Living in a Carbon-based World: CO2 and its impact on the EU Power Sector Gavin Bell March 2010

First, a little about me ecovest limited 2  Ph.D. from Canterbury  EMRG  One of the many from Canty that ended up in Europe...  Worked since 1999 in energy sector as consultant and in industry  UK, Germany, Austria, Netherlands, Spain, Albania, Montinegro, Macedonia, Norway, Denmark, Czech Republic, Cuba  Headed up the continental power market analysis team and the cross commodity analysis team at Statkraft  Europe’s largest renewable generator  Around 55 TWh annual production  Currently CEO of Ably (plant data and analysis firm) and independent consultant  Based in Norway since 2003

Key EU ETS Takeaways ecovest limited 3  EU ETS market is part of an ”energy complex” involving power, fuels, CO2, and other commodity markets  Each drives the other  Increasingly, money cannot be made in one market only – you need to look at them all simultaneously  CO2 will drive increasing internationalisation of energy markets, as CO2 markets interlink  EU ETS in the forefront  Any CO2 market is a political beast – politics drives the price and direction

Outline 4  EU ETS Overview  A multi-commodity energy complex  Short term interactions  Long term interations and drivers  Summary ecovest limited

EU ETS Overview

EU ETS – What is it? Technically... Really... 6  Classic cap and trade system to regulate CO2 emissions in the EU + EEA countries  Absolute limit on CO2 emissions  Allowances distributed to facilities covered by the scheme  >12000 facilities  >4000 companies  Participating facilities surrender an allowance per tonne CO2 emitted during annual compliance periods  Commercially crucially important market in the EU energy sector  Driver of investments  Impact on price  CCS  CERs  Credit rating  Hedging  Exposed to CO2  Need to mitigate to manage risk  Trading  Direct opportunity to make money ecovest limited

ETS Summary Phase 3++ Phase 2 Phase Post-Kyoto Period % of EU emissions (incl. Aviation, CCS) Single EU Cap, reducing 1.74% p.a. Auctioning – 50% in 2013, 100% by %(ish) auctioning in power sector from 2013 Links with 3rd Country schemes; harmonisation of CDM/JI rules 95% free allowances Allocation of permits done nationally (National Allocation Plans - NAPs) Tighter limits based on phase 1 experience (6.5% below 2005) 90% free allowances 3% Auctioning 6% New Entrant Reserve EEA included Allocation via NAPs Can import credits from other flexible mechanisms Appx. 12% of total Kyoto PeriodTrial Period ecovest limited

Banking and borrowing  Banking and borrowing allowed within a phase  No banking or borrowing between phases 1 and 2  A key reason for observed priced development  Banking allowed from phase 2 to phase 3  Linking prices in these two phases  Especially important now phase 2 seems long  No borrowing ecovest limited

Distribution of allowances  Two key ”sectors”  Power  Industry  Behave differently in relation to ETS  Industry  Generally long  Reduce emissions via investment (med-long term)  Often annual or ”period” view  Power sector  Generally short  CO2 price impacts dispatch  Hedging of power production ecovest limited

EU ETS History Fuel bull run 2005 Verified emissions 2nd phase NAP cut Fuel bull run Financial crisis Fuel bear run Financial crisis Fuel bear run Industrial length gradually in market Oil, equities bull run ecovest limited

A multi-commodity energy complex CO2 and Power (and fuels, currencies, interest rates etc etc)

Coal Gas Complex interactions driving markets FuelCO2SRMC FuelCO2SRMC Price of CO2 Price of gas Coal Gas FuelCO2SRMC FuelCO2SRMC Price of CO2 Price of gas ecovest limited

CO2 and power market interaction Short term Long term  The power stack  Stack driving emission levels  ETS price impacting the stack  Non-market external effects  Weather  Driving power and heat demand and availability (hydro, wind)  Hedging, market psychology  Energy complex  Oil a strong sentiment driver of power and CO2 (++)  External economy (e.g. recent demand destruction)  CO2 market is key driver in investment decisions  Power market investments (emitting vs non-emitting) driver of future CO2 price  CO2 price feed-through to power price a driver of future power demand  Future CO2 price driver of todays CO2 price (banking effect) ecovest limited

