1 Greenhouse gas emissions trading Performance-based allocation for a faster, undistorted and effective global carbon market European Chemical Regions Network Seminar 13 February 2008 Brussels Vianney Schyns Manager Climate & Energy Efficiency Utility Support Group Utility provider for a.o. DSM and SABIC

2 Faster realisation global carbon market Benchmark: Specific energy use or CO 2 emission Benchmark EU-Japan Transition period (with 3 or more BMs for same product) avoids high cost in case of auctioning for regions with higher emissions per unit of product (vital: BMs without differentiation new/old plants) 2032 Incentive low carbon technologies the same in global trading scheme 2008 Benchmark USA-Canada Benchmark China-India Global benchmark Model proposed by European Industry

3 Faster realisation global carbon market This model is possible with global sectoral agreements Clean Development Mechanism (CDM) – improvements needed –Same type of project receives different quantity of credits (“Certified Emission Reductions” – CERs) in different nations –From ambiguous baselines to benchmarks – growing list Globally linked markets essential – as fast as possible –Developed regions: with guarantee of total cap –Developing regions: transition, without guarantee of total cap  EU Emissions Trading Scheme (EU ETS) and other emerging schemes must abandon demand of total cap for linking  Relatively few sectors cover >/= 50% of total GHG emissions, e.g. electricity, steel, cement, refineries, paper and pulp, ceramics, glass, chemical industry

4 Existing and emerging GHG trading schemes EU ETS 2013: 45% EU GHG emissions, broad coverage of electricity and industry USA –Western Climate Initiative (WCI): California + 6 US states & 2 Canadian provinces, broad coverage as well –Regional Greenhouse Gas Initiative (RGGI): New York + 9 US states, covers only electricity –Midwestern Climate Pact (MCP): 6 US states & Manitoba Other emerging schemes: –Canada, Australia, New Zealand Japan so far reluctant for a mandatory scheme

5 Cap & trade and allocation methods Definition of cap & trade –A cap & trade system is an emissions trading system where total emissions are limited or “capped” (source: Point Carbon) Four main allocation methods MethodCap per companyTotal cap Historical grandfatheringYes AuctioningNoYes or no Performance-based, with benchmarks No Performance-based cap & trade (novel method) NoYes

6 Historical grandfathering – cap per company Lack of effectiveness & market distortions –Lower emissions = fewer allowances in next period (“updating”) –Distorts CO 2 -price signal –Distorts market share competition, winners must buy allowances –Efficient producers are to be encouraged to win market share –Unsolvable dilemmas for new entrants and closures –Closure rules enhance market concentration – esp. electricity –Economic rents for electricity producers – windfall profits =Example EU ETS : at € 30/ton, € 54 billion/year calculated =At expense of citizen & EU industry –“Leakage” of emissions, lowering production and importing product is encouraged – called “equally legitimate” !!! =Canadian J.H. Dales 1968: “Pollution in one region must never be reduced by increasing pollution in another” =EU Commissioner Verheugen: we don’t want “export of pollution and import of unemployment”

7 Auctioning – ideal, but only if applied globally No problems with “updating”, market share competition, no distortion of CO 2 -price signal Problems are “leakage”, distortions and loss of competitiveness –Border Adjustments (obligation for importers to buy allowances) not feasible (thousands of products of all value chains of steel, aluminium, chemicals, etc.) and opposed by EU Commissioner Mandelson (DG Trade), Germany, UK, USA, etc. –With full auctioning for electricity as foreseen in EU =Price effect at € 35/ton increases to € 82 billion/year =Windfall profits remain for nuclear & large hydro: € 45 billion/year =Logical in a global auctioning scheme, but with isolated auctioning loss of competitiveness industry, killer for aluminium, electrolysis, etc.

