What’s wrong with EU greenhouse gas emissions trading What’s the way to go?

European Chemical Industry Outlook 2008 Conference Hotel Amigo, Brussels, 18 June 2007

Vianney Schyns Manager Climate & Energy Efficiency Utility Support Group Utility provider for a.o. DSM and SABIC

Contents

1.

• • • • •

What’s wrong with present EU ETS rules

Free competition Power price issue New entrants & closures Incentive to lower production – leakage What mean historic data for individual allocations ?

2. Solution: performance-based allocation as the alternative to auctioning 3. Annexes

What’s wrong with present EU ETS rules?

Free competition Power price impact New entrants & closures Incentive to lower production – leakage What mean historic data for the future ?

What’s wrong with present ETS rules (1)

 Effective ETS: Scarcity of allowances sufficient ?

 Lesson learned: allocation method is equally vital (Grubb, Delbeke) 

Ex-ante grandfathering conflicts with free market

  Uncertain incentive for improvement, “updating” problem Short allocation new plants    caused highly distorting transfer rules, barrier to entry  example 1000 MWe coal-fired plant: € 250-300 mln incumbent advantage  Plant replacement without loss by closure, if more plants on a site or if old plant stand-by   example 1000 MWe coal-fired plant: € 200-250 mln/year incumbent advantage  Ex-ante grandfathering enhances market concentration

What’s wrong with present ETS rules (2)

• • •

No sales below opportunity cost Selling allowances is then more profitable than producing Amazing impact on electricity profits by EU legislation Economic rents:

  Period 1: perhaps € 15 billion/year average Period 2: double, triple or even quadruple  Competitiveness European industry strongly affected

What’s wrong with present ETS rules (3)



Unsolvable dilemmas new entrants (NE) & closures (C) (see e.g. also Grubb and Neuhoff, Stern, Egenhofer, Weishaar, Matthes, Schyns, Ecofys report for the EU Commission)

 Theory: freeze allocation [all allowances after C & zero for NE]    Zero for NE actually hinders low carbon investments/competitiveness Retaining allowances after C – how long? – is worse than transfer rules, as we saw Withdrawal allowances after C: perverse incentive keeping inefficient plants operational  Most authors elaborate on these problems, but fail to conclude that within ex-ante frozen caps solutions are simply impossible  search for square circle

What’s wrong with present ETS rules (4)



Lowering production no benefit for the environment

 J.H. Dales (1968): “Pollution in one region must never be reduced by increasing pollution in another”  Lowering production and importing goods = exporting the problem  leakage of emissions outside EU  Not intended in aims of Directive  Danger for CO 2 - and electricity intensive processes (cement, steel, ammonia, aluminium, electrolysis, etc), but this must be seen as a fundamental shortcoming  See statement 21 May 2007

“Lowering Production is no Benefit for the Environment, says European Industry”

Historic data for individual allocation (1)

Benchmarking with the adequate basis Benchmark x „X“ = allowanced granted

The issue to define „X“:

decided in advance decided subsequently

• • • • standard load factor historic production projected production actual production Question: Would taxes ever by based on frozen history ?

Normal procedure:  Final settlement based on correction to actual data

Historic data for individual allocation (2)

The quality of historic data … with climate change instruments based on history?

Variations in annual load factors over five years, found in UK by NERA

Historic data for individual allocation (3)

The quality of historic data

•

What means a historic cap when many new plants enter the market?

Many new power plants in Italy around 2009 •

What means a historic cap when an economy is strongly recovering?

Growth in central Europe, e.g. Poland etc.

• •

What means a historic cap when import or export of product changes?

More electricity import NL from Germany – Is NL then doing well?

New CHP in Luxembourg – Is Luxembourg doing bad?

  

Problems become an obstacle in the long period 2012- 2020 Insolvable consequences for new entrants and closures Leakage undesired part of the rules

Solution: performance-based allocation as alternative to auctioning

Three steps: (1) Define true benchmarks (2) Ex-post adjustment to actual production (3) Automatic guarantee of total cap

Key principles of benchmarking (1)



What a CEO wants to know?

 He wants to know – e.g. with cost-price:   Where his plants stand?; then Why? + What can be done about it?