Question ? What is correlation and what is causality? ecovest limited

Short term interaction

The classic – fuel switching 16  Relationship between gas, coal, and CO2 drives stack and emissions  Other aspects reduce fuel switch flexibility  Fuel contracts  Inflexibilities in fuel access  Don’t always get the fuel switching you expect... coal CCGT gas, oil GT lignite nuke, wind Coal – gas fuel switching CO2 cost SRMC ecovest limited

Impact of fundamentals EUA Dec-08 Acc. Changes: fuel prices & weather ecovest limited Source: Point Carbon

But it’s not a ”tick the boxes” world...  Relationships are not straightforward, nor consistent  Sometimes, CO2 can explain power price movements, sometimes its, say, coal and gas prices, or something entirely different  Often possible to know in hindsight...  But forecasting is not easy  Q: What sort of analysis is useful...? ecovest limited

Hedging activities 19  Hedging of production begins already 3 years ahead  CO2 part of that hedge  Thus, begin to hedge production in phase 3 of ETS from 2010 onwards  BUT – phase 3 allowances not yet available  Via purchase of phase 2 (2012) allowances for banking  Hedging demand can drive prices YearCO2 volumes Total2200 Mt Could turn a long phase 2 market into a short one... ecovest limited

Crude oil – key sentiment driver ecovest limited 20

Economy driving demand in power and CO2 21  Significant demand destruction as a result of financial crisis – from 2008 to 2009:  Germany: 6% decline  France: 3% decline  Less demand for EUAs  Lower price  Pressure on power prices  Market is expected long in phase 2... ecovest limited Source: Point Carbon

Phase 2 market balance 22  Market is long in phase 2  Including credits: 970 Mt  In theory...  Price in phase 2 should equal discounted price in 2013 (first year, phase 3)  Prices today are lower than this...  Anticipate at least that phase 3 will increasingly impact phase 2 prices  What is driving phase 3 price expectation? short long ecovest limited Source: Point Carbon

Long term interaction

CO2 price in 2020 and beyond 24  How can we assess the long term price?  And thus today’s ”equilibrium” price level?  Equilibrium model  What price balances supply and demand  That is, long term relationships between  Power and CO2  Industry and CO2  CERs, other ETS schemes and the EU ETS  Or... an educated guess – it is a political process after all  What price needed to drive CCS?  EU effectively target long term caps to achieve this price level... ecovest limited

Phase 3 supply: political and commercial process 25  Steadily declining allowance cap  21% below 2005 emissions in 2020  Power sector (more-or-less) 100% short  Industry reducing from 80% free allowances in 2013 to 30% in 2020  CERs/ERUs  Supply depends on a ”post Kyoto” agreement  No agreement, only Kyoto + ”bilaterals” CERs  Credit limit of at least 11% of the phase 2 allocation  Can choose when to use the credits (phase 2 or phase 3)  But, max 1400 Mt in phase 2 ecovest limited

Phase 3 demand: interation between markets 26  Power and heat  Change in stack, through investments and retirements  Expected future prices (fuels, capital costs, exhange rates, cost of money)  Portfolio considerations  Other mechanisms – e.g. Renewables directive  Demand for power and heat  Industry  Economic growth  Change in energy intensive industry in EU  Change in carbon intensity ecovest limited

And the results... Bottom up forecast ”Political” forecast  Typical price forecast ranges for CO2 for 2020  Point Carbon 37 €/t  Barclays – 40 €/t long term  Deutsche Bank 30 €t  UBS – 20 €/t  UK EAC – 22 €/t  The CCS approach (or renewables or whatever...) for, say, 2025  Additional capital cost  Reduction in efficiency  CO2 emissions saved  + fuel cost assumptions etc...  Around 50 €/t (2025)  Discounts to 35 €/t (2020) ecovest limited

Summary

29  CO2 (via ETS) integral part of EU energy markets  Investment  Hedging  Trading  Complex interactions between these markets  Drive prices  Significant and dynamic relationship between long and short term dynamics  And don’t forget it is a political process  Once there is an ETS, there’s a strong pressure for consistency and predictability ecovest limited

Gavin Bell ecovest limited Armauer Hansens gate 6a 0455 Oslo, Norway tel: