Clean Dark Spreads
The Clean Dark Spread is one of the main short term drivers of carbon prices as we explain below. Clean Dark Spreads (Clean Dark Spread) measure the profitability of coal fired electricity (power) ¬generation based on the variable cost of inputs (coal and carbon credits) and the value of the output (electricity). The constituents of the phrase are more or less self-explanatory but the “Dark” part refers to coal, the “Clean” part refers to the fact that the cost of carbon pollution is accounted for and “Spread” refers to the cost of fuel relative to the value of the electricity produced. Other derivatives of the naming convention are “Spark Spread” for the difference between gas costs and electricity and the more light-hearted than truly useful “Quark Spread” and “Bark Spread” referring to the profitability of Nuclear and Biomass electricity production respectively.
Apart from the price of the underlying constituents the other major factor is FX. Coal is priced in $, emissions in € and power in the relevant currency of the country being described. Typically discussions of Clean Dark Spread revolve around German power prices which is priced in € thus making the calculation a little simpler. Additionally, calculations need to take into account an energy conversion factor, i.e. the fuel to electricity conversion efficiency of a plant. This factor varies by plant and is based on its technical efficiency levels (newer plant are more efficient than older plant for example) AND it’s usage pattern, a power plant that is constantly cycled on and off is much less efficient than one that is continuously generating. However, for the purpose of carbon market analysis the Clean Dark Spreads are typically calculated using constant factors that provide an indication of the average Clean Dark Spread of a given electricity system, for example a 36% fuel conversion factor. Finally, the carbon content of a tonne of coal (which will impact the quantity of CO2 produced to generate 1 unit of electricity) can vary by quite a lot however for simplicity this is also kept constant at an approximation of the average carbon content of coal burned in the given system.
So Why Are The Clean Dark Spreads Important?
Europe’s electricity generating utilities are the largest compliance buyers within the EU ETS. For example, RWE were the largest CO2 emitter in Europe in 2014 with annual emissions of over 140Mt CO2. With no or very little free allocation of EU Allowances (EUAs) this equates to the need to purchase, on average, more than 500,000 EUAs per working day. The utilities typically hedge up to 3 years in advance and have hedging “windows” such that they are required by their boards to have set percentages of their hedging done for each year by the end of that window. Assessing when, and in what size utilities are likely to come to the carbon market to buy their shortfall therefore becomes an important part of any analysis of carbon price movements. So much so that the European Commission “shapes” their auction calendar to provide more EUAs for sale in periods of perceived higher demand and less in periods of low demand, for example August and December. When the utilities are keen to lock in profit levels they hedge the Clean Dark Spread, that is the coal, FX, carbon and power exposure, all at the same time. It is accepted wisdom amongst carbon market analysts, pundits and traders that “high” Clean Dark Spread market conditions will lead to more demand for EUA purchases.
So If I Track The Clean Dark Spread I Can Trade Carbon Successfully, Right?
“High” of course is a relative term so analysts track Clean Dark Spread averages and recent trends. The analysis is not especially robust at times, for example in a period of “low” Clean Dark Spread levels utilities may collectively reach the edge of their hedging windows and buy carbon regardless of the relative strength of the spread. At times like this the relationship breaks down and traders scratch their heads and possibly lick their wounds if they call the carbon price move wrong. To add to the complexity Clean Dark Spread levels are calculated across various time periods (e.g months, quarters, years) which can move independently of each other as well as for different countries.
It is impossible to know exactly when the hedging will take place however, by analysing the profitability levels of coal fired power generation it is possible to gain some insight into the short term buying and selling triggers of the biggest carbon traders, the utilities.
Make sure you are subscribed to the Redshaw Advisors Weekly Carbon Trading Market Update to find out the latest developments of the Clean Dark Spread levels.