1. Climate change: challenges & the search for a sustainable policy Clim. change tech.& policies Tue 31May05.PPT Vianney Schyns Manager Climate & Energy Efficiency Utility Support Group Energy provider for DSM & SABIC Symposium Sustainable Energy Eindhoven University of Technology Designers association “Octave Levenspiel” 31 May 2005 Eindhoven, Netherlands

2. 2 Contents History of a successful change –Political views early 21 st century –Shaping a carbon constrained economy Where we are today –Technology & policy challenges –Policy cap & trade emissions trading: fitness for purpose –Electricity & opportunity cost Alternative policy: Performance Standard Rate (PSR) –Policy objective: effective trading scheme –How it works

3. History of a successful change How we might look back in 2030

4. 4 Political views beginning 21 st century Climate change increasingly perceived as a potential significant threat to our way of life Climate change policies far from coherent –Kyoto protocol nations adopted absolute caps –USA & developing nations reluctant The riddle of absolute caps was questioned –Would acceptance of an absolute cap be responsible behaviour for a developing nation? –What scientific method exists for establishing a cap? –What is the influence of actor decisions on climate change when building a new installation in country A or B?

5. 5 Shaping a carbon constrained economy Consensus: in a carbon constrained world sustainable progress needed in all fields e.g. –Energy efficiency –Carbon sequestration (capture & underground storage) –Biomass –Renewables –Nuclear (inherent safe & fusion) Needed is … and … and –No single solution (yet) to curb greenhouse gas emissions –Leaving coal & nuclear no realistic scenario Immense challenge: absolute lowering of emissions while maintaining growth of worldwide welfare

6. 6 The world of our grandchildren Welfare growth: 50% Energy efficiency improvement: 40% –Buildings, installations, transportation Carbon sequestration: 30% –C apture technology breakthroughs, international CO 2 pipelines, 2 nd lifetime of coal & lignite using immense reserves Biomass economy: 20% –N ew impulse to co-operation industrialised & industrialising nations (sustainable plantations, concentrating technologies, use for electricity plants, industrial raw materials, transportation) Comeback of other renewables –W ind, solar, tidal Hydrogen –Upcoming energy carrier Greenhouse gas emissions: -35%

7. 7 Drastic policy changes Innovation priority 1 –Two drivers: emissions trading + support breakthrough technologies Kyoto targets adapted –Caps for nations abandoned; worldwide sector & product targets –First industry initiatives (Al, cement, steel, chemicals …) moving to same requirements for similar plants in whatever nation One standard for electricity (kg CO 2 /MWh) –Otherwise not to combine: carbon constraint, future for coal by carbon sequestration and (co-firing) biomass, adequate CHP reward Fundamental obstacles CDM tackled –Arbitrary baselines changed: harmonised standards (growing list)

8. 8 Leading to concrete actions Meaning for industrial actors Inefficient plants undertook improvement investments or closed earlier than BAU (Business As Usual) Production shift to efficient plants (new or existing) Fast growth of gas for CHP (industrial heat use) Development & implementation innovative technologies (reward front runners) Carbon sequestration Biomass

9. Climate change policy Where we are today Technology challenges Policy challenges

10. 10 Technology challenges Large improvement potential of most processes –Exergy efficiency most often still 10%-20% –Innovative processes: much lower capital investment, but … =But takes time, huge efforts & risk taking Intensified carbon capture technologies (clean coal) –Achieve € 20-25/ton CO 2 for sequestration by 2015 or earlier Wind & solar need further development –Subsidy currently at € 100-150/ton CO 2 if all investments included (grid, back-up capacity); solar x 2-3 more expensive

11. 11 Vision on process intensification

12. 12 Example of (new) PI equipment Higee separators –Application example: separations & extractions (carbon capture?) –Compact equipment, very short residence time

13. 13 Policy challenges Immense support for renewables –Spurs significant (too fast) growth; although also sudden changes: wind in Denmark & NL (subsidy stop off-shore, 2005) Still much scope for CHP (Combined Heat & Power) –EU wants to double penetration (9% to 18% in 2010), but … allowances in Europe make no difference Acceleration need innovation (“clean, clever, competitive” EU Council) –Reward frontrunners with emission allowances & special support European Union started cap & trade scheme in 2005 –Theory of cap & trade is based on incorrect assumptions –Challenge to reform the transposition of the Directive

14. 14 Cap & trade: assumptions of the theory Scientific literature: advocates argue cap & trade superior to PSR (Performance Standard Rate) Cap & trade versus PSR would offer –Certainty of environmental outcome –Better or necessary for market liquidity –Significant lower transaction costs –Better or necessary for investments to reduce emissions Postulation: assumptions are not based on facts

15. 15 Cap & trade: the conventional picture Emission Energy use Allowances under a cap Claim: certainty of outcome

16. 16 PSR: the conventional picture Emission Energy use Allowances under a PSR Claim: no certainty of outcome

