Archive for May, 2011

The nature of uncertainty

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As the debate continues in Australia with regards the implementation of a carbon price, the issue of investor uncertainty has risen up the agenda. A recent interview conducted by ABC (Australian Broadcasting Corporation) illustrates the point:

One of Australia’s largest home and business electricity suppliers has warned that household power bills will double in six years after a carbon price is introduced and uncertainty over its implementation might lead to power shortages.

The gas and electricity giant’s chief executive said uncertainty over what the long-term carbon price might be has stalled capital investment in the industry and halted construction of new power stations. “Capital is not being invested so we haven’t seen new power stations built,” the CEO told ABC TV today.

Electricity regulator Australian Energy Market Operator (AEMO) had forecast shortages of baseload power for Queensland in 2013 and 2014, with Victoria and NSW experiencing shortages in 2015 and 2016, he said. “Given the timeframe for building new power stations, we’re concerned that we need that certainty today so we can build power stations to meet that coming gap in the market,” the CEO said.

He said that gap had resulted in electricity prices rising by 40 per cent in the past three years as a result of network investment. Rising fuel and gas prices would cause them to increase by another 30 per cent over the next three years, the CEO said. The mooted carbon tax of between $20 and $25 a tonne of emissions would not change industry behaviour but would double electricity bills for households over six years given the 30 per cent rise, he said.

Without wanting to comment on any of the figures in the interview, it is nevertheless clear that uncertainty surrounding the implementation of policy is a problem for some, but should it be?

When it comes to power generation on a national scale, arguably the uncertainty question is about the exact nature of the policy rather than the existence of carbon policy at all. Although some will still choose to disagree, there really is very little uncertainty around the need to reduce CO2 emissions, so it is much more about how and when rather than if.

The “when” question is perhaps less uncertain than we might imagine. In the context of major power projects with planning, approval and construction periods of up to ten years, exposure to a carbon price during the operational lifetime of the facility (i.e. the 2020s and 2030s) becomes a near certainty. Although there is concern as to the lack of policy development in key regions today, it is also true that in the last ten years there has been a spectacular shift in the policy agenda. Carbon markets are a reality, global carbon trade exists, carbon targets are the stated goal of dozens of economies and most financial institutions now operate carbon business units of one sort or another (from trading to analysis). By 2020 and beyond, as the environmental picture becomes clearer, policy implementation will likely accelerate, even if it still isn’t sufficient to address the issue head on. So the working assumption should be that a carbon policy framework will be in place during the operational life of a project just starting out today.

So the real issue is “how” (in actual fact “how much”) – i.e. what will the policy look like and what sort of price signal will it send? This was probably at the root of the decision by a number of coal fired generators to actively engage in the formulation of US cap-and-trade policy in 2009 and 2010 – it wasn’t a burst of environmental enthusiasm that brought them to the table, but the sobering reality of a regulatory future that might be created without their input. Many companies now address this aspect of uncertainty with assumed carbon prices, as is the case in Shell today. From a planning perspective looking out 10-20 years, the actual shape of the policy isn’t that important, the key issue is the carbon price it might deliver. Even this can be picked apart based on signals from legislators today and arguments put forward by academia. For example, it is clear from signals in the EU and the UK that in the EU-ETS covered sector the desired outcome is a noticeable shift in the type of generating capacity, so we therefore shouldn’t imagine that a price of €5-10 will somehow suffice. Equally, there are enough technology options in play at the moment to offer significant emission reduction opportunites below €100 per tonne of CO2.

Although it all looks messy today, there is reason to believe that this issue is far more certain than it appears. Even in Australia, both parties now have carbon price policies of some sort whereas neither really did ten years ago. In Canada, there is the proposed moratorium on unabated coal which certainly injects a carbon price into the power sector and in the USA the progressive implementation of rules under the Clean Air Act may well persuade legislators to look again at a more comprehensive approach. Even if they don’t the CAA alone delivers a pretty powerful signal.

Of course, once governments start to collect significant revenue from carbon pricing policies, certainty abounds.

Ambitious reduction targets for the United Kingdom, but . . .

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On Tuesday in the House of Commons, the Secretary of State for Energy and Climate Change, Chris Huhne, announced that the UK would adopt the recommendations of the Climate Change Committee and shift the economy towards ambitious 2030 carbon reductions. Specifically, Huhne announced a 4th Carbon Budget of 1950 Mt CO2 for the period 2023-2027 which is aligned with an indicative 2030 target to reduce emissions by 60% relative to 1990 levels (46% relative to 2009 levels). The government did deviate from the recommendations in one important area in that it accepted the need to keep carbon trading options open – “to maintain maximum flexibility, and minimise costs in the medium-long term”.

