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The good, the bad and the upside

With the launch of the EU Emissions Trading Scheme, 2005 promises to be a defining year for the energy sector and climate change that will present great challenges and opportunities for power generators.

From 1 January 2005, power stations of over 7 MW cannot legally emit carbon dioxide without an allowance. These allowances are presently not so difficult to obtain as in most cases they are distributed by government free of charge. However, as concern over global warming increases, emissions of greenhouse gases, like carbon dioxide, will be controlled by simply issuing fewer and fewer of these allowances.

The European Emissions Trading Directive is designed to help the European Member States comply with the Kyoto Protocol. This protocol requires the EU as a whole (15 members at the time) to reduce average annual emissions of greenhouse gases in the period 2008 to 2012 to 92 per cent of those in 1990. The Protocol also set individual limits for each member state, but the European nations decided to combine under the ‘Burden Sharing Agreement’ so that those better equipped to reduce their emissions took a greater responsibility.

Figure 1. Abatement options
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The European Emissions Trading Scheme (EU ETS) imposes limits on the amount of greenhouse gases that may be emitted and requires sites in the power sector to obtain ‘allowances’ (each one covers the emission of 1 tonne of CO2) to match their actual emissions in each year. Under the terms of the directive, each installation will be given a number of these allowances free of charge (the allocation) and additional allowances may be purchased in an open pan-European market. Should an installation emit more gases than it has allowances in a particular year, it will be required to purchase allowances to cover the deficit and to pay a fine.

The Directive established two periods for the scheme. The first runs from 2005 to 2007 and the second from 2008 to 1012, to coincide with the first Kyoto Period. During the first period, the fine for non-compliance is set at €40/tCO2 and the scheme covers carbon dioxide alone. The scheme may be extended to cover additional greenhouse gases during the second period but, in any case, the fine for non-compliance will be €100/tCO2. These are not insubstantial fines.

Trading tactics

Through trading it is expected that the price of allowances will rise to meet the marginal cost of reducing emissions. In the power sector, the impact of the ETS is easy to assess. The cost of buying, or not selling, an allowance should be added to the marginal cost of generation. Since coal fired generation is almost twice as carbon intensive as gas fired CCGTs, the introduction of the scheme will tend to favour gas generation over coal. Consequently, we anticipate that the load factors of coal stations will fall and be made up by increased loading of under-utilised gas stations.

The price at any point on a typical load duration curve is simply set by the marginal cost of fuel. When a price is put on carbon emissions the marginal costs rise but, for low allowance prices, the merit order stays the same. However, as the allowance price rises, the marginal cost of coal+allowance exceeds that of gas+allowance, so the merit order switches.

It is unlikely, in the short term, that companies will invest capital in order to meet emissions targets, given the current uncertainty in the emissions price. It therefore appears that, for the first period at least, abatement opportunities will be dependent on switching within the existing plant mix.

Figure 2. Impact of higher allocation prices
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A major point of contention has been the way in which the allowances have been allocated to existing installations. The Directive required each member state to design its own National Allocation Plan (NAP), as well as establish all the necessary administrative institutions such as registries and verifiers. These plans were supposed to be consistent with each country achieving the emissions reductions required by the Burden Sharing Agreement. However, the problem with this condition is that the Burden Sharing Agreement refers to the Kyoto Period, while the first NAP applies to an earlier period. It seems that most countries have set NAPs that allowed most installations to receive allowances sufficient to meet their normal operation. Only the power sector has been clawed back and been given fewer allowances than might have been expected under a ‘business as usual’ scenario.

However, current indications are that the marginal cost of power will incorporate the cost of an allowance. Thus we expect prices to rise. The extent to which they will rise will depend on the type of plant at the margin. If gas is at the margin and the allowance price is €5/tCO2, then prices will rise by around €2/MWh. If coal is at the margin, the price will rise by some €5/MWh. Thus we expect the cost of allowance to be passed onto customers. The Emissions Trading Scheme Directive, insisted that at least 95 per cent of allowances in the first period must be given allocated free of charge (and 90 per cent in the second). The important point is that the size of the allocation to each installation effectively determines the windfall profit that installation will enjoy. After all, if the price rises to follow the allowance price, but the actual allowances have been given free of charge, profits will inexorably rise.

The only companies that will not enjoy a windfall are coal generators whose operating regime requires them to purchase additional allowances. If they operate when gas is at the margin, the rise in power prices will not allow them to recover the allowance cost in full.

The key determinant of the allowance prices is the amount of abatement required across the EU. Our analysis suggests that the EU traded sector is likely to be around 50 million tCO2 short annually during 2005-7, despite the fact that the current forecast for emissions in 2010 is 346 million t CO2 in excess of the Kyoto target.

Figure 3. Balance of emissions and caps for EU-15
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At this stage governments are confident that new measures being introduced, such as the biofuels directive and enhanced support for energy conservation, will reduce emissions by some 292 million t CO2. This suggests that prices will be in the range indicated. However, we expect that the situation will be far tighter during the second period, as this time around the NAPs will have to be consistent with the Burden Sharing Agreement. A similar analysis for 2008-2012 suggests that the EU-25 could require the trading scheme to provide some 100 million tCO2 of abatement. This assumes that countries or companies within the EU purchase ‘flexibility allowances’ from other countries involved in the Kyoto Protocol to the tune of some 170 million t CO2 annually.

These reductions would involve projects based in developing countries which reduce greenhouse gas emissions against some ‘business as usual’ baseline (Clean Development Mechanism projects), or in other Kyoto capped countries (Joint Implementation).

Future uncertainty

Although allowances from the first period cannot be used in the second period, those for 2006, for example, may be used to meet the requirements of 2005. But we do not yet know what will happen to unused allowances in 2012. The ability to carry over allowances during 2005 and 2006 but not in 2007 suggests that trading could all take place just once a year – but in 2007 either prices of the 2007 allowances will collapse to zero – or companies will have to pay the fine of €100/tCO2. Also, although the trading scheme may be established, the accounting and taxation rules are still in some confusion, compounded by different VAT rates in the member states. Despite these shortcomings, this is a world-leading scheme set to address one of the greatest risks faced by mankind. The European Union should be congratulated on implementing such a scheme.

Dr Anthony White, Climate Change Capital, UK

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