Change in the air

For several years, Kyoto mechnisms such as joint implementation have helped to finance power projects across Central and Eastern Europe. However, the start of the European Emissions Trading Scheme in January 2005 threatens the future of such financing initiatives.

The energy sector in Central and Eastern Europe can gain from additional carbon finance revenues coming from the Joint Implementation (JI) mechanism under the Kyoto protocol. The JI mechanism gives participating countries, that have ratified the protocol, the ability to exchange greenhouse gas emission reductions. This mechanism also applies to countries like Bulgaria, Romania and Ukraine that already have ratified the Kyoto protocol.

Countries such as the Netherlands, that have a need for emission reduction under the Kyoto protocol, are interested in exploiting the JI mechanism to buy additional emission rights under the Kyoto protocol from other countries. For example in the Netherlands, the marginal costs to reduce 1 t of CO2 can be as much as g50 per t. This relatively high value is the result of an already very CO2 efficient energy industry. This low carbon economy has been achieved by considerable investment in energy efficiency over the past few years as well as by using a relatively large amount of natural gas.

In countries like Bulgaria, the same amount of CO2 reduction can be achieved by g5 per t. There, with a relatively low amount of investment, huge increases in energy efficiency can be achieved. In addition, potential emission reductions through fuel switching to natural gas are significant in countries like Bulgaria.

The CO2 reduction activities undertaken by the early moving countries such as the Netherlands have been done in anticipation of the enforcement of the Kyoto protocol. The protocol will enter into force after it has been ratified by Russia.

Joint implementation

The amount of emission reductions under the JI mechanism is estimated through the application of the baseline concept (see Figure 1). The baseline represents the existing situation that would continue without the project at sector or country level. In the energy sector, the baseline is expressed in grammes of CO2 per kWh. This is called the carbon emission factor (CEF). When a project is implemented, its emissions are monitored every year. These monitored emissions are then compared to the baseline. The estimated difference is expressed in ERUs (emission reduction units, i.e. 1 t of CO2 reduction) which can be sold to buyers such as the Dutch government, which can then use these emission reductions for compliance under the Kyoto protocol.

Figure 1. Baseline concept for estimation of emission reductions in JI
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This concept is especially interesting for those parts of the energy sector which use fossil fuels. In this sector, energy efficiency investments or retrofits can realise CO2 emission reductions through lowering the used amount of fuel. In addition, in most cases a retrofit project also increases the capacity of the installation.

Financial drive

In the case of an electricity generating installation, the increase in capacity will replace production from other generators from the electricity grid. For example, an existing CHP (combined heat and power) installation in Eastern Europe might be 30 years old and use natural gas as a primary fuel. An investment in increasing the efficiency of the old installation combined with an upgrade in capacity will result in a considerable amount of CO2 emission reductions. At the plant itself, the CEF will decrease. This will result in a certain amount of emission reduction units that can be sold to interested buyers. In addition, due to the capacity increase, the plant would also be capable of injecting more electricity, with a lower CEF, into the national grid. If the new CEF of the retrofit project is lower than the average CEF of all the electricity producers on the national grid, ERUs can be claimed from this additional capacity. This is generally the case in most Central and Eastern European countries.

The renewable energy sector is capable of using its reduction potential following the same approach. A new wind farm or hydro facility, for example, can use JI to obtain financing. Widespread use of this concept would allow the average CEF or national power emissions per kWh from generators on the grid to be replaced with CO2-free electricity from renewable installations.

The JI mechanism has been successfully exploited in the last couple of years by, among others, the Netherlands. More than 8 million t of CO2 reduction has been contracted by the Netherlands from projects in Czech and Slovak Republics, Romania and Bulgaria and other countries in Central and Eastern Europe. Generally, against a price of g5 per t, the carbon financing is capable of covering between ten and 30 per cent of the investment. Therefore, this mechanism is a significant financial driver for the energy sector in these countries to reduce their CO2 emissions. However, the possibility of using climate mechanisms such as JI for co-financing CO2 reduction investments in these countries will change because of the introduction of the European Emissions Trading Scheme (ETS).

JI under ETS

In October 2003, the European parliament passed a CO2 emission trading directive for CO2 emitting installations in the European Union (EU). Under this scheme, the actual emitting industries will be given a CO2 emission allocation. Of these industries, the energy sector and energy intensive industries cover almost 50 per cent of the emissions in the EU. The directive establishes a mandatory cap-and-trade system for more than 14 000 CO2 emitting installations throughout the greater EU. Trading will commence in 2005.

Figure 2. Double counting explained
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The system will start with the initial allocation of every installation covered under the trading scheme. Installations that are smaller than 20 MWth will be excluded from participation in the scheme. Also renewable installations, that do not emit any emissions, will be excluded from the scheme. If installations are projected to emit more than their allocated allowances, they can choose between implementing emission reduction measures inside their installation and buying emission rights from installations under the scheme that have excess allowances. If nothing is done a shortage of emission allowances will emerge in the monitoring report that will be produced at the end of each year. In this case, the company will be fined g100 per excess t in the period 2008-2012.

