1 EU ETS: Relative importance of the different factors affecting the competitiveness of the energy intensive industries Wyn Jones OBE High Level Group on Competitiveness for Energy Intensive Industries: Ad Hoc Group 3 Brussels 31 March, 2006

2 Simplified supply chain of energy FUEL cost efficiency operationsdistribution Variable Base load WholesaleRetailDemand Fuel and CO2 efficiencies for base-load not reflected Distribution efficiencies not reflected in CO2 pass-through Long-term financing efficiencies not rewarded ETS is meant to reward efficiency but there is no cost-reflective pricing Of carbon in todays energy markets (why 27 ?!).

3 Market Assessments Wholesale Prices - EU ETS The EU ETS has become an integral part of the UK energy market. Prices have increased in line with energy prices and fuel cost differentials. Historical EU ETS Prices Vs Coal and GasComments Euro / mt (Nominal) Since January 2005 the price of EU Emissions has increased from Euro 7 / mt to Euro 27 / mt. The EU ETS has become an important price driver in the UK energy market high power prices encourage generation which generation fuel is used is dictated by fuel cost differentials and the differential opportunity cost of allowances. Coal emits around twice as much CO2 as CCGT High gas prices relative to coal have encouraged increased coal generation increasing demand for allowances. Generator pricing behavior has been to pass the total opportunity cost of the EU ETS into power prices, despite free allocation of 84% of allowances. Forward prices suggest that the rise in cost of CO2 will be sustained. Prices for the first (2005-7) and second phase ( ) of the scheme have increased to above 27 / mt. Gas and Coal (Mar 05 = 100) Gas Coal CO2 Sources: Point Carbon (CO2), Statoil (Gas), Argus / McCloskey (Coal)

4 Climate change priorities not being met: Power prices have increased by 35-50% since Jan 05: Oil and gas prices ETS High prices have focused attention on power market imperfections. These have been highlighted by the scale and ease of pass-through of ETS costs. However, the fuel pass- through tends to be under-emphasised and is also imperfect. Terminal pain is being felt by energy intensive companies that have exceeded Kyoto and aspirational CO2 reductions As well as damaging the EU it is diverting the debate from non- responsive sectors such as domestic.

5 ETS has priced CO2, but to whom? The sectors most sensitive to energy prices have already reduced CO2 emissions by huge amounts. Further improvement is a small percentage of the total needed. Yet they are subjected to further price signals at a time when energy prices are at a high. Under current power markets, a common ETS price signal on CO2 is sent to sectors that are not price sensitive. It has little effect where needed. Since power companies can be seen to pass through ETS costs, and due to their commitments to security of energy supply, there is no reason to expect significant energy efficiency from existing power assets beyond fuel switching – hence strong correlation between ETS and fuel price changes.

6 Recommendations* No auctioning – unless the power sector is isolated with no pass- through Ensure early action based on efficiency is recognised in allowances for EU ETS. Differentiate electricity pricing to reward the physical efficiencies of true base-load demand as opposed to the financial construct of traders base-load (aggregated variable demand). Power generation is capital-intensive with a significant risk in fuel price. Vertical integration is a classic response to such risk and should be allowed in order to protect security of supply and adequate investment. However it should be accompanied by appropriate transparency e.g of wholesale prices and ETS costs. Long term contractual arrangements between generators and demand side represent a form of vertical integration. Providing they have a commercial basis for managing investment risk they should be encouraged, both from demand to power generation and from power generation to fuel cost. *And of course longer trading periods; no cliff-edges, sell off new entrant reserves early etc etc

7 Recommendations (2) No limit on CDM / JI credits that can be used. Cap the ET price until market is fixed. Better define the role of Governments in - developing infrastructure; removing planning constraints; avoiding abrupt changes in policy – e.g. between market efficiency and security of energy supply; nuclear policy. Recognise that innovation in climate change will need to be brought forward by different mechanisms than emissions trading e.g tax breaks for R&D etc Focus policy on outcomes not selection of winners.

8 A final comment: The principle of shareholder perception is underestimated in economic analysis. We must beware that Europe is not seen as a bad place to do business. We should: Recognise businesses that have exceeded aspirational CO2 targets. State that Europe is not an area of intrinsically high energy costs. (Energy is not inherently cheap in China! Stranded energy is declining). Encourage and reward innovation in technology that will reduce energy consumption and CO2 emissions whilst meeting the aspirations of the electorate. Focus on non-performing sectors and pull through innovation