The international economics of climate change, emissions trading and innovation

Joint Institute of Policy Studies / EFNZ presentation Wellington, 18 Oct 2006

Michael Grubb, Chief Economist, The Carbon Trust

Visiting Professor of Climate Change and Energy Policy, Imperial College, London, & Senior Research Associate, Faculty of Economics, Cambridge University Imperial College OF SCIENCE, TECHNOLOGY AND MEDICINE

Outline

 The nature of the problem  Stabilisation strategies and economics  Mitigation: scale of challenge and costs  Economic instruments and insights from the EU Emissions Trading Scheme  Low carbon innovation  The international stage

The nature of the problem

- Is not that climate change may hurt ‘us’ at some time in the future, but that it is …

.. Already evident, probably implicated in some ’extreme events’ , but unevenly distributed and (usually) difficult to isolate from other factors (a) c. 1900 (b) Recent Photos: Courtesy of Munich Society for Environmental Research

… inherently unpredictable concerning some of the most important potential impacts, which arise from instabilities rather than incremental change …

… and cumulative over huge time horizons with a lot of inertia and irreversibility

“Climate Uncertainty” has only been going one way since 2001 IPCC report  Significant uncertainties still exist over the scale, timing and distribution of climate impacts  However, almost all the new research over the last 5 years has shown impacts to be happening quicker than previously expected e.g. ice sheet melting; glacier retreat; ecological boundaries, etc  Last main element of “contrarian” evidence – apparent discrepancy in satellite temperature data – now resolved  Previous “focal point” of 550ppm now seen as too high ..

Scale of the challenge – where are we trying to get to?

Temperatures projections and stabilized temperatures at different CO

2

concentrations

Source: IPCC Synthesis Report, 2001 •

1000 to 1861, N. Hemisphere, proxy data;

•

1861 to 2000 Global, Instrumental;

•

2000 to 2100, SRES projections

Range temperature for stabilization of CO 2 concentration at equilibrium after 2100 450 550 650

Climate change impacts are best expressed in terms of risk categories

Very low Higher

Risks of large scale singularities

Positive or negative monetary; majority of people adversely affected Net negative in all metrics

Aggregate impacts

Negative for some regions Increase Negative for most regions

Distribution of impacts

Large increase

Risk of extreme weather events

Risks to some Risks to many

Risks to unique & threatened systems 5 -0.7

0 1 2 3 4 Past 450 Future 550

Increase in global mean temperature after 1990 (°C)

650 Source: IPCC Synthesis Report, 2001

Quantifying impacts in global economic terms is fraught with difficulty

   Discounting – the weight accorded to future impacts – is critical and is subject to basic ethical principles – Discounting for public policy is not the same as deriving from market returns, but expresses fundamental principles about responsibilities for and expectations about the welfare of future generations – Discount rate should be “endogenous” in case of impacts that could have substantial impact on global welfare Aggregation – the weight accorded to impacts on different peoples & countries – similarly has to reflect fundamental ethical principles cannot be dismissed eg. by comparison with foreign aid – – – no practical substitution between foreign aid and mitigation expenditure a highly imperfect expression of willingness to help others confuses willingness to help others with responsibilities not to inflict damage (fundamental distinction between acts of omission and acts of commission) Done properly, the costs of climate change left unchecked probably equate to 10-30% of current consumption-equivalent

Mitigation: the challenge and the costs

Historic emissions show developed country responsibility for fossil CO2….

3 x 10 7 2.5

2 1.5

1 0.5

0 1900 1910 N2O CH4 Forestry CO2 Fossil CO2 Annex I 3 x 10 7 2.5

2 1.5

1 1920 1930 N2O CH4 Forestry CO2 Fossil CO2 1940 1950 Year Non-Annex I 1960 0.5

0 1900 1910 1920 1930 1940 1950 Year Source: Marland et al. / Houghton et al. / EDGAR 3.2

1960 1970 1980 1990 2000 1970 1980 1990 2000

.. Rich countries still dominate in per-capita terms, in a unequal patterns of emissions that underlie both political complexities and huge pressures for growth

6.00

United States

per-capita emissions vs population, 2000

5.00

Can-Aus-NZ 4.00

3.00

2.00

1.00

0 Russia Japan W. Europe Developing country (non-Annex I) countries E ITs South Africa Middle East Latin America China Other Asia India Other Africa 1000 2000 3000 4000 Population (Million) 5000 6000 7000

.. Whilst most growth is expected to be in developing countries 3 x 10 7 2.5

2 1.5

1 0.5

0 1900 1910 N2O CH4 Forestry CO2 Fossil CO2 1920 1930 3 x 10 7 2.5

2 1.5

1 0.5

0 1900 1910 N2O CH4 Forestry CO2 Fossil CO2 1920 1930 Annex I 1940 1950 Year Non-Annex I 1960 How can developed country emissions be reduced… 1970 1980 1990 2000 … and developing country emission growth be limited?

