one discussed above could incentivise electricity suppliers in the EU to increase imports of GB-generated power to maximise profits. The increase in demand is likely met through an increase in GB-based power generation based on non-coal fossil fuels, given current production and storage constraints to renewable power, thus leading to an increase in UK carbon prices. This channel could explain the correlation between the UK and EU ETS allowance prices too, as higher carbon prices in the EU spills over to the UK through the power markets.

Another channel relates to substitution effects occurring in non-power sectors. Higher gas prices also lead to fuel switching away from gas to more carbon-intensive fuels in these sectors, also driving up carbon prices. Chart 2 shows that within a long-term rising trend, the share of natural gas across core fossil fuels’ consumption tends to fall when gas price rises in the UK manufacturing sector, which is in part within the scope of the UK ETS.

This supports substitution between gas and more carbon-intensive fuels such as oil and coal in non-power sectors as another potential transmission channel between gas and carbon prices. The significance of this transmission channel could grow if non-power sectors were to receive fewer ETS allowances for free in the future.

Chart 2: Higher gas prices generally incentivise other fossil fuels’ usage in manufacturing

Notes: Manufacturing industry’s core fuels are defined as natural gas, coal, petrol and fuel oil. Gas price is an average gas price purchased by the UK manufacturing industry.

Sources: Department for Energy Security and Net Zero – manufacturing industry’s fuel prices, Office for National Statistics – fossil fuels by fuel type and industry and Bank calculations.

Finally, the last channel is financial speculators who trade based on the predicted relationship between gas and carbon prices explained above. Despite the coal phase-out, speculators could continue to buy ETS allowances upon higher gas prices, amplifying the impact of a gas price shock on carbon prices. Speculators could also trade on the correlation between the UK and EU ETS, amplifying spillovers from the EU.

These three channels have likely contributed to the correlation between gas and carbon prices. As the economies undergo structural changes as a result of climate change and associated policies, the drivers behind changes in carbon prices are likely to also evolve.

As grids transition towards zero-carbon, the power sector could see a reduction of the substitution effect on fuel choice between gas and coal. Simultaneously, if non-power sectors were to increasingly fall within the scope of ETS or were to receive fewer ETS allowances for free, their fuel choices could have a stronger impact on carbon prices. Furthermore, transition policy-driven changes in carbon prices have a significant macroeconomic impact on the economy, with likely second round effects on carbon prices themselves through demand side effects.

Overall, although much of the future market dynamics of carbon prices is likely to depend on green technologies and government policies, today gas markets still play a central role. The Bank of England’s 2025 Bank Capital Stress Test (BCST) scenario brings to attention the relationship between gas and carbon prices, a concrete example of how climate-related risks interact with traditional financial risk drivers and part of the ongoing Bank’s work exploring how climate-related risks could impact the UK financial system through a wide variety of channels.

Dooho Shin and Rebecca Mari work in the Bank’s Climate, Sustainability and Community Division.

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