In Central and Eastern Europe, for the energy sector, the introduction of the ETS implies a significant change in possible opportunities to claim emission reductions under the JI mechanism.

Using again the example of the retrofit of the CHP plant, the situation under the ETS is different. Although the efficiency increase by the retrofit project will result in a lower amount of emissions, generally the increase in capacity will surpass these reductions. When the increase in emissions due to the capacity increase is bigger than the reduction of emissions from the efficiency increase, the retrofit will cost additional money. The project then has a need for additional emission rights under the ETS.

For the renewable energy sector, with the introduction of the ETS, it will be even more difficult to benefit from the Kyoto mechanisms. As previously described, by generating green electricity, the actual CO2 emission reductions will be achieved at the fossil-fuelled power generators by decreasing their activity level. Their decrease in energy output will result in a decrease in CO2 emissions. This enables these ETS participants to sell emission rights, due to the expansion of renewable capacity. As a consequence, the new renewable capacity will be unable to claim emission reductions under JI. Otherwise, this would lead to double counting of the same emissions (Figure 2) under both the ETS as well as the JI mechanism. It is unclear how this will affect the renewable sector in these countries.

Apart from the differences in the calculation of the reductions, the ETS also implies uncertainties due to its implementation status. Whereas the JI is an established mechanism with over five years of practical experience, the ETS system currently still is under development and has an envisaged starting date of January 2005.

Allocation differences

In order to start the ETS scheme in Europe, the initial division of emission rights among the participants first needs to be established. The individual EU country governments participating in the scheme have been preparing their National Allocation Plans (NAPs). In designing these plans, the individual countries have considerable freedom. At the end of March, only five out of 15 EU countries had submitted their final allocation plans on time to the European Commission. More importantly, a first assessment of these plans and draft plans shows that the formulas to calculate these quotas show basic differences among each of the different countries.

These differences in allocation might lead to unfair competition across EU markets, particularly between interconnected, liberalized markets where the operators compete with each other.

The Commission has a responsibility towards harmonizing allocations of comparable sectors and industries across EU countries’ borders. It will try to harmonize the allocations plans accordingly before the system commences in 2005.

In addition, the first assessment of the NAPs also shows that the plans tend to accommodate the ETS participants by allocating just enough allowances to cover the current emissions, and even allowing some future growth. This fact might hamper the actual functioning of the ETS system because of reduced scarcity of emission allowances in the system. Generally, the proper working of a cap-and-trade scheme depends on a certain amount of scarcity within the system. While having rather comfortable allocations for the ETS participants, the expectations on market activity and volumes are quite limited. Furthermore, because of the limited need for allowances, expectations on trading prices also are on the lower side.

Figure 3. January 2005 is the marked diary date for the start of the EU ETS
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Comfortable allocation is also an issue that the European Commission will try to mitigate as much as possible. According to EU officials, too-generous allocation plans for the ETS participants in the EU countries would be inconsistent with the Kyoto protocol targets. The suggested adjustments to be made by the European Commission in the coming months will result in uncertainty for ETS participants about their allocations. This will also result in a wait and see attitude with respect to CO2 reducing investments by these companies, until their initial allocation is more certain.

Linking directives

On 7 April 2004, the European Ministers of Environment agreed on the linking directive that will amend the EU ETS directive. The Ministers agreed to allow firms to buy foreign credits from JI and from the Clean Development Mechanism (CDM), regardless of whether the Kyoto treaty comes into force internationally. For each installation participating in the EU ETS.scheme, the use of these foreign credits is allowed up to a certain percentage of the initial allocation, to be specified by the government of the host country. The final outcome of this long awaited linking directive is good news for the ETS participants as well as for the CDM and JI markets. It will allow the EU ETS participants to cost effectively comply with their liabilities under the scheme through purchases of JI and CDM credits.

However, in the short term, the JI mechanism will not face increasing demand from the energy sector due to this linking directive for two main reasons. First of all, the uncertainty about the initial allocation will push companies into a wait-and-see attitude with respect to undertaking activities to mitigate compliance issues. Secondly, the import of credits from JI schemes will only be allowed after 2008. It is uncertain how big the activities of ETS participants will be to mitigate their compliance with trading in future JI emissions.

Europe’s ETS scheme may offer fewer possibilities on co-financing of CO2 reducing projects than JI. In addition the ETS leaves the participants in uncertainty about their allocation. For the energy sector, it is expected that the developments in the allocation of the ETS participants will not be clear before the system actually enters into operation in 2005. This might result in a wait and see attitude of these participants with respect to CO2 reducing projects.

From long term experience with the JI mechanism, it has become clear that carbon financing adds a significant amount of money to CO2 reducing projects in the energy sector. CO2 reducing projects in the energy sector in Central and Eastern Europe that seek carbon financing revenues in the near future up to 2005, should seriously consider participating in the current purchasing programmes for JI.

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