1940 1950 Year 1960 1970 1980 1990 2000 2010 2020 2030 2040 IPCC SRES A1B scenario

4500 3750 3000 2250 1500 750 2000 6750 6000

Abatement scenarios involve a

wide range

of technologies and systems across all big countries ..

- Emissions and technologies in Indian long-term Scenarios Conventional Technology Paths Synfuels, Gas hydrates, Nuclear fission

IA2

Fuel cell vehicle: Carbon-free hydrogen Energy efficient appliances/ infrastrucutre CO 2 Capture/ Storage, pipeline networks

Frozen Technology

5250 2020 2040 2060 Source: P.R.Shukla

2080 2100

IB2 IA1 IA1T IB1

Nuclear Fusion, Backstops Information highways, High speed trains Advanced materials, Nanotechnology High share of renewable Energy Substitution of transport by IT Dematerialization, material substitutions Sustainable habitats, Public amenities

450ppm requires radical action in next 10 years – even 550ppm will be difficult 14 Global CO 2 emissions: 8.5 to 10.5 GtC Change from 1990 to 2020: +23% to +50% 13 12 11 10 9 8 7 6 5 1970 1980 1990 2000 2010 2020 2030

550 ppmv

2040

450 ppmv

Mitigation costs with endogenous technical change suggest that efficient stabilisation at 450ppmCO2 may cost c. 1% GDP by 2050, and similar total discounted

- But outliers indicate both risk of higher costs and opportunities for gain

Present value total costs discounted @5% from 10 different models

Mitigation policies

A low carbon economy will need both much cleaner energy and big reductions in energy demand

Levers to reduce UK carbon emissions Carbon intensity (MtCe/MToe) 0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0 0 RCEP 2 Carbon Trust 0.05

IAG Global Sustainability RCEP 1 0.1

0.15

0.2

Energy intensity (MToe/£Bn GDP) Reduced energy demand 1990 (0.219) 2000 (0.161) 0.25

%Reduction 20% (0.103) 30% (0.072) 40% (0.050) 50% (0.033) 60% (0.021)

0.3

The UK 2003 Energy White Paper set the UK on a path to reduce carbon emissions by 60% by 2050 through a combination of energy efficiency in the short term and renewables in the long term: “[To achieve the required savings from energy efficiency] would

need roughly a doubling of the rate of energy efficiency improvement seen in the past thirty years” “Technology innovation will have a key part to play in underpinning all our goals and delivering a low carbon economy” “To deliver these outcomes our aim will be to provide industry and investors with a clear and stable policy framework”

Note: Figures in brackets show UK carbon intensity (MtC/£Bn), Scenarios show 2050 projections Source: RCEP 1998, DTI EP68 GDP growth forecasts, IAG “Long-term Reductions in GHG in the UK”, Feb 2002

Different drivers and concerns imply different instruments - mitigation not delivered by one policy any more than one technology - costs and competitiveness reflect the range of +ve & -ve impacts

Behaviour Voluntary, regulatory and systemic instruments Economic instruments Innovation instruments Buildings, Appliances & other Industry (Manufacturing and Construction) Substitution Technical innovation Transport

Economic instruments and the EU Emissions Trading Scheme

EU Emissions Trading Scheme – Overview

Participants • All EU 25 countries • All electricity, ferrous metals, pulp & paper, cement and all facilities > 20MW, total 46% of EU emissions • International links through Kyoto project crediting Allocation • Member states develop National Allocation Plans (NAPs) by sector and installation • To be consistent with Kyoto target and anti-subsidy provisions Timing • 2005-7: phase 1, no national target, opt-out provisions • 2008-12: governed by Kyoto target, opt-in possibilities • 2013+ ? Likely to strengthen Key issues • Market price – uncertainty – driven by NAPs, relative coal-gas pricing, and emerging nature of market with mixed / late participation • Specific allocation issues – including new plant, plant closure, etc • Various legal issues surrounding legal nature, tax rules etc.