 He refuses notions like “We are the best in the peer group of our [obsolete] technology, or in our [small] scale, or in our plant vintage” (many corrections make everyone equal) 

Key principle: benchmarks relate

 

The product … with the objective function – CO 2 in the EU ETS

 Deviations shall be possible, but temporary and aimed to avoid leakage outside EU (… objective function)  Example: energy efficiency as objective function can avoid leakage by switch to gas and shipping of carbon-rich fuels outside EU

Auctioning: clear incentive low carbon technologies, length trading period irrelevant, but leakage & detrimental for competitiveness

Buying allowances

High market liquidity

Specific energy use or CO 2 emission Weighted average Incentive Best Practice Incentive Decreasing efficiency order of plants

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

Specific energy use or CO 2 emission Buying allowances Free allocation

High market liquidity

Selling allowances Weighted average Incentive Best Practice Incentive

benchmark = total cap

Decreasing efficiency order of plants

Benchmarking: incentive to reduce emissions

 Incentive to reduce emissions is independent of the exact value of benchmark in a certain year Incentive = avoided purchases + sales of allowances Example: Investment to reduce emissions from 900 to 600 kg CO 2 of product (in old plant or new plant) per unit • Year 1, BM = 750: incentive = 150 + 150 = 300 • Year n, BM = 700: incentive = 200 + 100 = 300  Predictability of investment climate

Key principles of benchmarking (2)

 Same benchmarks for incumbents and new plants  Avoid = Distorting transfer rules = Barriers to entry = Enhanced market concentration  Ensure = Equal incentive for plant improvement & plant replacement  No “maximisation” or “minimisation” rules (NL 110% and 85% now)

A few benchmarks have already major coverage

Benchmarking Netherlands: about 90 PSRs

100% Coverage of emissions under the EU ETS Major chemicals (20-30 PSRs) Refineries (1 PSR) Cement (1-2 PSR) Steel (5-7 PSRs) Policy recommendation: include (co-)firing biomass Electricity (1 PSR) and for CHP (Combined Heat & Power) (1 additional PSR for heat)

Suitable benchmark formula

Benchmark = WAE – CF x {WAE – BP}

Examples chemical industry prove it works

EU bechmark data major chemicals Product Consultant Weighted EU Best EU average Practice WAE BP Efficiencies Electricity Heat PSR = WAE - CF x (WAE - BP) CF = Compliance Factor = 15% 20%

1 Steamcrackers (1) 2 Pyrolosis gasoline (pygas) 3 Benzene extraction 4 Butadiene 5 MTBE 6 ldPE (low density polyethylene) 7 hdPE (high density polyethylene) 8 PP (polypropylene) Phillip Townsend Associates 9 EPDM (ethylene propylene rubber) (2) Phillip Townsend Associates 10 PVC (polyvinyl chloride) 11 Nylon-6 12 Ammonia (3) 13 Nitric acid 14 Fertiliser (Calcium Ammonium Nitrate)Process Design Centre 15 Urea 16 Melamine (4) 17 Caprolactam excl. cyclohexanon 18 Acrylonitril (2) 19 Yeast Solomon Associates Process Design Centre Process Design Centre Solomon Associates Process Design Centre Phillip Townsend Associates Phillip Townsend Associates Process Design Centre Process Design Centre Plant Services International Process Design Centre Plant Services International Nexant Process Design Centre Phillip Townsend Associates Process Design Centre GJ/ton 144,8 1,3 3,8 9,72 1,9 8,53 5,43 3,56 32,22 3,8 10,0 13,13 -0,12 0,99 5,06 79,46 8,7 -6,2 5,9 GJ/ton 107,8 0,6 2,2 7,3 1,06 5,96 3,14 2,27 28,0 3,4 5,71 7,23 -1,8 0,35 3,06 60,55 -0,9 -8,3 5,62 37,5% 42% 42% 37,5% 42% 42% 42% 42% 42% 42% 42% 40% 42% 42% 42% 42% 42% 42% 42% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90% 90%

139,3 1,2 3,6 9,4 1,8 8,1 5,1 3,4 31,6 3,7 9,4 12,2 -0,4 0,9 4,8 76,6 7,3 -6,5 5,9

1) Solomon energy efficiency index (EEI) adjusted for supplemental feeds 2) 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.

