After a day in Brussels listening to European MEPs, it is clear that the Parliament vote next week on the Commission proposal to backload the auctioning timeline in Phase III of the European Emissions Trading System (EU ETS), is going to be very close. This is a policy proposal that was born out of the call by many participants in the EU ETS, as well as the European Parliament, to address the chronic allowance surplus and therefore begin to steer the CO2 price into a more useful range in terms of real action and investment. A positive vote on the proposal would also be the start of a more structured reform of the policy package designed to reduce emissions across the EU over the coming decades.

But in the frantic days left before the vote, clarity and reason are struggling to be heard over the clamour of opposition, so here are the top ten reasons why an MEP should vote to support the “backloading” amendment next week:

1. Market Confidence

The current CO2 price in the ETS is just a few euros. Even the assumption that there will be a robust price by 2030 (enough for deploying CCS in 2030s for example), but discounted back to now, should result in a higher price than the one we have. That means the market is discounting the ETS itself, in other words questioning its very existence in 2030. Nobody will invest given such an outlook. A positive vote for backloading will signal that the Parliament is prepared to act on the ETS and begin to restore confidence for energy investment decisions.

2. Low carbon Investment

Apart from its annual compliance function, which the ETS is delivering, its purpose is to provide an investment price signal. This in turn steers long term investment in the covered sector, providing support and justification for lower emission investment opportunities. The near zero price signal being seen today means the EU has returned to “business as usual” energy investment, which is even resulting in a resurgence of coal based power generation projects. This will just put upward pressure on EU emissions in the 2020s. 

3. Jobs

Rewind to 2008 and the €25-30 CO2 price, which in combination with the NER300 saw some 20+ CCS projects being considered. The construction of the world’s first CCS network was a real possibility. Today, with the exception of the UK where the necessary investment signal has been created in a national level ”carbon policy bubble“, these projects have been shelved. So too have the jobs that would have been created had they gone ahead.

4. Credibility

Investment depends as much on long term credibility of the policy structure as the policy itself. Business investment will not proceed unless there is a belief that the supporting policy framework is robust and long lasting and therefore able to deliver the necessary return on that investment.

5. Leadership

While there is an issue with the EU over leading on actual emissions reduction, this isn’t the case with leadership on policy development to reduce emissions. Today, many states, provinces and countries have implemented or are in the process of implementing an ETS on the back of the initial success in the EU. They are now watching developments here closely as the EU debates the future of the system. A decision to reject the backloading proposal will potentially undermine the implementation of emissions trading globally (see 10 below).

6. Support

There is a noisy opposition to this proposal, as there was opposition in 2003 to even having an ETS and again in 2008 to building a full policy framework for managing emissions over the longer term. But many companies, institutions, business associations and individuals see the clear merit of a functioning market based approach for reducing emissions and strongly support the proposal. The voice of some European business associations on this issue is not necessarily the consolidated view of business in Europe. 

7. Europe

The ETS was designed to build on the strength of a single EU market and deliver through the synergy that it offers. A weak ETS is leading to fragmentation of this goal as national policies are developed to fill the gaps. Just look at what the UK government is having to do to shore up investment cases which would otherwise be supported by the ETS. This only means a less effective and ultimately more expensive route to the same goal. 

8. Growth

This is all about investment in the EU energy system. Without investment guided by credible policy and clear market price signals, growth stalls.

9. Environment

The carbon price delivered by the ETS is the only mechanism in place to drive the development and deployment of carbon capture and storage. Without this one critical technology, the climate issue simply doesn’t get resolved. The demand for, abundance of and low cost of extraction of fossil fuels may well be unassailable this century, so atmospheric CO2 will continue to rise. 

. . . and most importantly at #10 (well it’s actually #1)

10. Economy and competitiveness

An emissions trading system can deliver the lowest cost emission reduction pathway for the economy, but to do this it needs to be left to do the heavy lifting. The very low price of CO2 in the EU today is not a sign of low cost abatement, but quite the opposite. Abatement is being driven by other policies, with the cost to the economy probably much higher than necessary. The ETS needs to be restored as the principle driver of change in the EU energy system. This will lower energy costs in the EU, which in turns helps competitiveness.

Supporting backloading now won’t deliver all this in one go, but it will get the wheels of change in motion and importantly, signal an intent on the part of the Parliament to correct the energy and climate policy framework and make the EU ETS central to the overall delivery of current and future emission reduction goals.

In a recent post I discussed the problems that the EU flagship programme to demonstrate CCS (carbon capture and storage) is having. With an allowance surplus building up in the ETS and a resulting low carbon price, the urgent need for commercial deployment of CCS has diminished. Furthermore, with natural gas availability growing and renewable energy becoming a sizable factor in the EU electricity mix, it may be well into the 2020s before large scale deployment of CCS is actually needed.

These developments might instill a false sense of security, in that we imagine there is no need to do anything now with regards large scale CCS commercialization. While it is clear that there is no immediate need for rapid rollout, every low carbon energy scenario still shows CCS as an essential component of energy delivery. In a posting late last year, I argued that global emissions are unlikely to be reduced at all without CCS.

Even with widespread deployment starting as late as 2030, action in this decade is still important. Early demonstration and commercialization of new technologies can be a long process. Take for example Shell’s own experience with Gas to Liquids technology. A very large scale plant is now operating successfully in Qatar, but the advanced catalysts used in the process started development in the 1980s and the small commercial scale demonstration plant in Malaysia was an early 1990s development. A final investment decision for the first full commercial deployment was made in 2006 and even then construction and startup took five years. A 10-20 year timeline for first commercial deployment is not unusual, which is one of the reasons why it takes 25+ years for new energy technologies to become globally material (>1% of the energy mix). I discussed this in a post back in late 2009.