8 Performance-based allocation - benchmarking No problems with “updating”, market share competition, no distortion of CO 2 -price signal, provided benchmarks (total CO 2 -emission per unit of product) are geared to product only, not to fuel, technology, age or size of production plants – then incentive same as auctioning –Fuel-specific benchmarks support the cheaper fueled coal-fired power plants and not low carbon technologies –Allocation with one electricity benchmark for fossil-fueled electricity related to actual production =Eliminates the windfall profits =Encourages CHP (Combined Heat & Power) first and coal with CCS (Carbon Capture & Storage) medium term – the market decides Problems of “leakage”, loss of competitiveness only at very high CO 2 -prices, > € /ton

9 Performance-based cap & trade Guarantee of total cap by adjusting the benchmark in the future when production was higher than forecasted –Benchmarks of a running year are always fixed ex-ante, they are never adjusted afterwards (otherwise: unclear market) –Novel method, see appendix how this works Lower electricity price could create higher demand (the “production subsidy” argument), this is countered by a proper benchmark approach –In a product benchmark the efficiency of all energy carriers is taken into account, i.e. CO 2 -emissions from fuel, heat (steam) and electricity

10 Historical grandfathering historical mistake Historical grandfathering  historical mistake EU Commission came with a proposal for revised EU ETS Directive in January 2008, then co-decision EU Parliament & Council –Takes years, is no decision for single Member State Allocation rules Historical grandfathering was a historical mistake –Finally admitted by EU Commission, March 2007 Proposal for 3 rd Trading period: auctioning for electricity & phase-in of auctioning for industry or benchmarking for industry “exposed” to global competition Benchmarking for allocation to companies –Ex-ante: based on historical production, announced latest 2006  2 nd historical mistake –Ex-post: based on actual production, proposed by European Industry

11 New legal cases – historic production What means a historic cap?: import and export –More electricity import NL from Germany – is NL then doing well? –New CHP in Luxembourg – is Luxembourg doing badly? Nine new legal cases –What means a historic cap?: economy is strongly recovering as we desire it to be (Lisbon strategy) –Forecast of growth in central Europe, 9 legal cases European Court of Justice against EU Commission: Estonia, Latvia, Lithuania, Poland, Czech Republic, Slovakia (withdrew), Hungary, Rumania, Bulgaria and Malta –Influence historic production on allocation is perverse Solution: benchmarks linked to actual production

12 Trends in the trading schemes EU ETS –Abandonment of historical grandfathering –Tension between (phase-in of) auctioning and benchmarking, threat it will be based on historical production RGGI with only electricity: partial or full auctioning WCI, Australia, New Zealand –No historical grandfathering, auctioning as vision for long term –Benchmarking in the mean time, with a total cap Canada: benchmarking without total cap Japan: certainly no auctioning and no cap per company

13 Conclusion – for a faster global carbon market MethodCap per company Total capNo total cap Historical grandfathering Yes, perverse incentives AuctioningNoLeakage & loss of competitiveness Unlikely globally, regional efficiency differences Performance-based allocation, regional benchmarks NoMain sectors of China, India, Brazil, etc. Performance-based cap & trade, regional benchmarks NoLikely for EU, USA, Australia, New Zealand

14 Let us foster innovation and global participation Thanks for your attention ! Questions ? References:

15 Appendix EU Commission High Level Group Competitiveness, Energy and the Environment Clear advice HLG CEE

16 HLG Competitiveness, Energy and the Environment High Level Group CEE members –Commissioners Verheugen, Kroes, Piebalgs and Dimas + representatives industry, NGOs and others The HLG CEE advice for EU ETS on 2 June 2006 –EU Commission & Member States to undertake (for implementation in 2 nd period, but this failed) =Stronger signal towards low carbon technologies =Competitiveness, reduce impact electricity windfall profits =Level playing field for new investments across EU =How can rules, notably for new entrants and closure, be more harmonised, incl. the possibility of using a benchmarking approach HLG CEE 30 October 2006 confirmed statements above HLG CEE: final conference 27 November 2007 “Towards a global low carbon economy”

17 Appendix Present political situation in the European Union Historical grandfathering  historical mistake Lowering production, no benefit for environment Industry wants benchmarks  no (partial) auctioning Leakage danger underestimated Border Adjustments: not feasible in practice

