A new EU target?

It is often the case that thought pieces on the future of climate change policy in the EU surface before formal publication. Such documents quickly do the rounds through various industry associations and the Commission then gets some early feedback on the reaction to the policy ideas. This has been the case in the last couple of weeks with the appearance of an early version of a discussion document on a proposal to shift the EU to a 30% by 2020 reduction target, rather than the current 20%.

The 30% target had, until now, been a negotiating position held by the EU in the context of a broad international agreement on climate change. The EU has long said that it would increase its commitment to a 30% reduction if other nations offered similar levels of reduction. But the world has changed. EU emissions have dropped sharply over the last 18 months as a result of the recession, the EU carbon market has a banked surplus which may well get bigger and as such there is a concern within the Commission that low carbon investment will not happen to the extent they envisaged. The proposed fix to this is to shift the target to 30%, irrespective of the initial idea to link this with progress internationally.

The Commission analysis argues that the cost of achieving a 30% reduction in emissions is now much lower than originally anticipated and that moving towards it will be an important stimulus for investment and “green jobs”. In the current economic situation, such measures are high on the political agenda. But simply shifting the goal posts may not be as easy as imagined. For starters, with a 30% target as part of an international agreement, much of the shift was in fact linked with a vastly expanded international carbon market, built on the back of mechanisms such as “sectoral crediting”. Although the Commission document talks about these, the lack of a detailed policy framework from Copenhagen means that it will be some years before they are available. In the medium term we only have the CDM to rely on to deliver offset capability.

The “new” target would be made up of two parts.

  1. A shift in the EU-ETS target from a 21% reduction by 2020 vs. 2005 to 34% by 2020 vs. 2005
  2. A shift in the non-EU-ETS target from a 10% reduction by 2020 vs. 2005 to 16% by 2020 vs. 2005.

In the ETS sector the more aggressive 34% target means an additional shortfall through to 2020 of some 1 billion allowances, even assuming some additional uptake of international offsets (CERs). Assuming the renewable target is met or almost met, nuclear new build taking many years and no uptake of CCS during the period other than the initial 10-12 project demonstration programme (there may well be rapid construction but little more on line by 2020), much of this differential will probably have to come from natural gas. An additional 1+ billion tonne shortfall can be bridged with 50 GW of natural gas power generation displacing coal and phasing in from 2013 to 2016. By contrast to this need, the 2009 IEA WEO reference scenario shows EU coal capacity peaking at 207 GW in 2015 and falling to 182 GW by 2020. Gas remains static at 208 GW over the period 2015 to 2020. A further shift of 50 GW is therefore considerable by comparison – but possible.

In the non-ETS sector, a 6% shift in the target may well fall on the transport sector. Progress in the buildings sector will likely be much slower. Assuming two thirds of the additional obligation falls on road transport, i.e. 4%, this would require an additional reduction of some 72 million tonnes from vehicles in 10 years. This is equivalent to a further shift in on-road (i.e. all vehicles) vehicle efficiency of some 3 mpg. This would mean new cars entering the fleet in 2015 to 2020 being some 10 mpg more efficient than currently planned (probably about 35-40 mpg).

Core to the EU framework is the Emissions Trading System. The ETS is not a short-term policy structure, but one that should be looked at in the context of a forty year journey during which time the energy system and industrial base across Europe must be fundamentally and permanently reshaped. By its very nature this journey can hardly be shorter, given the vast capital stock in place and the time and expense it takes to replace this. Power stations, chemical plants, refineries, kilns and smelters built before the ETS was even a consideration for policy makers have design lives that stretch far beyond 2020. Facilities built today could well be operating in 2050 when European emissions are targeted to be at extremely low levels compared to 1990. The ETS and the carbon price that it delivers are key to the investment decisions that will be made by companies over the coming years. The current price of CO2 will be a relatively minor consideration in these decisions, rather the focus will be on the longer term outlook for the carbon market and the expected supply-demand situation for allowances for this decade and that following. For a large project under consideration today, first emissions may not even occur until 2016 with the real economic return coming in the period 2020-2030.

In the event that the recent recession has given rise to a long-term structural shift in the allowance balance, there may be a case for some corrective action to ensure that a suitable price signal to drive change and foster innovation remains in place. Such action should always be commensurate with the shift that has occurred, rather than against some other arbitrary goal, for example the 30% that is now on the table. But the extent of this shift will not be known until the shape of the economic recovery becomes clearer.

Looking at the other sectors of the economy not covered by the ETS, the picture is very different. Policy instruments such as the Renewable Fuels target in the transport sector have an implicit cost of avoided CO2 emissions that is well above the current or indeed expected future CO2 prices in the ETS. Moreover, this cost is not sensitive to the business cycle, but is rather determined by the long-run cost of providing these alternative, cleaner sources of energy. 

The best approach for now may be to simply signal that some recalibration of the ETS may eventually be required to address any long run consequences of the unusually severe recession from which we are only just beginning to recover. However, it is probably premature to attempt any such recalibration. A commitment to do so in the future should be sufficient to stabilize the expected future CO2 price and the ongoing innovation process that is central to achieving the emission reduction goal.