But there is an important caveat to this ambition – namely the need to ensure alignment with the EU. While the UK may well be an island and even one with its own currency inside the EU, at least for carbon it is joined at the hip to the EU by the emissions trading system. A UK power generator and emitter handles exactly the same allowances as a continental EU one and sees, at least for now, exactly the same carbon price. If the UK happens to embark on its own reduction pathway independent of that prescribed by the EU then the result will be 100% carbon leakage into the EU via allowance trade. As such, the announcement by the Secretary of State included the following;

 Under the Climate Change Act, emissions reductions by the UK’s industrial and power sectors are determined by the UK’s share of the EU Emissions Trading System cap. This protects UK industrial and power sectors from exceeding EU requirements. However if the EU ETS cap is insufficiently ambitious, this could mean placing disproportionate strain on other sectors outside the EU ETS such as transport.

 To overcome this and to provide clearer signals for businesses and investors, government will review progress towards the EU emissions goal in early 2014. If at that point our domestic commitments place us on a different emissions trajectory than the Emissions Trading System trajectory agreed by the EU, we will, as appropriate, revise up our budget to align it with the actual EU trajectory.

At least in terms of the power sector, the future differences appear stark. In recent months the EU has released its Low Carbon Roadmap for 2050 which sees an EU wide reduction of some 40% by 2030 compared to 1990. This equates to a reduction in the power sector of around 60% by 2030 (or 54% for the EU-26), in contrast to the proposal of the 4th Carbon Budget which sees a nearly 90% reduction.

 

Although the time period is short, the UK and EU power sectors appear to have followed more aligned pathways since the start of the EU-ETS, as would be expected given the underlying trade in allowances. Between 2005 and 2008, both have been relatively flat.

A sustained, more aggressive pathway for the UK is not possible unless supplementary domestic policies are introduced to force the direction. As noted in previous postings, this will drive up the cost for UK consumers relative to the EU and potentially impact UK competitiveness. So the challenge now sits with the UK to force the issue in Europe, rather than focus on domestic energy policies to meet its goals. To date there has been an almost singular focus on the EU 2020 target (i.e. the 20% or 30% debate), but the reality is that 2020 emissions are now largely defined by major projects already in planning, car designs on the drawing boards and the current building codes. This means that the UK needs to get the EU to turn its attention to Phase IV of the EU-ETS and open up the discussion regarding its structure and ambition (i.e. the 2030 target).

The current EU legislation would see the post-2020 ETS continue to deliver reductions of 1.74% per annum (absolute percentage points, not percent relative to the previous year), which means about 35% between now and 2030. This is far short of the recommendations of the 4th Carbon Budget proposal for the UK.

The UK government has quite a challenge ahead.

Later this month the IPCC (Intergovernmental Panel on Climate Change) will launch a very substantial report on Renewable Energy and Climate Change. In advance of that, a “Summary for Policy Makers” was released early this week following the 11th Session of Working Group III of the IPCC, held in Abu Dhabi on 5-8th May. In tandem with the Summary document was a press release, which starts out with the words;

Abu Dhabi, 9 May 2011Close to 80 percent of the world’s energy supply could be met by renewables by mid-century if backed by the right enabling public policies a new report shows.

Not surprisingly, this key phrase was repeated in headlines the world over, with much media enthusiasm for the report. But it isn’t what the Summary is actually about, nor does the Summary give any details into how this may come about.

Instead, the Summary for Policy Makers provides an extensive overview of the current state of key renewable technologies, including wind, solar, hydro, geothermal, ocean and biomass. There is no doubt, based on the information provided, that renewable energy technologies are maturing rapidly and impressive strides have been made in development and deployment.

The view on the ultimate deployment of renewables and their potential to capture much of the world’s energy market by 2050 comes from a review of some 164 scenarios, with an in-depth review of four. Here it should be noted that the four represent a span from a baseline scenario without a specific mitigation target to three scenarios representing different CO2 stabilization levels. Although we will need to wait for the full report to see the specific details of the scenarios, the fact that they have specific mitigation targets is a telling sign. This implies that these are not scenarios in one important sense, in that they have an artificial constraint which dictates the outcome. Such a constraint doesn’t exist in the real world, but must be developed over time as part of the societal response to energy and climate change issues.