18 Historical grandfathering historical mistake Historical grandfathering  historical mistake EU Commission came with a proposal for revised EU ETS Directive in January 2008, then co-decision EU Parliament & Council –Takes years, is no decision for single Member State Allocation rules Historical grandfathering was a historical mistake –Finally admitted by EU Commission, March 2007 Proposal for 3 rd Trading period: auctioning for electricity & phase-in of auctioning for industry or benchmarking for industry “exposed” to global competition Benchmarking for allocation to companies –Ex-ante: based on historical production, announced latest 2006  2 nd historical mistake –Ex-post: based on actual production, proposed by European Industry

19 Lowering production … “Lowering Production is no Benefit for the Environment, says European Industry” Paper Alliance-Cefic-IFIEC, 21 May 2007 –EU Commission declared end 2006 =Lowering production and selling freed allowances is equally legitimate than investing in emissions reductions and selling freed allowances –European Industry recalled founding father J.H. Dales (1968): =“Pollution in one region must never be reduced by increasing pollution in another” =Ex-ante allocation  root cause of many distortions =Call for link to actual production =Italian representatives EU ETS review: “intra-period updates”

20 Auctioning seems ideal  facts tell different story 1 st trading period, € 12/ton CO 2 –Higher electricity cost: 2,750 mln MWh x € 5/MWh ~ € 14 billion/year –Cost of allowances: ~ zero (EU as a whole) –Economic rents electricity: ~ € 14 billion/year 2 nd trading period, € 30/ton CO 2, electricity typically 25% short –Higher electricity cost: 3,000 mln MWh x € 21/MWh ~ € 63 billion/year –Cost of allowances: 25% x 1,250 Mton x € 30/ton ~ € 9 billion/year –Economic rents electricity: ~ € 54 billion/year 3 rd trading period, € 35/ton CO 2, assume full auctioning –Higher electricity cost: 3,300 mln MWh x € 25/MWh ~ € 82 billion/year –Cost of allowances: 100% x 1,070 Mton x € 35/ton ~ € 37 billion/year –Economic rents electricity: ~ € 45 billion/year Auction revenues only 45% of total economic effect Auctioning reduces economic rents with only 17%

21 Benchmarks, no auctioning & solution “windfalls” Industry is against auctioning 3 rd trading period –Auctioning electricity =Electricity prices remain high  industry pays 40% of this bill / bad for competitiveness / leakage =Full auctioning 3 rd period: windfalls still high (IFIEC paper 23 Nov 07) –Auctioning industry =At stake € 27 billion/year at € 35/ton =Bad for competitiveness, “leakage”: production & investment relocation –Total loss of competitiveness European Industry ~ € 60 billion/year, which is ~ 50% of EU Budget  Alliance, Cefic, IFIEC, ECRN call for benchmarks and solution electricity windfall profits (letter European industry 16 Nov 07)

22 Leakage danger underestimated Leakage analyses show serious flaws –Assumption low CO 2 -price, e.g. € 20/ton –Assumption “only few sub-sectors” exposed to global competition  most sectors affected –Assumption electricity “not exposed”  industry pays 40% of bill =Detrimental for especially aluminium, electrolysis, etc. –Assumption (prosperous) recent added value  no guarantee for the long period to 2020 –Assumption added value hardly relevant  relevant is trade-off direct + indirect CO 2 -cost against transportation in Europe

23 Border Adjustments: not feasible in practice Border adjustments –Border obligation for only most CO 2 -intensive part of each sector – e.g. clinker for cement, blast furnace steel for steel, crackers for petrochemical industry  no remedy for value chain optimisations –Thousands of products affected, example chemicals and polymers until their application in final consumer goods (cars, electronic equipment, etc.) –Import: buy allowances  how much, how many products? –Export: refund of allowances  how much, how many products?  Results –Hole in the total cap! –Huge bureaucracy, can never be effective