All this still points to the need for some CCS activity in Europe this decade and for project development to proceed next decade for startup around 2030 (at the very latest). It may also be the case that a need for deeper cuts in emissions brings CCS forward.

The question of how to promote CCS activity today, in the midst of difficult economic times and carbon markets that are clearly not calling for it, is discussed in a new report issued today by the European Technology Platform for Zero Emission Fossil Fuel Power Plants (ZEP).The ZEP report, Creating a Secure Environment for Investment in Europe, looks comprehensively at short (through to 2020), medium (the 2020s) and long term (post 2030) measures. In the short term the focus must be on recalibrating the ETS, but the report also calls for a number of the measures similar (but not necessarily identical) to those being implemented in the UK as part of the Electricity Market Reform. CCS Feed-In Tariffs, CCS Purchase Contracts and CCS Capacity Payments are all discussed. These measures could also continue in some form into the 2020s, but securing early clarity on 2030 and 2040 EU carbon targets is seen as the key priority for the medium term. For the longer term, the 2050 emissions target is the key driver, but the introduction of an auction reserve price for ETS allowances post 2030 would provide investment certainty for large scale project decisions made in the 2020s. Such investments would be exposed to the prevailing carbon price in the 2030s and beyond.

The EU has put considerable effort into stimulating CCS, but the goal of early demonstration has proved to be intractable. The ZEP report provides some further thinking on the issue and because of the ZEP constituency, is backed by industry, academia and NGOs.

This week I attended the quarterly review meeting of the European Technology Platform for Zero Emission Fossil Fuel Power Plants (ZEP), a coalition of stakeholders united in their support for CO2 Capture and Storage (CCS) as a key technology for combating climate change. ZEP serves as advisor to the European Commission on the research, demonstration and deployment of CCS. Many topics related to CCS and the underpinning technology set are discussed at the quarterly meetings, as well as various overview presentations to look at the current status of deployment. It is this latter aspect that is in trouble.

Over the last five years the EU has put great effort into promoting CCS. The Commission has led this, creating a legislative framework for the technology to exist in the field, agreeing on the need for a 10-12 project demonstration programme, supporting that programme with funding mechanisms and of course institutionalizing a carbon price within the industrial economy to act as the principal driver for implementation and longer term deployment.

With such an effort and so much political capital spent, one would expect to see a burgeoning CCS industry, or at least the beginnings of it, appearing across the EU. Unfortunately this is not the case. With the possible exception of the UK, it could be that by 2020 there will not be a single large scale CCS project operating across the 27 member states. This was certainly not the plan.

Looking forward, CCS is clearly going to be required in the EU. The region continues to burn it’s considerable coal and gas resources for power generation and more recently, with the exception of France and the UK, there has been some trepidation with regards further deployment of nuclear for power generation. Renewable energy use may be growing and there have been some remarkable, albeit brief, instances of near 100% power generation from renewables in some parts of the EU, but overall renewable energy growth remains modest (see below).

The first barrier to CCS implementation is a simple political one. Progress on member state transposition of the EU CCS Directive remains stubbornly slow with some member states seemingly less enthusiastic than they first appeared. In particular and despite a wealth of R&D activity and small pilot projects, German interest with regards CCS implementation now appears very low, despite its significant coal capacity. Rather, the focus is on renewable energy. Of the 27 countries required to transpose the directive, only 9 countries are acting. However, these do at least make up the key locations for potential demonstration projects.

The next barrier is a tough one. Public acceptance of on-shore storage has weakened considerably. This has always been a concern, but more recently this concern has resulted in the termination of projects. A Shell project in the Netherlands is one example. The alternative is off-shore storage such as the Sleipner project in Norway, but the cost of this for on-shore produced CO2 is higher.

But the real problem rests with the economics of CCS. In the middle of 2008 the picture looked relatively robust.

• The ETS CO2 price was in the high €20’s and even broke through the €30 barrier.
• The Energy and Climate package making its way through the EU Parliament included a provision to set aside allowances as a funding mechanism for the demonstration programme (now called NER300 – short for 300 million allowances from the ETS New Entrant Reserve). The Directive describes the support mechanism as follows and the Commission has established a website to allow bidders and other interested parties to follow the process:

Up to 300 million allowances in the new entrants’ reserve shall be available until 31 December 2015 to help stimulate the construction and operation of up to 12 commercial demonstration projects that aim at the environmentally safe capture and geological storage (CCS) of CO2 as well as demonstration projects of innovative renewable energy technologies, in the territory of the Union.
The allowances shall be made available for support for demonstration projects that provide for the development, in geographically balanced locations, of a wide range of CCS and innovative renewable energy technologies that are not yet commercially viable. Their award shall be dependent upon the verified avoidance of CO2 emissions.
Projects shall be selected on the basis of objective and transparent criteria that include requirements for knowledge-sharing. Those criteria and the measures shall be adopted in accordance with the regulatory procedure with scrutiny referred to in Article 23(3), and shall be made available to the public.
Allowances shall be set aside for the projects that meet the criteria referred to in the third subparagraph. Support for these projects shall be given via Member States and shall be complementary to substantial co-financing by the operator of the installation. They could also be co-financed by the Member State concerned, as well as by other instruments. No project shall receive support via the mechanism under this paragraph that exceeds 15 % of the total number of allowances available for this purpose. These allowances shall be taken into account under paragraph 7.

The mechanism, in combination with a robust underlying carbon price, meant that a viable demonstration programme could emerge. The 300 million allowances could conceivably generate €9 billion in funds, which meant up to €1.35 billion for some projects (i.e. the 15% limit). With potential Member State co-funding adding additional support, a 500 MW end-to-end CCS power station was even feasible and some of the projects originally submitted to the Commission for consideration were on this scale.