17. 17 Reality of combined picture : law of physics Emission Energy use Allowances under a PSR Allowances under a cap Emission breaks through cap if energy > forecast

18. 18 Target setting Any target, via cap or PSR, must take account of –Lead time of investments to reduce emissions –Forecasted economic growth Cap & trade –Postulation: there is no scientific method for a justified target as an ex-ante cap

19. 19 Cap & trade: the real picture Emission Energy use Maximum fuel switch electricity, determines CO 2 -price Forecasted energy use Cap Energy use > expected margin: export emissions or paying penalty Very low CO 2 -price High CO 2 -price, possibly > penalty price Emission Business as usual

20. 20 Cap & trade & historical grandfathering Specific energy use or CO 2 emission Decreasing efficiency order of plants Cap Allowances unrelated to abatement cost Cap based on historical emissions Market liquidity: great influence of economic growth & weather

21. 21 Transaction costs: cap & trade versus PSR (1) Cap & trade –Allocation formulas often complicated –Biggest debate Europe: how representative is a historical reference period; reference periods differ in all countries; therefore: =Negotiations =Serious competitive distortions across Europe =Law suits – Data collection & verification Transaction costs cap & trade –Not negligible, but certainly bearable

22. 22 Transaction costs: cap & trade versus PSR (2) PSR –Netherlands applied about 100 PSRs: big step forward –Cost 1 PSR: € 25-40,000 (consultant + company efforts), often shared (multiple producers); total € 2.5-4 mln –Allocation: 5 year period x ~ 100 Mton = 500 Mton –Additional costs: ~ € 5mln/500 Mton ~ € 0.01/ton CO 2 Transaction costs: additional for PSR – Already low in one small country –Note: Verification office 10 people (industry experience), also active for data collection & annual emission verification

23. 23 Cap & trade: failure for carbon sequestration Emission Emission at same production level Cap trading period 1 Cap trading period 2 (or 3) or immediately as new entrant Project emission reduction Failure of allocation rules in all Member States

24. 24 EC Treaty & EU Directive emissions trading Requirements EC Treaty Principle of equal treatment –Between: incumbents, new entrants, incumbents & new entrants Competition rules: free market –Winners of market share not hindered (innovation) Polluter-pays principle –Largest scheme ever of environment to economy Requirements EU Directive emissions trading Environmental integrity –Recital 3 To promote reductions & energy efficiency such as CHP –Article 1 & recital 20 Current allocations rules: no compliance –Scheme was not allowed to be postponed – benefit of doubt

25. 25 Policy challenge EU trading scheme Directive transposed as cap & trade –Polluter-earns principle: historical grandfathering (most) –Different rules in different Member States: serious distortions –Limited incentive reduction investments: historic reference later –No incentive for closure: no allowances after same year or period –No or limited incentive for high efficiency new plants –Major uncertainty for new plants: limited new entrant reserve, first-come-first-serve Trading scheme lost track of purpose, lack of incentive

26. 26 Example competitive distortions (1) Ammonia excl. process emissions Assumption: ammonia in trading scheme (not yet in UK, Germany)

27. 27 Example competitive distortions (2) Other historical reference periods: NL 2001 & 2001; UK average best 5 years 1998-2003; Germany average 2000-2002;

28. 28 Theory cap & trade: wrong assumptions Assumptions scientific literature of advocates of cap & trade not based on facts Cap & trade versus PSR does not offer –Certainty of environmental outcome –Better market liquidity –Significant lower transaction costs –Clear incentive for reduction investments –On the contrary … lack of purpose, major failure of the theory

29. 29 Electricity & opportunity-cost principle Electricity –No storage, no imports from overseas (regional markets) –Severe demand fluctuations (day/night, weekend), reserve gas-fired Opportunity-cost principle under cap & trade –Sell allowances when lowering production (no new sales contract) –Allowances: generally free of charge for 95% of need –Therefore: CO 2 -price fully in electricity cost-price, windfall profits Fundamental problems cap & trade electricity –Polluter-earns principle –Inhibitor of a competitive market: enhancement of frozen market shares (market share winner must buy allowances) –Trading scheme advantage turns into one-sector winner Root cause: frozen caps give opportunity

30. 30 European merit order electricity (EU-15) 20 40 60 Short run marginal cost €/MWh 100300500 Installed capacity (GW) Source: IEA data Hydro Wind Nuclear Coal & lignite CCGT Gas Boiler OCGT Oil Range European short run marginal cost Market price indications in regional markets before emissions trading Germany, Belgium, France, UK Netherlands Italy

31. 31 1 st substitution: influence on merit order 20 40 60 Short run marginal cost €/MWh 100300500 Installed capacity (GW) Source: IEA data Hydro Wind Nuclear Coal & lignite CCGT Gas Boiler OCGT Oil Range European short run marginal cost CO 2 -price € 6/ton Price increase € 3-6/MWh 1 st substitution: Coal by Combined Cycle Gas Turbine