In the current Shell energy scenarios, Blueprints and Scramble, there are no specific mitigation targets at a global level. Rather, the scenarios track different levels of response to the issue of carbon emissions. Blueprints, the more optimistic in terms of a response to climate change, sees the early development of carbon pricing and carbon markets throughout much of the world which in turn drives the rapid deployment of a range of technologies, including renewables, carbon capture and storage and vehicle electrification. It is a bottom-up, national policy driven scenario that pushes technology deployment rates beyond historical norms. By 2100, Blueprints sees stabilization of CO2 at some 540 ppm, with other GHGs adding a further 110 ppm CO2 equivalent. This is above the level that equates to a 2°C rise in global temperatures.

This isn’t to say that targeted scenarios are not instructive. By establishing a future goal and modeling a pathway towards it, we can better understand the role of various technologies and the rates at which they need to be deployed. Such a model also gives insight into the future cost development of certain technologies. The scenario should also test the physical feasibility of the necessary rapid change in the energy system. But none of this means that it is actually possible to achieve such a goal. Society must be suitably motivated to do so and be prepared to shoulder the economic costs, particularly where it involves very early retirement of existing infrastructure.

A key chart in the Summary illustrates the nature of the scenarios that have been sampled.

Category I, II and III scenarios represent CO2 stabilization levels below 485 ppm, a level at which many observers regrettably now see as unobtainable. The green Category I scenarios see stabilization at current levels or below, which implies the deployment of air capture technologies or very large scale use of bio-char sequestration or similar.

Although there isn’t sufficient information in the Summary to extract the underlying numbers, the chart above also implies that the 2050 world in many of the scenarios uses less energy (or at least not that much more) than the current world (492 EJ in 2008). This is due in part to the calculation method for primary energy differing between fossil energy and renewable energy, but it would also appear that tremendous improvements in energy efficiency are made. This was a key feature of the “100% renewable energy by 2050” scenario that WWF released recently. The real story in that scenario was not the renewables per se (where total deployment was not that different to the Shell Blueprints scenario), but the transformation in energy use that accompanied them. This almost certainly requires yet another step change in societal response – it is unlikely to be just about better technology.

As we head towards the IPCC 5th Assessment Report this contribution from Working Group III is likely to be an important milestone and much referred to in the coming months. But we should recognize it for what it appears to be and not be. It certainly appears to be a very thorough review of the current state of renewable energy technologies and an important guide as to how they may contribute to the energy system of the future. But this isn’t  a forecast of what will be, nor does it appear to be a clear guide as to what is actually doable in the limited time available to respond, particularly given the current economic circumstances the world is experiencing and the political stalemate over carbon emissions that we see in some major economies.

Tough times in Australia for carbon

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The development of an acceptable carbon price policy framework in Australia is proving to be both politically and socially challenging. Recent media reports indicate that the clear support from business for “carbon price certainty” has the caveat of competitiveness concerns and that public support is low, although arguably the public is never that enthusiastic about taxation.

. . . . . MINING giant Rio Tinto has added its weight to calls for Julia Gillard to reassure big polluting industries that her carbon tax plans will not damage Australia’s international competitiveness, warning it is unwise to act before China and the US. In an exclusive interview with The Weekend Australian, Rio Tinto chairman Jan du Plessis urged the Gillard government to rethink its carbon pricing policy and timing, saying it threatened the Australian economy when other leading economies appeared to be stalling on climate change action. “The question is, how and when does Australia move in the light of the disappointment of the Copenhagen conference and in light of the fact there are very few signs the big gorillas – the US and China – really are going to be moving,” the London-based Mr du Plessis said in Sydney.

 . . . . . This week, BHP Billiton chief executive Marius Kloppers warned the Prime Minister that Australia’s go-it-alone approach would be a “dead weight” on heavy polluting industries, and the nation should not penalise its “trade-exposed industries” by moving ahead of its international competitors.

There is far more opposition to a carbon tax than there is support for it, an opinion poll has found.

. . . . . the Newspoll, published in Wednesday’s The Australian newspaper, reveals 60 per cent of voters are opposed to the government’s plan to put a price on carbon next year, compared with 30 per cent who support it. Of the 60 per cent who are opposed to the tax, which Ms Gillard plans on introducing from July next year, 39 per cent of the poll’s participants said they are “strongly against” it. In comparison, of the 30 per cent who said they supported the carbon tax, only 12 per cent said they were “strongly in favour” of it.

Australia finds itself with mixed fortunes at the moment. While the resource companies benefit from a booming commodity market, they are equally struggling with costs as the Australian dollar continues to appreciate on international markets. The claim that a carbon price would further damage the competitiveness of the export based natural resources economy is making it appear that there are deep divisions in the business community over the issue, when in fact this may not be the case at all – despite the recent headlines!!

