Climate change challenges & the search for a sustainable policy Unity of fitness for Purpose, Polluter-pays principle & level Playing field Sustainable policy ICCDU 20June05.PPT Vianney Schyns Manager Climate & Energy Efficiency Utility Support Group Energy provider for DSM & SABIC 8th International Conference on Carbon Dioxide Utilization ICCDU-VIII June 2005 Oslo, Norway

2 Contents History of a successful change –Imagine we live in 2030, and imagine we were successful Where we are today: Cap & Trade –Technology & policy challenges –Cap & trade: negative unity of basic principles =Fitness for Purpose, Polluter-pays principle & level Playing field Alternative: Performance Standard Rate (PSR) –Policy objective: positive unity of basic principles –How it works

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

4 Political views beginning 21 st century 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 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 was … 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 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 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 Leading to concrete actions For industrial actors Inefficient plants improved or closed earlier ; production shift to efficient plants (new & existing) Development & implementation innovative technologies (reward front runners) & CHP (industrial heat use) Co-firing biomass & carbon sequestration

Where we are today: Cap & Trade Technology challenges Policy challenges

10 Technology challenges Large improvement potential of most processes –Exergy efficiency most often still 10%-20% –Innovative processes: much lower capital investment, 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 € /ton CO 2 if all investments included (grid, back-up capacity); solar x 2-3 more expensive

11 Vision on process intensification

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

13 Policy challenges Still much scope for CHP (Combined Heat & Power) –Double penetration desired (9% to 18% in 2010), but … allowances in Europe make no difference Acceleration need innovation (“clean, clever, competitive” approach adopted by EU Council) –Reward frontrunners with emission allowances & special support Mindset –Absolute caps for nations (now & post 2012) =Is Luxembourg doing better than Spain? –Absolute caps for companies (EU trading scheme)

14 Cap & trade: assumptions of the theory Scientific economic 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 Cap & trade: the conventional picture Emission Production Allowances under a cap Claim: certainty of outcome

16 PSR: the conventional picture Emission Production Allowances under a PSR Claim: no certainty of outcome

17 Reality of combined picture : law of physics Emission Production Allowances under a PSR Allowances under a cap Emission breaks through cap if production > forecast

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 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

20 Transaction costs: PSR versus cap & trade PSR –Netherlands applied about 100 PSRs: big step forward –Cost 1 PSR: € 25-40,000 (consultant + company efforts), often shared (multiple producers); total € 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

21 Cap & trade & historical grandfathering Emission Emission at same production level Cap trading period 1 Cap trading period 2 or 3 In the absence of the reduction project, the company had virtually retained cap 1 Project emission reduction Production Uncertainty of reward of projects to reduce emissions Lower emission will be in future reference period

22 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

23 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

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 Policy challenge EU trading scheme Directive transposed as cap & trade –Polluter-earns principle: historical grandfathering (most) –Different rules in different Member States unlevel playing field =Serious distortions by different reference periods, different C-factors =Plants with same efficiency & production history: different allocations –Limited incentive reduction investments: historic reference later –Disincentive closure & shift to efficient plants: punishment –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 Distortions: Steamcracker current worldtop efficiency Sales Purchases in kton CO 2 /year Covenant Benchmarking now Netherlands 1 st period Expected 2 nd period UKGermany normal rule Germany option rule ! France? Spain?

27 Distortions: Steamcracker average EU efficiency Sales Purchases in kton CO 2 /year Covenant BM now Netherlands 1 st period Expected 2 nd period UKGermany normal rule Germany option rule ?? France? Spain?

