How does the price of CO2 affect your electricity bill?

We all play an important part and contribute to climate change to a greater or lesser extent. The products we buy, the energy we produce, the transport we use, the waste we generate, etc. Everything directly influences the acceleration of climate change.

Companies from different sectors release CO₂ and other gases on a daily basis and the more carbon dioxide there is in the atmosphere the more heat is retained. This causes what we call global warming and it has different consequences, such as changes in climate, in food production, in the water supply and especially in human health and biodiversity.

However, there are a number of tools to help us move towards a better future. The cornerstone for achieving the objectives established by the European Union is the Emissions Trading System that restricts emissions from energy-efficient installations and air transport between EU countries.

The EU has set very ambitious targets for reducing emissions and that is why the activities of the sectors covered by this market that emit CO₂ into the atmosphere will have to pay for this and buy emission rights on this market. There is no doubt that this is beneficial for the environment and this is why we need to understand why it directly affects our electricity bill.

What are emission rights?

The European Union has always been characterised as a benchmark in terms of climate ambition, as well as for its objectives to reduce greenhouse gas emissions.

The European Emissions Trading System was conceived as a tool to make it easier to meet the commitments undertaken by the European Community as a result of the approval of the Kyoto Protocol (1997). This led to Directive 2003/87/EC of the European Parliament and of the Council establishing a system for trading greenhouse gas emission rights in the EU which was approved on 13 October 2003. In accordance with the provisions of this Directive, the Emissions Trading System (ETS) became operational on 1 January 2005. Currently, it applies to 40% of emissions in the European Union.

The ETS has a certain number of credits to auction and companies need to have sufficient permits to cover their emissions every year; accrued rights are generally used from one year to the next. 

However, these rights are not shared equally between all companies. While industrial sectors at severe risk of carbon leakage are allocated enough rights free of charge to cover 100% of their emissions, the remaining industrial sectors are only able to cover 30% in this way. In fact, for the latter it is expected that by 2030 this will be 0%, as has been the case for the generation of electricity since 2013.

Approximately 43% of the rights in the emission rights trading system are allocated free of charge and the remaining 57% are auctioned in the market where companies such as electricity companies come to purchase them.

So if the permits the issuing companies have are insufficient, they need to reduce their emissions or buy more rights from another issuer on the market. This mechanism is leading companies to make decisions aimed at reducing their emissions and thus bringing the EU closer to a more sustainable future.

How is the price of CO₂ determined?

The aim is to reduce greenhouse gas emissions. In fact, the EU aims to reduce its emissions by 55% by 2030 compared to 1990 and to become carbon neutral by 2050. With this in mind, the solution that has been established is to assign a price to polluting emissions that will help redirect public and private investment towards production and consumption models that contribute to decarbonising the economy. 

Benefits of setting a price for carbon

The price is set by the market under a supply and demand model. Emissions trading works with a 'Cap and Trade' system. In this case, 'Cap' refers to the total limit for emissions that the EU puts into circulation, which each year is reduced in order to reach the proposed objective. 'Trade' refers to emission rights being subject to trade.

So we understand it well, an emission right is equivalent to one ton of CO₂ emissions and, the price for CO₂ is about €60/ton.

Developments in carbon prices

The price of CO₂ emission rights has varied significantly since it was introduced in 2005. Until 2017, the price of carbon was really low mainly due to the economic crisis and high imports of international credits that created a surplus of emission rights that led to a low price level.

It was the European Union that, from 2014 onwards, decided to reduce the rights in circulation, through shock measures such as what is called backloading (postponement of part of the auctions for 2014 – 2015 - 2016), and through structural measures such as the implementation of a Market Stability Reserve (which establishes the mechanism to control the existing surplus and any that could be generated in the future. For example, that which was generated in 2020 as a result of COVID).

The approval and implementation of this measure in 2019 led to the beginning of a bullish rally in prices, so the price rose and this meant that companies were forced to reduce their emissions. This, together with Brexit and the United Kingdom abandoning the EU Emissions Trading System, but above all the approval of an increase in EU ambitions establishing a target of emission reduction to 55% by 2030 compared to 1990, and the publication of the planned amendments to the trading system based on this new objective, resulted in a very significant increase in the price of CO₂.

While the average annual price in 2018 was around 15 euros, in the following two years it was approximately 25 euros. So far in 2021, the average has been 50.15 euros, with the highest price coming in November (67.54 euros) and the lowest in January (31.17 euros). 

How the price increase affects your electricity bill

Developments in the price of carbon, and above all how it has increased in recent years, have had an impact on electricity bills and together with this there is the significant rise in the price of gas. Although emission rights represent a mechanism that affects the finances of polluting companies, this rise ends up having an impact on the final bill for consumers.

Currently, renewable energy production is not enough to cover the high demand for electricity. This makes it necessary to continue producing energy in combined cycle plants, which because they are electricity generators need to acquire CO₂ rights in the Emissions Trading System market in order to generate emissions into the atmosphere during their activity. Specifically, with the current prices for CO₂ emission rights, this affects the cost of electricity production by about 20 euros/MWh.

To summarise, as long as it is combined cycles that establish the price per kilowatt in electricity generation, the price of CO2 will continue to have an impact on the price of electricity. At least, this will be the case in the short or medium term, until it becomes possible to cover most of the demand with renewable and nuclear energies.  

Although emissions trading represents a good mechanism to combat climate change and it is effective decarbonisation, it really does have an effect on the production costs of electricity companies. This increase, together with the increase in the price of gas, are the factors that are mainly responsible for the rise in the price of electricity and which in the end has an impact on the consumer's electricity bill.