The market works but carbon price has had a bumpy ride since inception

BIG Money – though not quite in the way that some expected

 At €20/tCO2, the asset value of 2.2bnCO2 allowance is around €40bn/yr … €100ms have been won or lost in trades against erroneous price expectations  Disputes continue over the reasons for the surplus in 2005 - but it is some combination of overallocation and greater than predicted abatement (eg. in cement sector)  Where competitive electricity markets, pricing effects as expected lead to profits – probably totalling around €5bn across the EU, swamping the modest net purchases in the sector

EU ETS can substantially increase marginal operating costs, but (eg. cement) can maintain profits with only modest pass-through & price impact (current allocns)

Increase in marginal production cost, %

Cost pass-through required to maintain sector operating profits

Proportion of increase in marginal cost passed through to prices, % Increase in wholesale cement price, % Scenario 1 €5/tCO 2 27.3% 7.0% 0.6% Scenario 2 €15/tCO 2 70.5% Scenario 3 €25/tCO 2 w/cutback 136.3% 7.5% 39.7% 2.0% 16.8% Phase 1 & 2, direct allocation helps offsets electricity price rise (c.90% cost pass-through in electricity) Long term scenario, required cement cost pass through increases as its direct allocation is cut back 30% Profit-maximising pass through predicted by market modeling: c.80%

Profit/loss depends upon pricing policies and incentives, allocation, and trade situation net value-at-stake insufficient for major problems in Kyoto period 20% 18% Electricity

MVAS:

Max. value at stake (no free allocation) Refining & Fuels 16% 14% 12% Cement

NVAS

: Net value at stake (100% free allocation; exposure to electricity price only) Food & Tobacco Glass & Ceramics 10% 8% 6% 4% Pulp & Paper Iron & Steel Chemicals & Plastics Metal Manufactures Non-ferrous metals inc. aluminium 2% Textiles 0% 0% 5% 10% 15% 20% 25%

UK trade intensity from outside the EU

30% 35% •

Upper end of range

: zero free allocation •

Lower end of range

: 100% free allowances (effect of €10/MWh electricity price increase to sectors) • Assumes allowance price of €15/tCO2 and no CO 2 price pass through in sector

As a result, most participating sectors profit on domestic markets (but exports hit if no reimbursement) Non-participants carry the cost, Al. may exit if buys from grid

Policy coverage

Value at stake in 2020, %* (% change in EBITDA predicted by Cournot model in brackets)

Steel Cement Petroleum

• EU ETS low

scenario

(15Euro/tCO2)

• EU ETS high

scenario

(30Euro/tCO2)

• EU ETS high

scenario with allowance cut back increased to 30%

11 (16) 27 (26) 43 (11) 23 (13) 52 (25) 75 (6) 0.5 (0.4) 1.3 (0.7) 2.0 (-0.1)

General Insights

• All ETS sectors profit under our standard allocations, as product pricing effects outweigh net input cost increase • ETS enables these sectors to capture bulk of the ‘scarcity rent’ • At €30/tCO2 both cement and steel approaching turning point from imports • Sectors outside ETS face the higher prices, Al. exits if on grid Note: • Steel imports impact profit taking at higher prices, still profit from ETS under 30% cutback but only a little Source: • Cement imports constrain cost pass through, 30% cutback neutralises gains • Marginal effect as energy is small fraction costs and profits *Value at stake = (increase in total costs after allowance allocation)/(starting EBITDA); high variant scenarios with CCL doubled; carbon price of 30Euro/tCO2 and cut back of 1% pa versus business as usual projected emissions Oxera

Some initial high-level conclusions from EU experience with economic instruments

    No practical economic instrument is ‘pure’: because it aims to change relative prices in ways that favour lower carbon technologies over high carbon incumbents, fierce struggles are inevitable It has proved possible to implement a harmonised market in emissions cap-and-trade for industrial emissions across 25 diverse countries Industry attitudes change once the instrument is adopted: lobbying then focuses upon ‘getting the best’, and ‘the best’ has been large aggregate profits for some sectors, The EU ETS will continue post 2012 irrespective of progress elsewhere

The power sector and low-carbon innovation

The need for carbon pricing implies ..

   An internationalist strategy that links abroad – – – – To provide a sizeable, liquid carbon market that maximises opportunities for efficient mitigation To assist developing country mitigation through the CDM To help converge carbon prices To strengthen influence in future ETS developments and provide a stronger international basis for next steps

Decarbonising the power sector

– – is the basis for minimising economic impact on other sectors may ultimately provide a platform for low carbon transport solutions An integrated strategy covering energy efficiency, electricity regulation, emission allowances and innovation

In theory, rising carbon prices / strengthened emission caps can provide the incentive for strategic investment in innovation… Volume = learning investment (10s of $bns across technologies) Volume = benefits compared to reference system generating costs with existing technology ($trillions)

Diverse scenarios are possible to get low carbon electricity; radical scenarios with high percentage of renewables require changes to system structure and more use of advanced transmission and power control Iceland Demand 390TWh Wind PV 45-50% 3-5% Norway Biomass Marine 25% 5-10% Northern Ireland CO2 capture Nuclear Only for hydrogen MicroGen 20% Netherlands