But the collapse of the CO2 price in the EU throws a huge question mark over the viability of the programme. So far the European Investment Bank (charged with monetizing the 300 million allowances) have sold over a 100 million allowances at a price of around €8.10 each. That’s a good effort in the current market, but it substantially changes the economics of a project. Now the maximum grant that any given project can collect is €360 million and it will be operating in a €6 CO2 market. Even with matching funds from the relevant member state, now much more challenging due to EU financial circumstances, a large scale project looks very unlikely. Large scale early CCS projects require a CO2 price in the range €60-100, not €20-25 (assuming €6 ETS price, maximum NER 300 financing and some member state co-financing).

The selection process for projects will proceed over the balance of this year with an announcement expected in December, but at least for the CCS part of the NER300 (innovative renewable energy projects are also supported) one wonders how this will pan out.

An exception to all this is the UK, which has taken matters into its own hands and which I have written quite a bit about in the past. A new UK CCS competition has been announced with £1 billion in funding and the UK is implementing a CO2 floor price for facilities operating under the EU ETS. In addition a clean energy CfD (Contract for Differences) construction will provide further support. A single viable CCS project (at least) should emerge from this approach.

Back in the rest of the EU, organizations like ZEP are stepping up their advocacy for a revised package of EU measures to ensure that at least some part of the demonstration programme is delivered. Without it, there will be real problems commercializing and gaining experience with CCS in the limited time available before much wider deployment is actually needed. The ZEP proposals should be available for a posting in the next week or so.

There has been considerable discussion over recent months as to what action needs to be taken both in the short and long term to ensure that the EU ETS continues to provide the necessary investment signal for major investments such as carbon capture and storage. The current price of €6.50 isn’t going to drive any change at all. I have discussed short term action in recent postings and the Commission now seems to be coming around to the idea of at least re-phasing upcoming auctions so as to “backload” the available allowances to the later part of this decade.

But the longer term also needs some thought. The UK has already acted in this regard and introduced its own floor price, although such unilateral local action in an EU wide system is problematic. But the idea here may be right. A floor price, even if not pitched particularly high, shifts the carbon pricing risk on a project at least to some extent. This is what lies behind the UK approach with the proposed £17 carbon price CFD (contract for difference).

Not all economists see this the same way though. In an opinion piece in the UK Daily Telegraph today, Tim Worstall, a Senior Fellow at the Adam Smith Institute in London, argues against the need for such a mechanism.

We’ve also an inspired misunderstanding about carbon prices. The EU has a cap and trade system: if you want to emit a tonne of CO2, you’ll need a permit to do so. Many of these are given to industry but some have to be bought. Our Ed Davey – you know, the man in charge of this whole climate change thing – has recently announced that there must be a minimum price for such permits. Showing, sadly, that he doesn’t understand the first thing about such a permit system. In the carbon tax that I recommend, yes, it is the tax which limits the emissions. In a permit system it is the number of permits: the price of the permits shows how expensive or cheap it is to meet the target. Thus we should all want to have very low permit prices, for that shows us that it is very cheap to meet that target. At which point the minister in charge says no, my goodness no, we can’t have it being cheap to save Gaia – we’ll have to artificially raise the price! I’m sure you’ll agree that this is just drivelling absurdity.

On the other hand, there is a body of literature that suggests there are good reasons to combine certain features of both price-based and quantity-based instruments, to create so-called hybrid policies (Fankhauser and Hepburn 2010, Fankhauser et al., 2010, Roberts and Spence 1976, Pizer 2002, Jacoby and Ellerman 2004, Hepburn et. al 2006, Grubb and Newbery 2008, Grubb 2009).  Hybrid instruments offer the potential for providing greater certainty regarding prices and investment signals, while maintaining the advantages of a trading scheme (Grubb 2012).

One approach is to introduce an auction reserve price which ensures that no allowances are released onto the market if the reserve auction price is not met.  This requires a sufficient proportion of allowances to be auctioned, instead of being allocated free of charge and auctions to be held periodically throughout the commitment period. It is too late to do this for Phase III of the EU ETS (2013-2020) but it could be introduced as part of the expected legislative process to set the parameters for Phase IV (2021 and beyond, probably extending to 2030). Such a reserve would also impact Phase III as buying allowances now and banking them to 2021 would offer an alternative to paying the reserve price at that time.

Summarizing the various pieces of literature on the subject of price floors (or an auction reserve price);

• A price floor gives investors in low-emission assets greater certainty about the minimum return to their investments—it effectively provides insurance against low carbon prices, analogous to the insurance function of a price ceiling against cost blow-outs to owners of existing high-emissions assets (Wood and Jozto, 2011).
• A very low carbon price could seriously undermine the credibility of emissions trading and undermine the EU’s attempts to forge a platform of leadership in the post-Durban negotiations. Moreover, the historical pattern of ‘boom and bust’ points to the inherently volatile characteristic of emissions trading systems to date, and the potential benefits of building in a more robust design. There are various options that could be considered. Amongst these, reserve price auctions merit particular attention (Grubb 2009).
• An auction reserve price would imply that there is no strict price floor, because although there would be a minimum price that firms would pay at auctions, the market price could fall below the reserve price. An advantage of having a reserve price is that independent of its function as a price floor, it is an auction design feature that can protect sellers and in some cases buyers from unexpected outcomes in the auction (Hepburn et al., 2006).
• Project investment and finance is hindered by the risk of low carbon prices. A reserve price in auctions addresses this risk (Neuhoff 2008). 
• There are interesting hybrid schemes, such as auction releases with a commitment to a floor and ceiling price that could evolve in response to success in reducing GHG emissions or otherwise in limiting the cumulative emissions available through the scheme (Grubb and Newbery 2008).
• Under a pure cap-and-trade approach, innovation will only increase abatement if the regulator adjusts emissions targets in response to a lower, or lower than expected, carbon price. A price floor by contrast provides a mechanism for additional emission reductions to be achieved automatically (Wood and Jotzo).
• Irrespective of the initial level set, establishing a rising floor price through a European Reserve Price for Auctions would give confidence for investors regarding a minimum allowance price in the EU ETS. It would remove large perceived downside risks, support low-carbon investment decisions, and reduce the cost of capital, which could result in substantial economic savings (Grubb, 2012).
• Investment certainty would be improved by price floors. Investments such as power plants, buildings, and infrastructure involve long-term time horizons. Uncertainty about the future carbon price increases costs for both investors in mitigation and investors in polluting technology. Policy design that reduces cost uncertainty can therefore limit the overall effective cost of achieving a mitigation outcome and is more likely to attract political support from business constituencies (Wood and Jozto 2010).
• A recent blog posting by Prof. Robert Stavins states that if complementary policies exist alongside an ETS then there will be interaction and if the objective of the ETS is to provide a signal for low emission investment then the concept of a price floor may be required.