28 Distortions: Steamcracker state-of-the-art efficiency Sales Purchases in kton CO 2 /year Covenant BM now Netherlands 1 st period Expected 2 nd period UKGermany normal rule Germany option rule ! France? Spain? Note: zero sales or purchases as new entrant zero incentive Maximised from 113% to 110% worldtop

29 Steamcracker bad performer (scale change !) Sales Purchases in kton CO 2 /year Covenant BM now Netherlands 1 st period Expected 2 nd period UKGermany normal rule Germany option rule ?? France? Spain? Minimum allocation 85% of benchmark

30 Electricity & opportunity-cost principle Fundamental problems cap & trade electricity Root cause: frozen caps give opportunity(-cost) Fuel-switch major driver CO 2 -price

31 1 st substitution: influence on merit order Short run marginal cost €/MWh Installed capacity (GW)Source: IEA data Hydro Wind Nuclear Coal & lignite CCGT Gas Boiler OCGT Oil Opportunity-cost € 3-6/MWh 1 st substitution: Coal by Combined Cycle Gas Turbine Low price differential coal – gas CO 2 -price € 7/ton Opportunity-cost below long run marginal cost Regional market prices

32 1 nd substitution: influence on merit order Short run marginal cost €/MWh Installed capacity (GW)Source: IEA data Hydro Wind Nuclear Coal & lignite CCGT Gas Boiler OCGT Oil Opportunity-cost € 9-19/MWh 1 st substitution: Coal by Combined Cycle Gas Turbine Higher price differential coal – gas CO 2 -price € 21/ton Opportunity-cost at about long run marginal cost Regional market prices

33 1 nd substitution: influence on merit order Short run marginal cost €/MWh Installed capacity (GW)Source: IEA data Hydro Wind Nuclear Coal & lignite CCGT Gas Boiler OCGT Oil Opportunity-cost € 12-27/MWh 1 st substitution: Coal by Combined Cycle Gas Turbine Even higher price differential coal – gas CO 2 -price € 30/ton Opportunity-cost above long run marginal cost Regional market prices

34 Findings electricity and cap & trade Fuel + opportunity-cost (F + O) –If market price < F + O: cut production & sell allowances –F + O serve as a cushion for electricity market price –When CO 2 -price further rise, market price is pushed up Competition rules & caps: frozen market shares –Market share winner buys allowances, loser sells –Zero sum game –Violating competition rules: hindered free trade Windfall profits start at € 15-20/ton CO 2 –Electricity one-sector winner of the scheme

35 Unity of basic principles under cap & trade Historical grandfathering without benchmark –No fitness for purpose –No polluter-pays principle –No level playing field  Unity = 3 x no Fitness for purpose drivers (1) Meaningful CO 2 -price (2) Clear volume incentive (efficiency differentiation) Efficiency differentiation denies sunk cost –Sunk cost hinder unity of basic principles –Sunk cost can therefore only be accommodated temporarily

36 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 would be perverse” =“Old reference should be taken, but this cannot go on for ever … next step must be bold”

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

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

39 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

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

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

42 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

43 Few PSRs: 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

44 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%

45 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

46 Transition regime to accommodate sunk cost PSR: Specific energy use or CO 2 emission PSR PSR A PSR B Transition period Starting efficiency installation A Starting efficiency installation B 2017 Action to reduce emissions is rewarded immediately

47 Sunk cost alternative Burden Sharing Agreement and EU-wide PSR cause –Frictions for Member States with efficient industries –Frictions for companies in Member States with low efficient industries Better alternative accommodating sunk cost –Reallocate part of EU development funds –Enables clear trading scheme Support for industrial renewal –Lisbon strategy –Global welfare

48 The way forward Consultants for data collection 2003 or 2004 –Electricity: emission & production incl. heat for CHP (6 months job) –Steel: similar –Probably available: cement, refineries, steamcrackers, ammonia, 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”, partly with industry experience, for main products

49 Conclusion Major transform of EU scheme required to avoid loss of real progress for 7.5 years, compliance with: –Worldwide environmental integrity –Unity of Fitness for Purpose, Polluter-pays principle, & level Playing field, three 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, in full support for the Lisbon strategy in Europe as well as global welfare