Effectiveness of allocation options and market clarity in the EU ETS Marcus Evans conference London 22 nd of January 2007 Vianney Schyns Manager Climate & Energy Efficiency Utility Support Group Utility provider for a.o. DSM and SABIC

Contents 1.Shortcomings present cap & trade rules 2.Effect cap & trade on electricity 3.PSR  Relevant EU data chemical industry 4.Market clarity cap & trade versus PSR 5.Benchmarks with ex-post adjustment to actual production as an alternative to auctioning

Shortcomings present implementation EU ETS Directive The EU Emissions Trading Directive is the centrepiece of EU Climate change policies, rightly so, but structural improvements are urgently needed

Basics of shortcomings present allocation Existing plants: ex-ante frozen cap based on historical emissions – rewarding pollution – same quantity allowances, whether production increases or decreases (“static, frozen economy”) New plants and debottleneckings: also an ex-ante frozen cap (“plan-economy”) This allocation principle = root cause of all shortcomings, PLUS, mostly as a result of this: –Insecurity investments in new plants (finite reserves) –Highly distorting transfer rules –New plants few versus existing plants many allowances: LACK OF EFFECTIVENESS to invest to reduce emissions

EU ETS in UK Parliament 9 January 2007 MP Mr Adrian Bailey sees 3 basic flaws: –History of low efficiency rewarded with more credits. –Production growth means buying of credits. –Less efficient companies can compensate for their inability to develop by selling unused allowances; by decoupling the allowances’ system from energy efficiency and relating it purely to levels of production the scheme has developed a number of perverse incentives that hamper investment and production in the UK while contributing little to the reduction of carbon emission. Steel industry advocates average oriented baseline, to be multiplied by the volume of steel produced. That system would reverse the existing perverse incentives.

Cap & trade & electricity Killer of free market

Cap & trade: market price at opportunity-cost Euros for an equal total production volume Companies A & B A wins market share from B Gross margin cash flow Opportunity cost Cost of buying allowances: distortion Profit of sales of allowances Company A Killer of a free, undistorted electricity market No sales below opportunity-cost, selling allowances more profitable than producing electricity EU-induced windfall profits

Ex-ante rules simply kill electricity liberalisation State interference prevents competitive market –At gross margin of opportunity-cost, winning and losing market share: zero sum game –New entrants, vital for more competition, but ex-ante state decision of operating hours determine profitability – plan economy –Transfer rules protect incumbents: barrier to entry can be € 0.25 billion for a 1000 MWe power plant (4 years, or trading period) –Even worse: incumbent does not apply for transfer rule and keeps old plant stand-by (imagine 1000 MWe plant, ~ € 0.2 billion/year) Fight for allowances overrides fight for market share Price of system: economic rents – windfall profits –Cause is the opportunity to sell allowances when not agreeing a contract (opportunity-costs) –Transfer of wealth to € billion/year or double (EU)

Benchmarks with ex-post as an alternative to auctioning The structural and workable alternative of benchmarks with ex-post adjustment to actual production, or Performance Standard Rate – PSR

A few PSRs have major coverage Benchmarking Netherlands: about 100 PSRs 100% Coverage of emissions under the EU ETS Electricity (1 PSR) and for CHP (Combined Heat & Power) (1 additional PSR for heat) Steel (6-7 PSRs) Cement (1 PSR) Refineries (1 PSR) Major chemicals (10-20 PSRs) Policy recommendation: include (co-)firing biomass

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

Recent chemical EU efficiency data Shell, Dow, SABIC advocate equal EEI (for example 136) steamcrackers

Benchmark with ex-post + guarantee total cap Novel method guarantees total cap, as demanded by EU Directive Virtually no interest costs Easy & fast introduction possible on the basis of estimated benchmarks (system is self-adjusting)

Market clarity cap & trade versus PSR Shortage of allowances in cap & trade less predictable than with PSR

Cap & trade historical grandfathering Great influence of individual growth or shrinkage & weather Specific energy use or CO 2 emission Decreasing efficiency order of plants Cap Cap based on historical emissions Buying allowances Free allocation Best Practice Uncertain incentive, updating unpredictable

Market clarity cap & trade versus PSR Cap & trade: a planned shortage can turn into a surplus, or is forced into surplus when selling allowances is more profitable than producing (leakage)

Benchmarks with ex-post adjustment to actual production as an alternative to auctioning Same incentive for low carbon technologies Auctioning is detrimental to EU competitiveness

Auctioning EU: clear incentive low carbon technologies, length trading period irrelevant, but leakage & detrimental for competitiveness Specific energy use or CO 2 emission Decreasing efficiency order of plants Total cap Buying allowances Free allocation Best Practice IncentiveWeighted average Incentive

Performance Standard Rate trading: same incentive as auctioning, length trading irrelevant, (hardly or) no leakage, good for competitiveness Specific energy use or CO 2 emission Decreasing efficiency order of plants Total cap Buying allowances Free allocation Best Practice IncentiveWeighted average Incentive Selling allowances PSR = total cap

PSR works equal as auctioning Company A & B –A = emission company A; B = emission company B –Xr = assume same realised production (for simplicity) –C = CO 2 -price Cost difference auctioning –(A*Xr – B*Xr)*C Cost difference PSR –{(A – PSR)*Xr – (B – PSR)*Xr}*C = (A*Xr – B*Xr)*C PSR: allowances coupled to realised production –Avoids distortions & enables free competition (e.g. electricity) –Solves windfall profits, stimulates efficient growth –Rewards investment to lower emission, independent of actual value of the PSR (example: emission 90 to 60 per unit of product, reward = 30, regardless PSR is 70 or later 60) –Length trading period therefore immaterial, like for auctioning

Misunderstandings power market cleared Fuel specific benchmarks: against objective function =High fuel-switch prices, e.g. € /ton CO 2 =Coal power plants without CCS encouraged One electricity benchmark no deathblow coal-fired power =Coal & lignite very important, climate policy means CCS ! =Opportunity-cost now in power price (soft cost) =One benchmark with ex-post: CO 2 -cost in power price (real cost) Dash to gas with one benchmark? =Does not depend on one benchmark, but on total cap =In fact more gas if more new coal and less CHP (given total cap) =We need a controlled transition (CCS needs time)

What may happen next? NAPs can be modified Legal case Germany against EU Commission Starting with benchmarks is easy Outlook post 2012

Post 2012 regime heads for benchmarking, auctioning or a combination (away from historical grandfathering) –Industry against auctioning (if no global participation) –EU-wide instead of national “corrected” benchmarks HLG and EU Commission seek stimulating low carbon technologies, e.g. –CHP, Carbon Capture & Storage, efficiency & innovation –Distorting transfer rules, solution: same benchmark Ex-ante (windfall profits and market distortions) or ex-post –Regional (EU, USA, China, India, etc.) differentiated relative targets option for global climate agreement – transition periods can be vital; –Long-term (2020 or 2030) absolute caps carved in stone deter participation, targets may be too strong or too soft (EU energy package, experience Burden Sharing)

Transition for a faster global trading scheme PSR: Specific energy use or CO 2 emission PSR EU-Japan Transition period (with 3 or more PSRs) avoids high cost in case of auctioning for regions with higher emissions per unit of product (vital: PSRs without differentiation new/old plants) 2032 Incentive low carbon technologies the same in global trading scheme 2008 PSR USA-Canada PSR China-India Global PSR