Price floors (through an auction reserve price) in an emissions trading system can reduce excessive price volatility and provide better management of cost uncertainty in the event of lower than expected abatement costs, which in turn improves predictability of returns and increases expected returns for low-emissions investments.  All in all, price floors could fulfill an important supporting role in ensuring effective and efficient climate change mitigation. They can be implemented without compromising vital aspects of emissions trading and their budgetary properties might be attractive to governments (Wood and Jozto 2011). The core benefit of hybrid systems is that they provide policy makers with greater control over the supply curve of emissions allowances. Like all markets, the market for emission reductions has a demand curve, determined by the marginal abatement costs of regulated entities and a supply curve, which is determined by policy (Fankhauser and Hepburn, 2010).

For those interested, the complete reference list is as follows:

Fankhauser, S. and Hepburn, C. (2010). Designing carbon markets. Part I: Carbon markets in time.  Energy Policy 38 (2010) 4363–4370

Fankhauser S., Hepburn, C., and Park, J. (2010). Combining multiple climate policy instruments: how not to do it. Climate Change Economics 1 (33), pp. 209-225. ISSN 2010-0078

Grubb, M. (2009). Reinforcing carbon markets under uncertainty: the role of reserve price auctions and other options. Climate Strategies Briefing Paper (www.climatestrategies.org).

Grubb, M. (2012). Strengthening the EU ETS. Creating a stable platform for EU energy sector investment. Climate Strategies Full Report (www.climatestrategies.org).

Grubb M. and D. Newbery (2008), ‘Pricing carbon for electricity generation’, in Grubb, Jamasb and Pollitt(eds), Delivering a low-carbon electricity system: technology, economics and policy, CUP, 2008.

Helm, D., Hepburn, C. and Mash, R. 2003. Credible carbon policy. Oxford Review of Economic Policy, 19:3, 438‐50.

Hepburn, C. 2006. Regulation by prices, quantities or both: a review of instrument choice. Oxford Review of Economic Policy, 22:2, forthcoming.

Hepburn, Cameron, Grubb, Michael, Neuhoff, Karsten, Matthes, Felix and Tse, Maximilien (2006) Auctioning of EU ETS Phase II Allowances: How and Why? Climate Policy, 6, 137-160.

Jacoby, H. D. and Ellerman, A. D. (2004). The safety valve and climate policy. Energy Policy, 32(4):481-491.

Neuhoff, K. (2011). Carbon Pricing for Low-Carbon Investment.  CPI and Climate Strategies

Neuhoff, K. (2008). Tackling Carbon: How to Price Carbon for Climate Policy. Climate Strategies Report.

Pizer, William A. 2002. Combining Price and Quantity Controls to Mitigate Global Climate Change. Journal of Public Economics 85(3): 409–434.

Roberts, M. and Spence, M. (1976). Effluent charges and licenses under uncertainty.

Journal of Public Economic, 5(3):193-208.

Stavins, R.(2012) Low Prices a Problem? Making Sense of Misleading Talk about Cap-and-Trade in Europe and the USA.  (http://www.robertstavinsblog.org/2012/)

Weitzman, M. L. (1974). Prices vs. quantities. Review of Economic Studies, 41(4):683-691.

Wood, P.J. and Jozto, F. (2011). Price floors for emissions trading, Energy Policy 39 (2011) 1746–1753

UK Government, Department of Trade and Industry (2006).  The Energy Challenge, Energy Review Report 2006. Page 157.

Thanks to my colleague Helen Bray for the research work behind this.

Over the weekend the UK Secretary for Energy and Climate Change, Ed Davey, announced plans to secure a continuing role for natural gas in the UK power generation sector. Mr Davey noted;

“Gas will continue to play a vital role in a low-carbon economy. Modern gas-fired power stations are relatively quick to build and twice as clean as many of the coal plant they’re replacing. Carbon capture and storage promises to give gas an even longer term future in the mix.”

The announcement from the Department of Energy and Climate Change (DECC) introduced further policy additions to the Electricity Market Reform as follows;

The Energy and Climate Change Secretary set out measures to be included in the intended Electricity Market Reform legislation to provide certainty to gas investors:

• The level of the Emissions Performance Standard (EPS), designed to limit the emissions from individual plant, will be enshrined in primary legislation. Power stations consented under the 450g/kWh-based level would then be subject to that level until 2045, a process called ‘grandfathering’ which provides long-term certainty to gas investors.
• The Capacity Market will be designed to bring forward sufficient investment in new reliable capacity, including gas, in order to ensure security of electricity supply. This will help to ensure that there is sufficient capacity in place to cope with peaks and troughs in demand.

The Government intends to bring forward this legislation, subject to the Queen’s Speech, in the next Session of Parliament.

He also announced plans to publish a new gas generation strategy in the Autumn.

