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Nat gas to EUA correlation will likely switch to negative in 2026/27 onward

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20 april, 2024

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Historically positive Nat gas to EUA correlation will likely switch to negative in 2026/27 onward

Bjarne Schieldrop, Chief analyst commodities, SEB

Historically there has been a strong, positive correlation between EUAs and nat gas prices. That correlation is still fully intact and possibly even stronger than ever as traders increasingly takes this correlation as a given with possible amplification through trading action.

The correlation broke down in 2022 as nat gas prices went ballistic but overall the relationship has been very strong for quite a few years.

The correlation between nat gas and EUAs should be positive as long as there is a dynamical mix of coal and gas in EU power sector and the EUA market is neither too tight nor too weak:

Nat gas price UP => ”you go black” by using more coal => higher emissions => EUA price UP

But in the future we’ll go beyond the dynamically capacity to flex between nat gas and coal. As the EUA price moves yet higher along with a tightening carbon market the dynamical coal to gas flex will max out. The EUA price will then trade significantly above where this flex technically will occur. There will still be quite a few coal fired power plants running since they are needed for grid stability and supply amid constrained local grids.

As it looks now we still have such overall coal to gas flex in 2024 and partially in 2025, but come 2026 it could be all maxed out. At least if we look at implied pricing on the forward curves where the forward EUA price for 2026 and 2027 are trading way above technical coal to gas differentials. The current forward pricing implications matches well with what we theoretically expect to see as the EUA market gets tighter and marginal abatement moves from the power sector to the industrial sector. The EUA price should then trade up and way above the technical coal to gas differentials. That is also what we see in current forward prices for 2026 and 2027.

The correlation between nat gas and EUAs should then (2026/27 onward) switch from positive to negative. What is left of coal in the power mix will then no longer be dynamically involved versus nat gas and EUAs. The overall power price will then be ruled by EUA prices, nat gas prices and renewable penetration. There will be pockets with high cost power in the geographical points where there are no other alternatives than coal.

The EUA price is an added cost of energy as long as we consume fossil energy. Thus both today and in future years we’ll have the following as long as we consume fossil energy:

EUA price UP => Pain for consumers of energy => lower energy consumption, faster implementation of energy efficiency and renewable energy => lower emissions

The whole idea with the EUA price is after all that emissions goes down when the EUA price goes up. Either due to reduced energy consumption directly, accelerated energy efficiency measures or faster switch to renewable energy etc.

Let’s say that the coal to gas flex is maxed out with an EUA price way above the technical coal to gas differentials in 2026/27 and later. If the nat gas price then goes up it will no longer be an option to ”go black” and use more coal as the distance to that is too far away price vise due to a tight carbon market and a high EUA price. We’ll then instead have that:

Nat gas higher => higher energy costs with pain for consumers => weaker nat gas / energy demand & stronger drive for energy efficiency implementation & stronger drive for more non-fossil energy => lower emissions => EUA price lower

And if nat gas prices goes down it will give an incentive to consume more nat gas and thus emit more CO2:

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Cheaper nat gas => Cheaper energy costs altogether, higher energy and nat gas consumption, less energy efficiency implementations in the broader economy => emissions either goes up or falls slower than before => EUA price UP

Historical and current positive correlation between nat gas and EUA prices should thus not at all be taken for granted for ever and we do expect this correlation to switch to negative some time in 2026/27.

In the UK there is hardly any coal left at all in the power mix. There is thus no option to ”go black” and burn more coal if the nat gas price goes up. A higher nat gas price will instead inflict pain on consumers of energy and lead to lower energy consumption, lower nat gas consumption and lower emissions on the margin. There is still some positive correlation left between nat gas and UKAs but it is very weak and it could relate to correlations between power prices in the UK and the continent as well as some correlations between UKAs and EUAs.

Correlation of daily changes in front month EUA prices and front-year TTF nat gas prices, 250dma correlation.

EUA price vs front-year TTF nat gas price since March 2023

Front-month EUA price vs regression function of EUA price vs. nat gas derived from data from Apr to Nov last year.

The EUA price vs the UKA price. Correlations previously, but not much any more.

Forward German power prices versus clean cost of coal and clean cost of gas power. Coal is totally priced out vs power and nat gas on a forward 2026/27 basis.

Forward price of EUAs versus technical level where dynamical coal to gas flex typically takes place. EUA price for 2026/27 is at a level where there is no longer any price dynamical interaction or flex between coal and nat gas. The EUA price should/could then start to be negatively correlated to nat gas.

Forward EAU price vs. BNEF base model run (look for new update will come in late April), SEB’s EUA price forecast.

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