24 Appendix Benchmarking

25 Key principle of benchmarking  What a CEO wants to know?  He wants to know – e.g. with cost-price:  Where his plants stand?; then  Why? + What can be done about it?  He refuses notions like “We are the best in the peer group of our [obsolete] technology, or in our [small] scale, or in our plant vintage” (many corrections make everyone equal)  Key principle: benchmarks relate  The product … with  the objective function – CO 2 in the EU ETS  Deviations shall be possible, but temporary and aimed to avoid leakage outside EU (… objective function)  Example: energy efficiency as objective function can avoid leakage by switch to gas and shipping of carbon-rich fuels outside EU

26 Benchmark with ex-post + guarantee total cap Automatic adjustments within an ex-ante agreed total cap More stringent benchmarks work exactly like auctioning (& cap & trade) System is self-adjusting; virtually no interest costs

27 Benchmark takes account of all energy carriers Production plant Feeds Steam Natural gas ? Other fuel ? Electricity CO 2 ? Product(s) Many energy functions can be done either with: Steam, or Electricity, or Natural gas or other fuel Benchmark takes this into account: Normalised calculation to (total) primary energy – or total CO 2 Benchmark for only fuel – direct emissions – is meaningless Examples: chemical plants, refineries, cement, paper plants, etc.

28 Benchmark takes account of all energy carriers Furnaces with heat recovery to steam Feeds Methane from feedstock CO 2 Separations with high power compressors Example steamcracker, simplified scheme 2/3 of the investment Separation train can be: Efficient, with net-export of steam of whole cracker Inefficient, steam import Both can be with the same direct emission of the cracker itself (ethane, LPG, naphta, gas oil, etc.) Power train can be: Steam turbine driven Electric motor driven Combinations High influence on electricity & steam balance, direct emissions elsewhere (ethylene, propylene, etc.) Products Steam recovery Electricity Steam

29  Benchmark data of plants under the scheme (now EU) Benchmark between average & best performance, e.g. Benchmark = WAE – CF x (WAE – BP) =WAE = Weighted Average Efficiency =CF = Compliance Factor, to comply with total cap =BP = proven Best Practice, proven means actual measured operational data (or rather BP Group, for extra stimulation of innovation)  Formula coincides with EU ETS Directive Annex III (3), average emissions and achievable progress for each activity  Industry opposes following alternative  Related only to BP (BP + X%) – too short allocation, contra-incentive to improve BP, effectiveness & innovation Suitable benchmark formula

30 Benchmarks in a direct emissions scheme Allocation = direct emission – emission {total plant – total BM} Production plant Feeds Steam Natural gas Other fuels Electricity CO 2 Product(s) Site utilities have also benchmarks Example 1: Net-import of secondary energy carriers: 70 – {120 – 100} = 50 Plant worse than benchmark Example 2: 70 – {90 – 100} = 80 Plant better than benchmark See formula in ANNEX

31 Benchmarks in a direct emissions scheme  Easy inclusion in an ETS  No conceptual problem in a direct scheme and no legal problem with Directive, on the contrary  Allowances according to deviation with benchmark  In formula: A = RDE + RSE – Σ production x (REE/RCE – benchmark) x CCF =RDE = Realised Direct Emission (ton CO 2 ) =RSE = Realised Sequestered Emissions (ton CO 2 ) =REE/RCE = Realised Energy Efficiency (GJ/ton product) or Realised CO 2 Efficiency (ton CO 2 /ton product) =Benchmark = benchmark energy (or CO 2 ) efficiency =CCF = CO 2 Conversion Factor (= 1.0 in case of CO 2 -benchmark)  Note: Process emission is in this view included in the Best Practice

32 Recent legal case Germany against EU Commission (judged 7 Nov 2007) –Germany contested the prohibition of the EU Commission to apply ex-post adjustments (also in 1 st & 2 nd guidance note) –Germany asserted that the whole Directive – also art. 10 and Annex III – does not forbid ex-post, provided total cap ensured –Court of First Instance fully confirmed German case –Findings of the Court a.o.: =“…, neither the incentive for operators to reduce their emissions nor the certainty in respect of investments made for this purpose is affected by the ex-post adjustments, quite the reverse.” (para 128) =“The Commission was wrong in asserting at the hearing that this recital [20] did no more than “record” a desirable future effect … only a “subordinate objective” … “whether the ex-post adjustments at issue are compatible with … recital 20 … the Directive “will encourage the use of more energy-efficient technologies … producing less emissions per unit of output.” (para 139)