There are two fundamental principles of carbon pricing in play here and a balanced debate on these doesn’t seem to be making it into the press. Unfortunately the issue has also become politically charged with the division between the parties looking more like a chasm at the moment. Nevertheless, these principles should be discussed more widely – both feature in the recent WBCSD publication on carbon pricing which I discussed in my last post.

The first is the issue of the tax burden on society as a whole. A carbon price isn’t and never should be about increasing the net tax (revenue collection by government) burden on society, rather it should be about realigning the same level of revenue collection against a different metric, in this case carbon emissions. Introducing a carbon price into the principal domestic sectors of the economy and demonstrating an equal but compensating reduction in another revenue collection mechanism would be a bold move that clearly demonstrates to an increasingly skeptical public that this is all about change and not about revenue. The government has certainly talked about revenue neutrality, but has yet to give any real clarity as to what it means by “compensation to households”

It might be too late for a bold move, but doing so could also be a catalyst for simplification and a return to the very basics of the carbon price issue. For example, and this is purely for illustrative purposes, a $30 carbon tax in the electricity generation and personal transport sectors of the economy (nearly three quarters of energy use CO2 emissions come from these two sources, 220 MT + 70 MT out of 400 MT) would raise some $9 billion per annum. This is roughly equivalent to a reduction in Australian GST (Goods and Services Tax – VAT in the UK) from 10% to 8% (GST collects about $50 billion). GST may not be the right approach, but however such a compensating move is implemented, there is a desperate need for clarity around the principle of the approach, as discussed by WBCSD.

The goal of a carbon price is to create a change in the economy such that the market begins to differentiate between goods and services on the basis of their carbon footprint. In its generic realization, the carbon price, initially experienced by the emitter or fuel provider (e.g. by paying a tax, purchasing allowances from the government or implementing a required project), is passed through to the consumers of the product. The result is a change in the relative cost of most goods and services based on their carbon footprint, and the emergence of a new cost ranking within the economy. This will influence the purchasing decisions of consumers. Products with a high carbon footprint will be less competitive, either forcing their removal from the market, or driving manufacturers to invest in projects to lower the footprint. Any revenue raised by the government from carbon pricing, will be typically directed to the treasury as part of the overall national budget process. It should be used efficiently; for example, to offset any net change in costs to the consumer by reducing taxes. 

The second issue deals with the competitiveness of trade exposed industries. This is where much of the industry rhetoric is targeted and in fact the government has a reasonably complete and broadly fair position in this area, although an observer would struggle to know that looking at the press coverage. But there is some commentary getting out – for example in the Sydney Morning Herald this week in an opinion piece entitled “Carbon tax won’t kill the economy”. It’s worth reading the article as it’s too long to reproduce here, but the key point made at the end pretty much tells the story;

So it appears that the negotiation boils down to the gap between the government’s offer of 94.5 per cent compensation and the EITE’s call for 100 per cent. We are not too far apart here!

It’s easy to see how people can come to the, in my view, misguided conclusion that “a carbon price will kill the economy”.

If the whole economy was populated by highly emission intensive and trade exposed activities AND there was no compensation provided, perhaps then I would agree with the conclusion.

But clearly that’s not the case.

It’s not quite the case that the government is offering universal 94.5 % compensation, but there is a negotiation underway and the commentator is broadly correct with the view that the two sides are not that far apart.

This issue of trade exposure is also covered in the WBCSD publication as follows;

A transparent pass-through of operating costs to the consumer is an important feature of any market. It allows the manufacturer to adjust the sales price to maintain profitability, as new costs enter a process, or existing costs change. An increase in the sales price could only occur to the extent that the market allows the change to take place, due to competition from manufacturers with a different cost structure that may limit the potential for cost pass-through. This gives rise to one of the principal challenges of introducing carbon pricing into an economy.

Carbon pricing is being introduced piecemeal throughout the world. Some manufacturers incur the cost of carbon, while others do not, although they may be competing in the same market. A manufacturer incurring the cost of carbon is penalized, as the market price is set by a lower cost provider without the carbon price. This can result in “carbon leakage”, where a higher cost manufacturer struggles to compete, and market share is gained by a producer not subject to the carbon price. Consequently, the environmental integrity of the approach can be undermined and economic distortions introduced.

The design of a carbon pricing policy must recognize [this] issue[s]. For example, if the policy involves the use of an emissions trading system, the free allocation of a portion of the allowances to certain sectors means that they do not incur the direct cost, but retain the opportunity cost of carbon in the free allowances. The environmental goal is retained, since a fixed number of allowances are in circulation.

So the fiery debate continues in Australia and the politics gets murkier – it appears that this has become the new norm for climate change policy development in many countries. But it needn’t be, as there are clear paths open for both government and business to reach agreement and take the much needed policy forward.