So continues the rollout of a comprehensive policy framework designed to decarbonise the UK power sector, ensure security of supply / cost and provide sufficient certainty for the necessary investments to take place. The announcement fits well with the statements made by Oliver Letwin MP, Minister of State (providing policy advice to the Prime Minister in the Cabinet Office) and Cabinet attendee, at a recent panel debate held by the Daily Telegraph. At that event Mr Letwin argued that there was a need for the government to ensure that the resulting energy mix was built on a variety of energy sources and technologies. These included renewables, nuclear and fossil fuels, the latter also supported by CCS. 

Regular readers will note that I have grumbled about some of the EMR provisions in the past, particularly the role of the carbon floor price in the context of an EU wide ETS (Emissions Trading System). However my concerns pale in comparison with those of a number of correspondents and NGOs who argued in the media this week that the level (450 g/kWh) and longevity (until 2045 for those receiving consent) of the EPS would threaten the core UK target of near complete power sector decarbonisation by 2030.

I can’t subscribe to this view.

They seem to have missed the fact that the UK power sector, like the power sector in the rest of the EU, is covered by the EU ETS. Ultimately this is what will determine the level of decarbonisation on any given date, not for the UK in isolation but for the EU as a whole. The targets set at EU level may well embed a certain desired trajectory for the UK, but once allowances are auctioned and trade is underway, actual decarbonisation in the UK may take a variety of courses. This will be influenced by the overall EU cap and the prevailing price of carbon, the economics of various UK power generation options and any local supplementary measures unique to the UK, such as the carbon floor price and the EPS. Gas will almost certainly find a home within the mix, particularly given the favourable capital cost for new facilities and the relatively low emissions from modern high efficiency gas fired CHP.

What the UK government has done is provide a level of investment certainty for the generators. This has been done for renewable energy, nuclear and now fossil energy. But the eventual mix will be determined by the overall carbon constraint in combination with other factors discussed above. The UK will find its own way forward within this, with each generator surrendering allowances against CO2 emitted. Actual UK power sector emissions in 2030 and beyond will not be determined by the EPS details announced on the weekend, but by a complex mix of factors, including the value of EU allowances.

The above was the title of a panel debate hosted by the UK newspaper, The Daily Telegraph, late last week. There is a short write up in the Saturday edition of the newspaper. I was fortunate to participate in this, alongside Oliver Letwin MP, Minister of State (providing policy advice to the Prime Minister in the Cabinet Office) and Cabinet attendee. Other panel members were UCL Professor Paul Ekins, Jeremy Nicholson from the Energy Intensive Users Group and renewable energy venture capitalist Ben Goldsmith.

Photo Courtesy of The Daily Telegraph

Although Mr Letwin chose not to offer any opening remarks, his subsequent comments revealed some interesting thinking in the UK Government on energy and climate change. Three particular lines of discussion emerged during the debate;

1. With the “Green Economy” often associated with wind-turbines and solar PV, there was much discussion on how the UK determines its future energy mix. Mr Letwin put forward the view that an entirely market determined outcome was not in the interests of Britain. There was the risk that such a direction could result in over dependency on a particular energy source, bringing with it issues such as reliability, future price exposure, capital cost and technology lock-in. He argued that although the market should play a major role in driving change, there was also a need for the government to ensure that the resulting energy mix was built on a variety of energy sources and technologies. These included renewables, nuclear and fossil fuels, the latter also supported by CCS. This in turn meant that there was a role for government to promote technologies in the early stages of development and that this would remain a feature of their energy policy. The government would also ensure that sufficient incentive was in place for the first stages of deployment of such technologies.
2. Following on from (1) there was some discussion on the potential role for CCS in the UK energy system. Mr Letwin reaffirmed the need for the government to support a large scale demonstration of the technology and that the proposed government injection of £1 billion was both justified and modest given the scale of the low carbon energy option that it had the potential to deliver, particularly given the remaining fossil fuel production potential of the UK. He expressed the view that the key issue with CCS was not the need to determine its technical feasibility but rather to determine its cost feasibility. Mr Letwin’s enthusiasm for CCS extended into his closing remarks where he concluded that the UK would have one of the first large scale CCS facilities in the world and that the demonstration therein that natural gas was a viable zero-carbon fuel would be of huge benefit to the UK.
3. Not surprisingly the subject of the UK carbon floor price emerged during the discussion. Mr Letwin linked the need for it to the points made in (1) above and defended its introduction given the current state of the EU-ETS and the very weak price signal it was now delivering. But he also made it clear that it would be better for all concerned if the ETS delivered the necessary price signal: his “fingers crossed” hand gesture when the proposed EU allowance set aside was mentioned was pretty clear body language. 

Overall, it was an interesting evening and well attended. I am not sure that we ever really answered the question, but we did at least get some useful insight into the thinking that supports the current energy policy direction of the UK.

The script of former Vice President Al Gore’s recent Climate Reality global web event started with the words, “Somewhere there may be an Earth where . . . . . . isn’t happening“ and went on to fill the blank with a series of climate events currently underway, then concluded, “But not here, not this Earth, we have to deal with reality.”

Reality was also an issue at two separate events that I attended this week in Europe, an IEA/IETA/EPRI Emissions Trading seminar in Paris and the annual Platts European Emissions Markets Conference in Brussels. I was also a keynote speaker at the latter. At the Brussels event the EU Commission spoke about the development of the EU Emissions Trading System, the progress towards Phase III and even noted that the current low carbon price in the EU was a suitable reaction to the recession and that the system had responded as necessary. In the Paris event, which was under the Chatham House Rule, we heard a similar story and a description of the expanding discussions between the EU and other governments with regards linkage of emissions trading systems. One might have come away from these thinking there is an Earth where rapid progress is being made in building carbon markets and using them to quickly and effectively reduce emissions on a global basis.

There may be an Earth which is doing this, but very unfortunately it isn’t this one. It should be, it needs to be, but we have to deal with reality.