Figure 1.5 : “Green plus” Scenario: UK Electricity Network in 2050 Source:

France Ch.2 in Future Electricity Technologies and Systems, CUP, 2006

Accelerating innovation requires combining ‘push’ and ‘pull’ to drive investment in technologies and systems that traverse the entire innovation chain Government

Policy & Programme Actions

Product/ Technology Push Pure research Basic R&D Applied R&D

Cost per unit

Demonstration Pre Commercial Niche Market Supported Commercial Fully Commercial

Market expansion

Technology “Valley of Death” Consumers Market engagement programmes Strategic deployment Internalisation policies & Barrier removal Market Pull

Investments

Business and finance community

Rents in the EU ETS – enough to pay the bill ?

•Power sector profits from EU ETS c. €5bn during 2005 •E.On announce €100m R&D Centre •UK Environmental Transformation Fund announced ‘co-incident’ with Auctioning decision •UK £1bn National Institute for Energy Technologies (NIET) announced to be 50:50 co funded with private sector, initial sponsors E.On, EdF, Shell, BP.

•International and sectoral investment linkages emerging through the CDM

The international stage …

Impact of any Kyoto-like agreement will accumulate over time and depend upon scope & strength of future action 14,000 First Commitment Period 12,000 10,000 8,000 6,000 developing country emission scenarios

Developing country scenarios of technology & policy spillover

Zero Adoption Intermediate Adoption

4,000 2,000 Industrialised Country Emissions (Kyoto -1% pa) 1990 2010 2050

Source: Grubb, Hope and Fouquet, in Climatic Change, 2003

2100

Maximum Adoption (Intensity Convergence)

2005 saw the launch of four international negotiation processes about the future ..

 The Kyoto Second Period negotiations launched at the Montreal Meeting of Parties to the Protocol (153 countries of which 32 are currently Annex B with a couple seeking to join)  The UN global dialogue on future action launched at the Montreal Conference of Parties to the UNFCCC (c. 180 countries)  The Gleneagles (G8+5+?) Dialogue that culminates in Japan in 2008 including the world’s Big Emitters  The Asia-Pacific Partnership on clean technologies including the A-P Big Emitters

Future development of the cap-and-trade structure could be usefully complemented by strengthening ‘other legs’ of the UNFCCC/Kyoto package A core structure of sequential commitment periods capping national emissions (‘assigned amounts’): – – – First period defined for industrialised countries 2008-2012 with differentiated allowances: total 5% reduction below 1990 ‘Basket’ of six greenhouse gases, plus some allowance for sinks / land-use change and forestry Extensive international adjustment / transfer provisions (‘Kyoto flexible mechanisms’) • Joint Implementation • Clean Development Mechanism • International Emissions Trading + Range of other provisions concerning activities in developing countries, technology transfer, policies and measures, etc.

After long hiatus, the international process is slowly gearing up ….

 There is not yet any feasible ‘zone of agreement’, but ..

 Conditions are changing and 2007-8 will see a number of forces combining for breakthroughs: – IPCC Fourth Assessment, and Stern Review, will force open the international debate on the basis of the seriousness of problem and the feasibility of solutions – – – Established carbon markets and investment flows through Kyoto mechanisms will embed these as a ‘reality’ Growing business concern about risks of inaction, and costs of an unstable and fragmented international regime, will help convergence Growing appreciation that ‘energy efficiency’, carbon markets and technology innovation are not alternates, but complements appropriate to different parts of the problem

Conclusions and prospects

Conclusions     

Science

– provides a clear and compelling case for action – Suggests aiming to stabilise in range c.450ppm-500CO2e ?

Economic analysis

– – confirms that not nearly enough is being done as yet Suggests costs of stabilisation broadly around 500ppmCO2e manageable, if action is swift and broad-based

Economic instruments

– – EU ETS demonstrates feasibility of cap and trade but also complexity of the allocation process Generate revenues that can usefully be used to support eg. …

Innovation

– requires additional instruments and integration with regulatory and infrastructure decisions

International

– Gearing up for the next round, built upon the emerging experience

Further information

EU ETS & Kyoto mechanisms: www.climate-strategies.org

‘Allocation and competitiveness in the EU ETS’ Climate Policy Special Issue, 2006 Energy efficiency, innovation & the Carbon Trust: www.carbontrust.co.uk

‘UK Climate Change Programme: potential evolution for business and public sector’ Global economics: ‘Endogenous technical change & the economics of atmospheric stabilisation’, Energy Journal Special Issue, 2006