Future Energy

The dynamic interrelationship of Coal, Oil, Gas and Carbon
(Abhishek Uppal, Clean Technology Private Equity 2009; Reference to DB Advisors Investing in Climate Change)

As carbon pricing spreads to new geographies, the interrelationship between coal, oil, gas and carbon becomes more complex. At the simplest level, carbon prices:

diminish demand for fossil fuels at the margin and;
help cleaner energy sources become competitive with fossil fuels.

The correlation between fossil fuel prices and carbon prices will depend on a number of factors - including which fossil fuel is under consideration. There are several scenarios that outline the possible correlation between carbon prices and the prices of coal, oil and gas. In reality, multiple scenarios will exist simultaneously, and therefore overlap and interact. The scenario that dominates will determine the direction of correlation. The key scenarios are:


Supply shocks - these come in two types, both of which imply negatively correlated carbon and fossil fuel prices:


Constraints (peak oil scenario): Fossil fuels are exhaustible resources. Once half of ultimately recoverable crude oil reserves have been depleted, production inevitably will fall, according to traditional peak oil theory. Crude oil production may be near its peak, and natural gas may follow soon after.
Surplus (coal glut scenario): Although other fossil fuels may be more constrained, coal is still plentiful, and the technologies for extracting it are improving. High prices for oil and natural gas may stimulate the availability of coal, and new technologies may in fact make it extremely cheap.


Demand boom (Emerging market growth) - Conservation and efficiency notwithstanding, world energy demand is likely to grow substantially over the next 20-50 years, and much of it likely supplied by fossil fuels, unless clean energy sources can scale up production rapidly. Demand-led scenarios imply positively correlated carbon and fuel prices.

The peak oil scenario (negative correlation for carbon and oil prices) addresses the "other environmental issue" in fossil fuels: their exhaustibility. If it is true that we are facing an energy crisis - increasingly limiting our ability to produce large quantities of fossil fuel on short notice - supply scarcity will drive fossil fuel prices higher. Fossil fuel scarcity and higher prices will create an environment where renewable energy is more competitive as a substitutable energy source and de-carbonization may be self-sustaining.

If energy demand stays constant as supplies dwindle:

Higher oil and gas prices will promote switching to alternatives in transport and electricity markets,
Switching can occur without extremely high carbon prices,
Total oil and gas use will decline, along with emissions from oil and gas.

To the extent that oil and and gas use drives the total demand for carbon, the peak oil scenario implies that oil and gas prices and carbon prices will tend to move in opposite directions.

The coal glut scenario (negative correlation for carbon and coal prices) addresses the possibility that coal may become extremely inexpensive and plentiful as global reserves remain substantial and the technologies for extracting and utilizing it improve in the medium term, bringing more of this resource to market. In this case, better technologies and substantial reserves allow for more coal to be supplied at cheaper prices. Other things equal, the quantity used will increase, driving up demand - and prices - for carbon offsets in a cap-and-trade carbon market. As coal prices collapse, carbon prices move higher to stop a massive shift towards coal use under a cap-and-trade system with a carbon target. Without a cap-and-trade carbon market in this scenario, there would be catastrophic emission consequences.

The emerging market growth scenario (positive correlation possible for carbon and fossil fuel prices) focuses on the recent growth of emerging market energy demand, which, together with industrialized energy use, increases demand for all energy sources. This scenario sees fossil fuel prices rising as well, but, in this case, because of increased global demand. The result is greater fossil fuel use, even at higher prices. With more fossil fuels being used, there is more demand for carbon offsets, and so fossil fuel and carbon prices rise in tandem.

The correlation between carbon and fossil fuel prices depends on which of these scenarios prevails.

The current situation
These scenarios can and probably will happen simultaneously, but the correlation of fuel and carbon prices will depend on which one dominates. Until recently, it looked like the emerging market growth scenario with tight energy markets would be most likely to dominate in the near-term.

However, in the context of market events, as the world moves into a likely recession, energy supplies will come under less pressure in the near-term, and prices are likely to remain lower.

In terms of the carbon price in Europe, the relationship between carbon and energy prices has been a function of the fuel switch between coal and gas leading to a reasonably high correlation between oil prices and carbon prices.

Long-term outlook
In the long-run, the emerging market growth scenario looks most likely to dominate, with peak oil and coal gluts both likely.