The Brussels conference also heard from Mark Lewis of Deutsche Bank, who laid out a somewhat grim supply-demand picture for the ETS. Deutsche Bank estimate that the system is 400 million European Allowances (EUAs) long in Phase II, but with an additional potential for 800 million CERs (units from the UNFCCC Clean Development Mechanism) to enter the system, giving a total EUA equivalent length of 1.2 billion allowances going into Phase III (or the equivalent of 20 big coal fired power plants running continuously for the whole of Phase III). In addition, 200 million EUAs from the CCS support mechanism will be auctioned in the near future and 2012 will also see the early auction of some of the 2013 Phase III allowances. On the upside they do see that the system has the capacity to absorb all this over the coming years, to the extent that by 2020 there is a short position of 400 million allowances (i.e. reductions that will have to be found). They see this being largely absorbed by fuel switching (coal to natural gas), with existing gas turbine generation capacity allowing this to happen relatively easily. As such, they forecast a price of some €25 by 2015, with a cost of carry taking it to €28 by 2020. But there are a number of caveats to this, the two key ones being;

• The assumption that neither the EU Energy Efficiency Target (the focus of the upcoming Energy Efficiency Directive) or the even higher profile Renewable Energy Target will be met. Of course if renewable energy supply surges as it has done in recent years thanks to the efforts in Spain (equivalent to 800 million allowances), the 400 million allowance short position will quickly evaporate.
• The assumption that the aviation emissions trading proposal will go into full operation, with both incoming and outgoing flights covered by an expanded ETS. Their analysis reckons aviation to be some 400 million allowances short through to 2020, so if this important add-on to the ETS doesn’t happen or is significantly delayed, then the whole ETS is flat through to 2020. Although there is no final ruling by the European Court of Justice, this week the Advocate General did express the view in favour of ETS implementation in response to the court challenges from a number of international airlines.

In addition, despite the gathering storm clouds, Deutsche Bank have not factored in the possibility of a second major economic downturn.

So the reality is that although the ETS carbon price has potential upside, it could well remain very weak for a number of years on the back of a long supply-demand position. This is problematic. Although the allowance based system will always ensure that emissions are reduced to the level of the cap, if this happens with a carbon price in single figures, the system will not deliver on its further critical underlying objectives, which are:

• Long term incentive to drive technology development, in particular carbon capture and storage (CCS) and renewable energy.
• Early trigger to begin the major task of decarbonising the power sector with a particular need to guide investment into the 2020s.
• Assisting developing countries in beginning the task of emissions reduction
• Demonstrating the effectiveness of carbon pricing through an ETS with the goal of encouraging similar systems elsewhere.
• Supporting the carbon market approach agreed under the Kyoto Protocol.

The combination of reduced emissions as a result of the recession in the EU and the impact of a plethora of Member State and Community wide supplementary policies operating in the ETS space has led to this overhang of allowances.

Over a number of recent blog postings I have set out the case for the removal of allowances in the ETS. At the Platts conference I spoke about the same thing using the linked presentation below. There is no challenge here to the ETS as such, it is a fully functioning, well designed emissions trading system, but it has been hit from all sides by a series of events.

The time to correct this is now. That is the new reality the EU Parliament and Commission must face up to.

Click here to see the presentation.

As global natural gas production has risen and shale gas in the US impacts on the energy outlook for that country in particular, there has been increasing discussion about the impact of natural gas on climate change. Several scientific papers have recently been released questioning the carbon dioxide benefits of natural gas over coal in power production.

Perhaps the best place to start on this tough subject is to look at the basic chemistry, which at least grounds the discussion in some fact. Combusting natural gas or coal to produce thermal energy (for conversion to electricity) results in differing amounts of carbon dioxide emissions. This is because of the hydrogen to carbon ratio of the two which sets both the amount of energy released and the production of CO2. 

Looking at the chart above, this means that a tonne of methane (natural gas) releases 2.75 tonnes of CO2 (calculated via the ratio of molecular weights) when combusted. Combining the release of CO2 with the release of energy gives the CO2 released per unit of thermal energy produced. Natural Resources Canada publishes CO2 emission factors as follows:

Coal                    0.093 kg CO2/MJ

Coke                   0.108 kg CO2/MJ

Natural gas    0.056 kg CO2/MJ

Natural gas emissions are shown as being about 40% below those of coal and 50% below those of coke simply on an energy basis (note that this is a simple combustion calculation and does not reflect factors such as the often found lower efficiency of older coal units in many countries, e.g. the IEA reports that the global average CO2 emissions for electricity/heat generated from coal is 904 gms CO2/kWhr, vs. 386 gms CO2/kWhr for gas).

So substituting natural gas for coke / coal in an economy can lead to emissions reduction from the power sector. This has been seen in the UK (Source: BP Statistical review of World Energy) where natural gas use has grown substantially over the last 30 years. Total UK fossil energy use has been stable over that period, whereas emissions have fallen by 20%. 

As I illustrated recently for the USA, this means natural gas offers an economy an energy pathway forward which can both underpin growth and deliver emission reductions. Importantly, gas is affordable, particularly given its low sulphur and particulate emissions, so it doesn’t require heavy handed policy intervention such as high feed in tariffs. In the case of the USA, such an outcome may be delivered anyway because of the retirement of older coal plants as they face new air, waste and water regulations, coupled with the powerful economic pressure of an abundant, indigenous and cleaner energy supply source. But such a pathway is not always guaranteed and could be delivered with increased certainty by having a carbon price operating in the economy. 

Some observers are concerned that such a change simply locks in a new, albeit lower, emissions pathway and sets up the economy for problems later on when very deep emission reductions are required (although in many countries gas infrastructure already exists). But such a pathway forward should not necessarily be dismissed, as it can have positive implications for the global negotiations, particularly when the USA is involved. With the current focus on the economy, short to medium term emission reduction targets are proving to be a significant impediment to action in a number of countries. This in term destabilizes the global discussion on climate change. A national route forward at modest cost can potentially contribute positively to the broader discussion.