137,4 1,2 3,5 9,2 1,7 8,0 5,0 3,3 31,4 3,7 9,1 11,9 -0,5 0,9 4,7 75,7 6,8 -6,6 5,8

Once defined, benchmarks are quite straightforward

Benchmarking in the product chain

Benchmarking with ex-post adjustment to actual production provides incentives in the product chain …

avoids “production subsidy”

effect (= higher electricity demand by lower electricity prices)

Fuel Electricity and heat generation Electricity Fuel Feed Heat, from CHP or from boilers Industrial manufacturing plant with use of electricity and heat Product … the efficiency of the production of electricity & heat … the efficiency of the use of (fuel), electricity & heat

Benchmark with ex-post + guarantee total cap

Benchmark with ex-post electricity (without contingency reserve)

FORECASTS Start Production fossil, TWh Benchmark, ton CO2/MWh Total cap, Mton CO2

Scenario with a higher production growth than forecasted Second trading period

2008 2009 2010 2011 2012

Total Third period

2013 2000 0,600 1200

Fixed

2034 0,590 1200

Fixed

2069 0,580 1200 2104 0,570 1200 2140 0,561 1200 10346

6000

Ex-post over 2008 done in 2009 to 2010 Update production fossil, TWh Ex-post, TWh Ex-post, Mton Allocation, Mton CO2 Benchmark, ton CO2/MWh Total cap, Mton CO2 2030 1200 0,600 1200

Fixed

2034 1200 0,590 1200

Fixed

2090 30 18 1194 0,571 1212

Fixed

2125 1194 0,562 1194 2155 1194 0,554 1194 10434 Update forecast

6000

2014 Ex-post over 2012 done in 2013 to 2014 Update production fossil, TWh Ex-post, TWh Ex-post, Mton Allocation, Mton CO2 Benchmark, ton CO2/MWh Total cap, Mton CO2 2030 1200 0,600 1200

Fixed

2045 1200 0,590 1200

Fixed

2130 30 18 1194 0,571 1212

Fixed

2140 11 6 1191 0,563 1197

Fixed

2175 40 23 1168 0,538 1191

Fixed

10520

6000

2190 25 14 986 0,450 1011

Fixed

2230 5 3 997 0,447 1002

Fixed

•

Automatic adjustments within an ex-ante agreed total cap

• More stringent benchmarks work exactly like auctioning (& cap & trade) • System is self-adjusting; virtually no interest costs

Annexes

What should be expected of emissions trading

• Effective rules allocation of allowances – Robust, predictable – Incentive for investments to reduce emissions, for low carbon technologies • Level playing field across Europe • Stimulates activities, employment … Lisbon strategy … competitiveness • Fair & free competition • • See for example: PhD thesis 1992 Ass. Prof. Marjan Peeters, Maastricht University PhD thesis 2006 Anja Pauksztat, Rheinisch Westfälischen Technischen Hochschule Aachen • Note: each site must surrender after each year the allowances equal to the direct emissions of that year (direct emissions scheme)

Facts EU GHG Emissions Trading Scheme

• Fast start by 1-1-2005: 1 • Biggest scheme ever worldwide, a great achievement – 50% of EU emissions st 3-year period 2005-2007 – 12,000 installations (production sites) – Fossil-fuelled electricity, cement, steel, refineries, paper & pulp, glass, ceramics, major part of chemical industry • Rules virtually unchanged for 2 nd 5-year period 2008-2012 – Allocation: frozen cap, basis historic emissions

1)

• EU committed -20% in 2020 compared with 1990 • EU ETS confirmed as central instrument 1) “Historical grandfathering”

What are we heading to?

• Review of EU Directive for post 2012 period underway – Other allocation rules: benchmarking and/or auctioning – Will it be ex-ante frozen caps, or with ex-post following production?

Further: – Expansion participants: aviation (2010?), other sectors & gases – Linking with other schemes: Norway, Switzerland, California – Western Alliance, Regional Greenhouse Gas Initiative (RGGI) North East USA, Japan, Korea, Canada, Australia …. ?

• Time schedule: – End 2007: proposals EU Commission – 2008-2009: co-decision procedure between EP and Council

Cap & trade historical grandfathering

Great influence of individual growth or shrinkage & weather

Benchmark curve of one product Buying allowances Specific energy use or CO 2 emission Free allocation

Best Practice

Cap based on historical emissions

in theory

Decreasing efficiency order of plants Cap

Cap & trade historical grandfathering

Actual allocation 1 st trading period 2005-2007!

