Effectiveness of allocation options and market clarity

in the EU ETS

Marcus Evans conferenceLondon

22nd of January 2007

Vianney SchynsManager Climate & Energy Efficiency

Utility Support GroupUtility 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

Eurosfor anequal totalproductionvolume Companies

A & B

A winsmarketsharefrom B

Grossmargincashflow

Opportunitycost

Cost of buyingallowances:distortion

Profit ofsales ofallowances

Company A

Killer of a free, undistorted electricity marketNo sales below opportunity-cost, selling allowancesmore profitable than producing electricityEU-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 € 40-50 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 coverageBenchmarking Netherlands: about 100 PSRs

100%

Coverageofemissionsunder theEU ETS

Electricity (1 PSR) and for CHP (Combined Heat& Power) (1 additional PSRfor 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)

Specificenergy useor CO2

emission

Decreasing efficiency order of plants

Weightedaverage 1

PSR 1

BestPractice

Product 1steep curve

Product 2flat curve

Normalised curves

Weighted average 2

PSR 2

Recent chemical EU efficiency data

EU bechmark data major chemicals

Product Consultant Weighted EU Best Efficiencies PSR = WAE - CF x (WAE - BP)EU average Practice Electricity Heat CF = Compliance Factor =

WAE BP 15% 20%

GJ/ton GJ/ton1 Steamcrackers (1) Solomon Associates 144,8 107,8 37,5% 90% 139,3 137,42 Pyrolosis gasoline (pygas) Process Design Centre 1,3 0,6 42% 90% 1,2 1,23 Benzene extraction Process Design Centre 3,8 2,2 42% 90% 3,6 3,54 Butadiene Solomon Associates 9,72 7,3 37,5% 90% 9,4 9,25 MTBE Process Design Centre 1,9 1,06 42% 90% 1,8 1,76 ldPE (low density polyethylene) Phillip Townsend Associates 8,53 5,96 42% 90% 8,1 8,07 hdPE (high density polyethylene) Phillip Townsend Associates 5,43 3,14 42% 90% 5,1 5,08 PP (polypropylene) Phillip Townsend Associates 3,56 2,27 42% 90% 3,4 3,39 EPDM (ethylene propylene rubber) (2) Phillip Townsend Associates 32,22 28,0 42% 90% 31,6 31,4

10 PVC (polyvinyl chloride) Process Design Centre 3,8 3,4 42% 90% 3,7 3,711 Nylon-6 Process Design Centre 10,0 5,71 42% 90% 9,4 9,112 Ammonia (3) Plant Services International 13,13 7,23 40% 90% 12,2 11,913 Nitric acid Process Design Centre -0,12 -1,8 42% 90% -0,4 -0,514 Fertiliser (Calcium Ammonium Nitrate)Process Design Centre 0,99 0,35 42% 90% 0,9 0,915 Urea Plant Services International 5,06 3,06 42% 90% 4,8 4,716 Melamine (4) Nexant 79,46 60,55 42% 90% 76,6 75,717 Caprolactam excl. cyclohexanon Process Design Centre 8,7 -0,9 42% 90% 7,3 6,818 Acrylonitril (2) Phillip Townsend Associates -6,2 -8,3 42% 90% -6,5 -6,619 Yeast Process Design Centre 5,9 5,62 42% 90% 5,9 5,8

1) Solomon energy efficiency index (EEI) adjusted for supplemental feeds2) WAE and BP are not EU but worldwide data (for confidentialilty reasons)3) 20.67 GJ/ton feedstock energy (these process emissions fall outside the EU ETS)4) These data include feedstock use which must be subtracted: 29.5 GJ/ton ammonia and 21.99 GJ/ton urea incl. ammonia use. Typicals are: 3.2 ton urea and -0.9 ton ammonia, both per ton melamine. This gives WAE = 35.6 GJ/ton melamine and BP = 16.7 GJ/ton melamine.

Shell, Dow, SABIC advocate equal EEI (for example 136) steamcrackers

Benchmark with ex-post + guarantee total cap

Benchmark with ex-post electricity Scenario with a higher production growth than forecasted

(without contingency reserve) Second trading period Third period2008 2009 2010 2011 2012 Total 2013 2014

FORECASTS Production fossil, TWh 2000 2034 2069 2104 2140 10346Start Benchmark, ton CO2/MWh 0,600 0,590 0,580 0,570 0,561

Total cap, Mton CO2 1200 1200 1200 1200 1200 6000Fixed Fixed

Ex-post Update production fossil, TWh 2030 2034 2090 2125 2155 10434 Update forecastover 2008 Ex-post, TWh 30

done in 2009 Ex-post, Mton 18to 2010 Allocation, Mton CO2 1200 1200 1194 1194 1194

Benchmark, ton CO2/MWh 0,600 0,590 0,571 0,562 0,554Total cap, Mton CO2 1200 1200 1212 1194 1194 6000

Fixed Fixed Fixed

Ex-post Update production fossil, TWh 2030 2045 2130 2140 2175 10520 2190 2230over 2012 Ex-post, TWh 30 11 40 25 5

done in 2013 Ex-post, Mton 18 6 23 14 3to 2014 Allocation, Mton CO2 1200 1200 1194 1191 1168 986 997

Benchmark, ton CO2/MWh 0,600 0,590 0,571 0,563 0,538 0,450 0,447Total cap, Mton CO2 1200 1200 1212 1197 1191 6000 1011 1002

Fixed Fixed Fixed Fixed Fixed Fixed Fixed

• 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 grandfatheringGreat influence of individual growth or shrinkage & weather

Specificenergy useor CO2 emission

Decreasing efficiency order of plants

Cap

Cap basedon historicalemissions

Buying allowances

Free allocation

BestPractice

Uncertain incentive,

updating unpredictable

Market clarity cap & trade versus PSR

Shortage to cap & PSR

-100

-50

0

50

100

150

200

250

1 2 3 4 5 6 7 8 9 10 11 12

Time

Pro

du

cti

on

& k

ton

CO

2

Production forecast

Production realisation

Cap

Shortage to cap

Allowances PSR realisation

Shortage to PSR

Cap & trade: a planned shortage can turn into a surplus, or is forced intosurplus 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

Specificenergy useor CO2 emission

Decreasing efficiency order of plants

Totalcap

Buying allowances

Free allocation

BestPractice

IncentiveWeighted average

Incentive

Performance Standard Rate trading: same incentive as auctioning, length trading irrelevant, (hardly or) no leakage, good for competitiveness

Specificenergy useor CO2 emission

Decreasing efficiency order of plants

Totalcap

Buying allowances

Free allocation

BestPractice

IncentiveWeighted average

Incentive

Selling allowances

PSR=totalcap

Misunderstandings power market cleared

• Fuel specific benchmarks: against objective function= High fuel-switch prices, e.g. € 300-500/ton CO2

= 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: CO2-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 modifiedLegal case Germany against EU Commission

Starting with benchmarks is easyOutlook post 2012

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:Specificenergy useor CO2

emission

2012 2017 2022 2027

PSR EU-Japan

Transition period (with 3 or more PSRs) avoids high costin 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