This isn’t the end of the story though. There has been recent focus on the methane emissions related to natural gas production and delivery to market. For example, a study by Cornell University argued that emissions from shale gas production meant that use of this fuel in the energy system may be little better than coal (although a number of questions have now been raised as to the accuracy of this study). However, a more recent analysis by Carnegie Mellon found that the life cycle GHG emissions of Marcellus shale natural gas are estimated to be 63–75 g CO2e/MJ of gas produced with an average of 68 g CO2e/MJ and that Marcellus shale natural gas GHG emissions are comparable to those of imported liquefied natural gas. Therefore, gas still delivers an advantage over coal and as such, shale gas can also be the driver of national reductions such as those seen with gas in the UK.

Finally there is the issue of the longer term – can natural gas alone solve the climate change issue? The short answer here is “no” – it contributes to a solution but further discussion is necessary. This issue was highlighted recently by a paper from Tom Wigley, currently at Adelaide University in Australia (by coincidence my alma mater). Wigley argued that natural gas production could be associated with high leakage rates of methane which would offset any combustion emissions advantage. He also argued that coal combustion also results in at least some sulphur emissions which in turn, by acting as a coolant in the stratosphere, offset part of the warming associated with the CO2 emissions from the coal. There is some validity in this argument, but other considerations should come into play:

• The atmospheric methane issue is one that is posing some interesting questions. Two recent papers in Nature discuss the issue in response to the fact that the previously increasing atmospheric methane concentration has inexplicably stalled over the past three decades. This may be due to a fall in fossil-fuel emissions or to farming practices that are curtailing microbial sources. Certainly the fossil fuel industry has done a great deal to reduce methane venting, a common practice up to the 1990s. Today, even remote natural gas has much greater commercial value thanks to the development of a global market, which in turn makes venting and leakage just poor business practice. The leakage rates assumed by Wigley range up to 10%, which in practice would be a considerable commercial penalty for a project.
• Carbon dioxide is a stock pollutant, which means that the cumulative amount emitted over time matters. By contrast, sulphur drops out of the atmosphere very quickly (weeks to months). Should coal use decline in the future or sulphur emission standards become even stricter or at least more widespread, the climate protection currently offered will decline. At that point, the benefit of a lower stock of atmospheric CO2 as a result of earlier use of natural gas would be advantageous. The stock pollutant argument also means that the earlier coal is backed out of the power generation system the better. Such a move would also deliver local air quality benefits in many places.

Eventually though the issue does come back to the stock of CO2 in the atmosphere. In 2009 I discussed a paper on this issue published by Nature. Assuming an atmospheric carrying capacity of one trillion tonnes of carbon, equating to 2 deg.C, a business as usual pathway would see this limit exceeded in 2044. Even if there is massive global replacement of coal with natural gas over the next 30 years, we still wouldn’t get far into the 2050s before this limit was breached. So natural gas may gain us some valuable years, but before long it will also need decarbonisation options. This then points to the future need for carbon capture and storage (CCS) and of course a big push on renewable energy and nuclear power. All of these technologies also have issues related to cost, public acceptance, technical capacity and suitability for grid management.

So it really comes down to a question of balancing emissions targets, cost and meeting the  continually increasing demand for energy. In the short to medium term, natural gas potentially does all of these. Emissions targets can be met at modest ( or possibly zero) cost and energy demand is satisfied. As natural gas use increases in deference to coal there is the benefit of a lower stock of carbon in the atmosphere. Finally, as we face up to a world of really deep emission cuts, natural gas with CCS offers a further low emission energy source which can compete with nuclear and renewable sources.

Last Saturday (August 27, 2011) The Times featured the EU Emissions Trading System (EU ETS) on its front page.  Carbon markets are becomingly increasingly important and should appear in the mainstream media, but it’s also important that the media provide accurate context to fully explain often complex issues to the public.  This particular story suggested that the EU ETS was being manipulated by power companies, enabling them to pass on to their consumers the full cost of carbon on the allowances that they are granted for free:

Flawed green scheme

costs households £120

“. . . . an investigation by The Times has found. Energy companies such as Scottish Power, EDF Energy and Centrica, the owner of British Gas, have pocketed about £9 billion in free windfall profits by manipulating a carbon trading scheme.”

As with many other policy instruments, the EU ETS has changed over time and has become stronger and more effective.  The issue of allowances is complicated but the simple fact is that concerns regarding the free allocation of allowances were corrected by the European Parliament way back in 2009 for the upcoming Phase III of the ETS which starts in 2013.

Let’s examine the history of the scheme. The European Commission and Parliament decided, during the ETS design and legislative process (2001-2003), that allowances should be granted for free to most participants in the first two phases of the trading system (2005-2012 inclusive). This was done to ensure the softest of starts for the EU economy, particularly for industries that exported outside the EU, or competed with imports, and therefore couldn’t pass on carbon costs to their customers. What was less recognized at the time, although anticipated by a number of observers, was that in some electricity markets, particularly the deregulated UK market, the carbon price that traded at the margin would be the one that set the electricity price, thereby granting those holding free allowances infra-marginal rent.

It may be the case that the electricity companies didn’t have to pass on the cost of their ‘free’ allowance allocation to their consumers, but it should be stressed that pricing at the margin isn’t manipulation, rather it is exactly how markets should function. For the most part, they do work this way. The price of many goods and services is set by the marginal supplier, with those able to produce the same goods or services at lower cost profiting from this. 

With the benefit of hindsight, what was wrong about Phases I and II of the ETS was to create such a circumstance artificially, but as noted above, this rent opportunity ends with 100% auctioning of allowances to the power companies in Phase III onwards.