32. 32 2 nd substitution, same price difference coal - gas 20 40 60 Short run marginal cost €/MWh 100300500 Installed capacity (GW) Source: IEA data Hydro Wind Nuclear Coal & lignite CCGT Gas Boiler OCGT Oil Range European short run marginal cost CO 2 -price € 22/ton Price increase € 11-20/MWh 2 nd substitution: Coal by gas boiler

33. 33 Electricity windfall profits by cap & trade Windfall profit at € 20/ton CO 2 : € 20-30 billion/year Optimisation profit of the scheme at € 20/ton CO 2 : € 2.5 billion/year Source: EU Commission Price below fuel + opportunity-cost: cut production & sell allowances

34. 34 Emerging recognition of purpose problem Fitness for purpose –Reduction investments should never be regretted, but … =Cap & trade: reduction becomes historical emission in future Problems with cap & trade –Quotes of advocates of cap & trade (!) =“No sensible company undertakes reduction investments on the basis of current allocation methods” –Peter Vis, EU Commission DG Environment =“Reference 2005 for allowances 2008-2012 would be perverse” =“Old reference should be taken, but this cannot go on for ever … next step must be bold”

35. Alternative: Performance Standard Rate Policy objective: effective trading scheme How it works

36. 36 Policy objective: decoupling emission & growth Emission Production growth Business as usual Energy efficiency Biomass, carbon sequestration, technology breakthroughs

37. 37 PSR: weather & growth secondary factors Specific energy use or CO 2 emission Decreasing efficiency order of plants Weighted average Sellers of allowances Buyers of allowances PSR High abatement cost Low abatement cost Much better market liquidity: many buyers & sellers

38. 38 PSR: incentive suited for purpose Emission Emission at same production level PSR year 1 Allowances coupled to production level PSR year n Allowances coupled to production level Key feature: project reward, independent of future PSR Certainty of reward for reduction investments

39. 39 PSR: incentive suited for purpose Emission Emission at same production level PSR year 1 Allowances coupled to production level PSR year n Allowances coupled to production level Key feature: project reward, independent of future PSR Successful reward of carbon sequestration Example: clean coal plant

40. 40 Cornerstones of PSR 1.Start with major emitters: limited number of products 2.PSR not timely available: each operator starts with own efficiency; establish PSR after first year Predictable business environment, operator knows efficiency will be rewarded, PSR will emerge soon 3.PSR just below average: otherwise market unable to supply shortage of allowances 4.PSRs will gradually tighten: environmental purpose 5.Banking & lending: market stability (5% - 7%) 6.Recommendation independent “Climate Board” similar as for monetary policy, making annual reviews, giving policy advice and adjusting when needed PSR Banking & lending rate

41. 41 Few PSRs: already major coverage 100% Coverage of emissions under the scheme Electricity (1 PSR) incl. for CHP (Combined Heat & Power) Steel (4-5 PSRs) Cement (1 or few PSRs) Refineries (1 PSR) Major chemicals (10-20 PSRs) Benchmarking in the Netherlands: 100 PSRs

42. 42 Benchmark formula for PSR Benchmark data: population under the scheme –EU-25, future with Norway, Japan, South Korea, Canada, etc. PSR = WAE – CF x (WAE – BAT) –WAE = Weighted Average Efficiency –BAT = Best Available Technique (proven Best Practice) –CF = Compliance Factor, equal for all PSRs, reflecting equal efforts between different types of installations Compliance Factor –2008: CF = 3% (to create CO 2 market price) –2012: possibly 15%-20%

43. 43 PSR = WAE – CF x (WAE – BAT) Specific energy use or CO 2 emission Decreasing efficiency order of plants Weighted average 1 PSR 1 BAT Product 1 steep curve Product 2 flat curve Normalised curves Weighted average 2 PSR 2

44. 44 Practical recommendations to start in 2008 Consultants for data collection 2003 or 2004 –Electricity: emission & production incl. heat for CHP (6 months job) –Steel: similar –Probably already available: cement, refineries, steamcrackers, ammonia, sugar, etc. Producers must accept: keep it simple –No correction for secondary effects Major countries: not waiting but taking initiative –Germany, UK, Italy, France, Spain, Scandinavia, etc.+ Benelux with benchmark experience (not wait for completeness, expand gradually) –Appoint high level “champions” with industry experience for main products (fresh & independent views) –Hire consultants for concrete jobs, no theoretical studies

45. 45 Conclusion Major transform of EU scheme required to avoid loss of real progress for 8 years, to ensure compliance with: –Worldwide environmental integrity –Polluter-pays principle and competition rules, two acid tests for a sustainable scheme when attracting new participants such as Norway, Canada, South Korea, Japan & later USA, China, India, etc.; –A predictable business environment, leading to clear stimulation of innovation, essential for environmental results and in full support for the Lisbon strategy in Europe as well as global welfare