Deep Decarbonization: Green Hydrogen, Net Zero, and the Future of the EU-ETS

14th October 2020 by Emma Goring

This paper offers a theoretical approach to the foundations of price formation in the EU’s Emissions-Trading Scheme (EU-ETS).

This paper offers a theoretical approach to the foundations of price formation in the EU’s Emissions-Trading Scheme (EU-ETS).

It postulates that the pricing paradigm of the European carbon market should in theory be a function of three variables:

  • market participants’ understanding of the purpose for which the EU-ETS has been established (i.e. the policy objective it is intended to achieve);
  • market participant’s perception of the effectiveness of design of the EU-ETS, and hence of its technical ability to achieve the policy objective;
  • market participants’ assessment of the political priority attached to achieving this objective, and hence of policymakers’ commitment to ensuring that the supply of European carbon allowances (EUAs) is engineered to deliver this outcome.

The paper’s key insight is that as a cap-and-trade scheme that allows policymakers to modulate the supply of EUAs with a view to meeting a specific policy objective, the pricing paradigm for the EU-ETS is in theory fundamentally different from that of other commodity markets.

The pricing paradigm for naturally occurring commodity markets such as oil or copper is based on the supply/demand balance in the prompt, with the forward curve reflecting the market’s assessment of how this balance will develop over time, and the shape of the curve a function of the cost of carry.

By contrast, in a policy-driven market such as the EU-ETS, the forward curve should in theory reflect the market’s assessment of the price at which the supply of allowances will be sufficiently constrained to achieve the desired policy objective, and the point in time at which this will occur, with the forward curve then derived by discounting back from this future point of convergence at the appropriate discount rate.

As such, today’s price should in theory reflect today’s perception of the future price required to deliver the policy goal adjusted for the time value of money.

In short, in a naturally occurring commodity market the forward curve is derived from the prompt, while in the EU-ETS – in theory at least — the forward curve should be derived backwards from the most valuable point in the future.

As a contribution to the theoretical discussion over the nature and structure of price formation in the EU-ETS, this paper should not be read as a recommendation to buy, hold, or sell EUAs. Rather, its aim is to show how the deep decarbonization required across the entire EU economy in order for the policy objective of net-zero emissions by 2050 to be achieved could lead to a wide range of potential pricing outcomes if – as we think it will – the emerging technology of green hydrogen comes to be viewed by EU-ETS market participants as the marginal abatement option that will deliver the EU’s 2050 net-zero target. The logic of this paper’s argument is straightforward, and rests on three key premises.

First, given that the EU’s target for achieving net-zero emissions by 2050 is soon to be enshrined in EU law, there is now a clear endgame in place for the EU-ETS. This endgame consists in ensuring that EUA prices reach the level required to achieve the policy objective of net-zero emissions by 2050.

Second, according to the European Commission’s recently launched strategic vision for green hydrogen – i.e. hydrogen produced via electrolyzers powered by wind- and solar-generated electricity – the ultimate objective of net-zero emissions by 2050 cannot be achieved without green hydrogen contributing a significant part of the solution. At some point, therefore, EUAs will have to reach the price level that incentivizes the use of green hydrogen over alternative fossil-fuel energy sources in buildings, transportation, and power generation.

Third, the pre-requisite for making green hydrogen commercially viable as an energy source is to make it commercially viable as an industrial feedstock by 2030.

This is because green hydrogen will be competitive with grey hydrogen as a feedstock well before it will be competitive with fossil-fuel energy carriers such as natural gas or petroleum products as an energy source for space heating or transport or power generation.

Owing to the fact that the production process for grey hydrogen is very carbon intensive, the higher production costs for green hydrogen can be offset by means of a carbon price. However, the greater the production-cost differential between green and grey hydrogen, the higher the carbon price will need to be in order for green hydrogen to displace grey hydrogen.

This means that the cost of producing green hydrogen needs to be reduced significantly between now and 2030 so that carbon pricing at a politically acceptable level can make green hydrogen competitive with grey hydrogen. The European Commission is targeting a production cost for green hydrogen by 2030 of around €2 per kilogramme (kg), compared with cost estimates today of €4.5/kg-€6/k. This compares with a production cost for grey hydrogen today of around €1.5/kg.

It is not our purpose here to analyze in detail the feasibility of reducing the cost of green hydrogen to the range of €1.1/kg-€2.4kg by 2030 envisaged by the Commission, not least as there are a number of specialist studies already available that have looked at this in exhaustive detail both at the global and the EU level. Rather, our objective is to consider the theoretical carbon-pricing implications in the EU from today’s standpoint for a range of potential green-hydrogen cost outcomes by 2030 assuming that the cost of green hydrogen can be brought down to a range of €2/kg–€2.5/kg.

That being said, and based on both (i) our review of the literature on the economics of green hydrogen, and (ii) our own analysis of the Commission’s investment estimates for scaling up green-hydrogen production, we think it is reasonable to assume that the cost of producing it can indeed be reduced to €2/kg-€2.5/kg by 2030.

From these three premises it follows that the EU-ETS will only be able to play its part in delivering net-zero emissions by 2050 if it first enables green hydrogen to displace grey hydrogen as a feedstock by 2030.

Accordingly, this paper concludes that if the EU’s 2050 net-zero target is to be met then the EU-ETS pricing paradigm will need to shift at some point from one based on fuel-switching in the power sector to one based on fuel-switching in industry, whereby the cost of switching from grey hydrogen to green hydrogen becomes the key pricing parameter.

Read the rest of the report here: http://bit.ly/MCL_BNP