33 Quality of historic data for operators Variations in annual load factors over five years, found in UK by consultant NERA for UK government … with climate change instruments based on history? Historic production tells nothing about the future Link to actual production:  Avoids distortions  Avoids windfall profits  Solves problems new entrants and closures

34 New legal cases – historic production What means a historic cap?: import and export –More electricity import NL from Germany – is NL then doing well? –New CHP in Luxembourg – is Luxembourg doing badly? Nine new legal cases –What means a historic cap?: economy is strongly recovering as we desire it to be (Lisbon strategy) –Forecast of growth in central Europe, 9 legal cases European Court of Justice against EU Commission: Estonia, Latvia, Lithuania, Poland, Czech Republic, Slovakia (withdrew), Hungary, Rumania, Bulgaria and Malta –Influence historic production on allocation is perverse Solution: benchmarks linked to actual production

35 Benchmarks with ex-post Few benchmarks provide high coverage =E.g. electricity, cement, refineries, steamcrackers, etc. Real benchmarking is easier that often assumed =Output related, same BM for incumbents & new entrants Benchmarks with link to actual production, solution for: =Leakage, level playing field, no insecurity for new entrants, no transfer rules, no windfall profits, free market without cartel problem =Works as effective as auctioning European Industry at ETS Directive review meeting =How to ensure total cap =How it works in the electricity market

36 Setting total cap – effectiveness Total cap may appear to be too stringent –Renewables behind target, higher economic growth than expected, etc.  very high CO 2 -price Total cap may appear to be too soft –Reverse of possible causes above  very low CO 2 -price  Ex-ante frozen allocation not effective Solution –Contingency reserve if cap too stringent  for example 100 Mton –No loser benchmarks if cap too soft –Can be done in any allocation system  Target is to maintain a realistic CO 2 -price to ensure a robust and predictable EU ETS for companies to reduce emissions

37 Benchmarking same effectiveness as auctioning (1)  Incentive to reduce emissions is independent of the exact value of benchmark in a certain year Incentive = avoided purchases + sales of allowances Example: Investment to reduce emissions from 900 to 600 kg CO 2 per unit of product (in old plant or new plant) Year 1, BM = 750: incentive = = 300 Year n, BM = 700: incentive = = 300  Predictability of investment climate

38 Benchmarking same effectiveness as auctioning (2)  Same benchmarks for incumbents and new plants Recognised by EU Commission  Avoids =Distorting transfer rules =Barriers to entry =Enhanced market concentration  Ensures =Equal incentive for plant improvement & plant replacement  No “maximisation” or “minimisation” rules, see e.g. Matthes (NL 110% and 85% now)

39 References: “Climate change challenges and the search for a sustainable policy”, 21 June 2005, 8th International Conference on Carbon Dioxide Utilisation (ICCDU- VIII) June 2005, Oslo, Norway. “Options and consequences for the allocation of allowances to electricity producers”, 21 December 2005, European Chemical Region Network (ECRN) presidium meeting December 2005, Maastricht, the Netherlands. “Towards a simple, robust and predictable EU Emissions Trading Scheme – Benchmarks from concept to practice”, 21 March 2006, presented to the Dutch Ministry of Economic Affairs. “The EU ETS is urgently in need of: effectiveness, level playing field, competitiveness, fair & free competition”, 4th Congress of the ECRN, 10 November 2006, Tarragona, Spain, including: –“One single benchmark for fossil-fuelled electricity in an Emissions Trading Scheme: does it work, does it hurt and what about alternatives?”. –“How to fit benchmarks with ex-post adjustments in the present EU Emissions Trading Directive”. “Auctioning for electricity seems ideal – but the facts tell a different story”, by Annette Loske (VIK - Germany) and Vianney Schyns “Interpretation outcome legal case Germany against EU Commission concerning ex-post adjustments”, by Jan Berends (Royal DSM) and Vianney Schyns