Specific energy use or CO 2 emission Buying allowances Free allocation

Best Practice

Cap & trading position is

unpredictable in practice

Decreasing efficiency order of plants Cap

Distortion due to Emission Based Allocation Reality check short / long of real cement installations (courtesy Holcim)

20 15 High emission is rewarded with excess of initial allowances 10 5 0 -5 750 -10 -15 800 850 900 950 1'000 1'050 1'100 1'150 1'200 Up to 40 % difference in initial allowances for equal installations -20 Low emission is punished with

CO2 efficiency of installation

• •

Basics of shortcomings present allocation

Existing plants: allowances ex-ante frozen cap based on historical emissions – rewarding pollution – frozen quantity, whether production in or decreases (“static, frozen economy”) New plants and debottleneckings: theory says buying (inhibits efficient industry renewal); repair = allowances from a new entrants’ reserve, also an ex-ante frozen cap (“plan-economy”)

• This principle = root cause of shortcomings, PLUS, as result: – Insecurity investments in new plants (finite reserves) – The allocation habit of few allowances for new plants versus many allowances for existing plants : LACK OF EFFECTIVENESS to invest to reduce emissions – Repair: “transfer rules” (allowances closed plant to new efficient plant), but new problem: high distortions, reinforcing market concentration –

Lowering production & selling freed allowances is declared equally legitimate as investing to reduce emissions

• • •

Ex-ante rules prevent electricity liberalisation

State interference prevents competitive market

– At gross margin of opportunity-cost, winning and losing market share:

zero sum game;

at higher gross margin:

distortions

– New entrants, vital for more competition, but ex-ante state decision of operating hours determines 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 (1000 MWe coal-fired plant of € 1.1 billion, distortion ~

€ 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-28)

Cap & trade: market price > opportunity-cost

Companies A & B: same production, efficiency and same quantity of allowances A Euros for an equal total production volume Gross margin cash flow Companies A & B Mark-up Opportunity cost A wins market share from B Cost of buying allowances: = distortion Net profit B Net loss Profit of sales of Allowances = distortion

28 €

(1)

24 €

(1)

49 €

(3)

84 €

(3)

60 €

(3)

67 €

(3)

57 €

(3)

60 €

(3)

70 €

(3)

46 €

(3)

24 €

(2)

< 25 € (4)

World Map electricity prices ( €/MWh)

20 €

(1) Courtesy Cefic

32 €

(1) Sources: (1) Presentation European Aluminium Association HLG-Ad hoc 1 (Long Term Contracts) -2005 (2) R.Tarjanne and K. Luostaninen, Lappeenranta University of technology (Long term contract) – 2003 (3) Platts Base load year 2007 (Platts 4 April 2006) (4) Jean Maillard

Suitable benchmark formula



Benchmark data of plants under the scheme (now EU)

Benchmark between average & best performance, e.g.

Benchmark = WAE – CF x (WAE – BP)

= = = WAE = Weighted Average Efficiency CF = Compliance Factor, to comply with total cap BP = proven Best Practice, proven means actual measured operational data (or rather BP Group, for extra stimulation of innovation)   Formula coincides with EU ETS Directive Annex III (3), average emissions and achievable progress for each activity

Industry opposes following alternatives

  Dutch/Flemish worldtop 10% – too short allocation, unstable outcome  shape benchmark curve

+

incomplete participation Related only to BP (BP + X%) – too short allocation, contra-incentive to improve BP, effectiveness & innovation

Equity of Performance Based Allocation (Benchmarking)

Percent short / long of same cement installations as a function of CO2 efficiency

20 Gives the right signals: 15 10 Performance is rewarded, Polluters pay 5 0 -5 750 -10 -15 -20 800 850 900 950 1'000 1'050 1'100 1'150 -25 -30

CO2 efficiency of installation

Discussion on differences between equal installations are futile, compared to differences in case of grandfathering 1'200

Benchmark takes account of all energy carriers (1)

CO 2 ?

Many energy functions can • • • be done either with: Steam, or Electricity, or Natural gas or other fuel Feeds Steam Production plant Product(s) Electricity Benchmark takes this into account:

Normalised calculation to (total) primary energy – or total CO 2

Benchmark for only fuel is meaningless Natural gas ?

Other fuel ?

Examples: chemical plants, refineries, paper plants, etc.