The only reason this construct persisted for a number of years is because the Commission has maintained a hands-off approach to the ETS in order to assure the market of stability and give confidence to those investing in it. It rightly took the view that the market would be much worse off if government was constantly changing the rules by which it operated. Within a known window of change the free allocation to electricity producers was ended, but could only be enacted from the start of the next operating phase, which is January 1st 2013. Auctioning for this period will begin in a few months time, in 2012.

The Times article also makes a link between free allocations, the overall performance of the market and the modest CO2 reductions achieved during Phases I and II. However, there is hardly any relationship between the reductions achieved by the system and the mechanism for distribution of allowances. The overall reduction is set by the number of allowances distributed. This then establishes the price at which allowances trade and it is this opportunity cost which guides project investors. Most experts noted that in Phase I of the ETS there was considerable over-allocation, as the Commission had limited data upon which to base the likely demand for allowances. As a result the system traded near zero for some months before Phase II got going. Phase I had no mechanism to correct for this over allocation as banking into the future was not allowed in this “learning by doing” period.

Actual CO2 reductions in Phase II continue, but the recession linked to the global financial crisis has taken some steam out of the market, as has been the case in so many sectors. Most observers now agree that a Phase II surplus is accumulating and that this will be banked forward by market participants. This has led to the call for a set-aside of allowances within Phase III which will ensure a robust CO2 price.

But none of this is related to the free allocation approach taken in Phases I and II.

The EU ETS has not been perfect, but it is a learning process that continues, evolves and improves. Other jurisdictions considering the use of emissions trading have learned a great deal from it. For example, the north-eastern US Regional Greenhouse Gas Initiative (RGGI) noted the issues with electricity producers and implemented full auctioning from the outset.  We need to recognise that the European Union broke new ground with the ETS, that early teething problems have been resolved and the system is improving.

We know from both the economic theory and practical implementation (US sulphur trading system) that emissions trading / cap-and-trade is the most flexible and lowest cost approach to reducing emissions against a fixed future target. But the system constantly bares its soul for all to see through operational transparency, which in turn makes it an easy target for criticism. The alternative is to have government demand CO2 reductions, specify the power generation mix and order up wind turbines or nuclear reactors with much less price transparency and almost certainly higher cost to the consumer. In this period of fiscal uncertainty, the carbon market approach must be the preferred option.

But such good news, setting out a reasonable, measured and effective way of moving towards a lower carbon European economy, doesn’t usually sell newspapers!

One of the big issues that has been debated in the EU since before the ink was even dry on the 2008/2009 Energy and Climate package (EU ETS Directive, CCS Directive, Renewable Fuel Directive etc.) is whether the EU emission reduction target should be adjusted up to 30% from the base 20% originally agreed. Formally, the shift to a 30% target is linked to the nature of an international agreement on climate change. For example, had Copenhagen delivered a new framework within which real and meaningful reduction targets were agreed, there would have been a fairly swift move on the part of the EU to 30%. But of course that didn’t happen.

Rather, we are almost nowhere on the international discussion and in the meantime the EU, like most of the rest of the world, has suffered the impact of the global financial crisis. As is widely recognized, this has resulted in a significant dip in emissions in 2008-2010 because of a real drop in industrial output, resulting in a likely surplus of Phase II ETS allowances and a much lower carbon price going into Phase III (2013-2020) than was ever envisaged. Of course this means that delivery on the 2020 target has become much easier for the EU, but also that much less of the emissions reduction through major change hoped for in the power and industry sectors would actually take place. Put simply, this wasn’t the plan that EU governments had signed up to. They wanted real and visible change, not just compliance with a 2020 target.

The first reaction by many has been to look on the policy shelf, see the 30% option sitting there and propose that this be implemented. The debate over such a move has been vigorous, splitting the ranks of businesses, governments and even non-government organisations. But arguably, there are reasons to consider a change, although a more focused approach is probably what is needed.

The real problem lies in the ETS itself which covers about half the EU emissions, but most of heavy industry and power generation. With a depressed carbon price and the EU ETS stuck at its -21% target (its share of the EU’s overall -20% goal) two things have happened – apart from the lack of emission reduction projects;

• Some member states have begun to take unilateral action to ensure more happens in their domestic sectors and notably power. The most current example is the proposal by the UK Government to introduce a floor price in the ETS, i.e. a UK carbon bubble. Apart from the impacts that I described in a recent post, a recent report from CDC Climate Research points out that the move also shifts auction revenue from continental EU member states to the UK. This may result in similar policies being developed in other jurisdictions, further undermining the ETS itself. The more the ETS is stifled, the less economically efficient is the reduction pathway in the EU and the more it will cost both business and the consumer.
• The Clean Development Mechanism (CDM) of the Kyoto Protocol has started to dry up in terms of demand for CERs. It isn’t just the low price doing this, but also the EU limits on CER intake in Phase III while the target remains at 20%. With the CDM being the only substantive component of the nascent global carbon market, problems with it mean big problems for the further development of carbon trade and the carbon market more generally. Of course this isn’t helped by the lack of action in the UNFCCC discussions, but the situation in Europe is just adding to the misery for the CDM.

A potential solution to both these problems is to remove some of the EU-ETS allowances in Phase III and set them aside, either permanently or in a carbon bank for Phase IV and later. This would bolster the carbon price and potentially make mechanisms such as the UK floor price irrelevant which in turn lowers the pressure for other Member States to reciprocate. A set-aside could also be delivered with some changes in allowed CER in-flow, thereby supporting the international carbon market as well.

The set-aside is the proposal on the table today and one which is worthy of real consideration, rather than just a knee-jerk “no” that might be expected from some business groups and Member States. Exactly how many allowances need to be removed, when and by what mechanism have yet to be defined. At a minimum, we should better understand the nature of the economic recovery that is now getting going (albeit significant problems remaining with Member State debt), but by early next year the situation should be much clearer and in any case there is plenty of work to do this year building the case.