Benchmarks for manufacturing and (related) utility plants

Benchmark takes account of all energy carriers (2)

Feeds (ethane, LPG, naphta, gas oil, etc.) Simplified scheme steamcracker CO 2 2/3 of the investment Steam recovery • Separation train can be: Efficient, with net-export • • of steam of whole cracker Inefficient, steam import Both can be with the same direct emission of the cracker itself Furnaces with heat recovery to steam Separations with high power compressors Electricity Methane from feedstock Steam Products (ethylene, propylene, etc.) • • •

Power train can be:

Steam turbine driven Electric motor driven Combinations High influence on electricity & steam balance, direct emissions elsewhere

Benchmarks in a direct emissions scheme

Allocation

= direct emission – emission {total plant – total BM} CO 2 Feeds Production plant Product(s) •

Example:

Net-import of secondary energy carriers:

70 – {120 – 100} = 50 Plant worse than benchmark

Steam Electricity Natural gas Other fuels Site utilities have also benchmarks •

Further examples:

Zero net-import: •

120 – {120 -100} = 100 Plant worse than benchmark

Net-import:

70 – {90 – 100} = 80 Plant better than benchmark

Benchmarks in a direct emissions scheme

 Easy inclusion in an ETS  No conceptual problem in a direct scheme and no legal problem with Directive, on the contrary 

Allowances according to deviation with benchmark

 In formula:

A = RDE + RSE – Σ production x (REE/RCE – benchmark) x CCF

= = = = = RDE = Realised Direct Emission (ton CO 2 ) RSE = Realised Sequestered Emissions (ton CO 2 ) REE/RCE = Realised Energy (or CO 2 ) Efficiency (GJ/ton product or ton CO 2 /ton product) Benchmark = benchmark energy (or CO 2 ) efficiency CCF = CO 2 Conversion Factor (= 1.0 in case of CO 2 -benchmark)  Note: Process emission is in this view included in the Best Practice

Misunderstandings power market cleared

• • •

Fuel specific benchmarks: against objective function

= With ex-post: high fuel-switch prices, e.g. € 300-500/ton CO 2 = Fuel switch limited with at least 50% (in case of 2 benchmarks) = Coal plants without CCS encouraged (Carbon Capture & Storage)

One electricity benchmark no deathblow coal-fired power

= Coal & lignite very important, climate policy means CCS !

= Cap & trade: opportunity-cost in power price (soft cost) = 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 = Fuel switch at same CO 2 -price as cap & trade & auctioning = In fact more gas if more new coal and less CHP (given a total cap) = We need a controlled transition (CCS needs time)

Legal aspects EC Treaty (1)

• Competition rules, art. 81-82 – Cartels, concerted practices prohibited – Frozen cap & trade: works like cartel, winner of market share must buy allowances, loser sells (= penalty payment winner to loser) – But: no jurisprudence (yet) to prohibit this implementation • State aid rules, art. 87-88 – State aid problems confirmed by EU Commission – Alternative so far not taken into account, Commission prohibited ex-post adjustment to actual production – This state aid so far admitted, argument: interest for environment • Either no support from art. 86: art. 81 89” “In the case of public undertakings and undertakings to which Member States grant special or exclusive rights, Member States shall neither enact or maintain in force any measure contrary to the rules in this Treaty, in particular …

Transition for a faster global trading scheme

Benchmark: Specific energy use or CO 2 emission

Benchmark China-India Incentive low carbon technologies the same in global trading scheme Benchmark USA-Canada Benchmark EU-Japan Global benchmark

Transition period (with 3 or more BMs for same product) avoids high cost in case of auctioning for regions with higher emissions per unit of product (vital: BMs without differentiation new/old plants) 2008 2012 2017 2022 2027 2032

• •

References

References of the author: < http://www.dsm.com/en_US/html/sustainability/emission_trading.htm

> • • • • “

Climate change challenges and the search for a sustainable policy

VIII) 20-23 June 2005, Oslo, Norway.

”, 21 June 2005, 8th International Conference on Carbon Dioxide Utilisation (ICCDU “

Options and consequences for the allocation of allowances to electricity producers

”, 21 December 2005, European Chemical Region Network (ECRN) presidium meeting 21-22 December 2005, Maastricht, the Netherlands.

“

Towards a simple, robust and predictable EU Emissions Trading Scheme – Benchmarks from concept to practice

”, 21 March 2006, presented to the Dutch Ministry of Economic Affairs.

“The EU ETS is urgently in need of: effectiveness, level playing field, competitiveness, fair & free competition”,

– 4th Congress of the ECRN, 10 November 2006, Tarragona, Spain, including:

“One single benchmark for fossil-fuelled electricity in an Emissions Trading Scheme: does it work, does it hurt and what about alternatives?”

.

–

“How to fit benchmarks with ex-post adjustments in the present EU Emissions Trading Directive”.