The crystal ball learns from the remarkable history of greenhouse gas emissions trading What did we learn, what are we heading to? EURO-members conference Hilton Brussels, 2-3 April 2007 Vianney Schyns Manager Climate & Energy Efficiency Utility Support Group Utility provider for a.o. DSM and SABIC

Contents 1.Introduction 2.Shortcomings present EU ETS cap & trade rules 3.Legal aspects 4.Solution: performance-based allocation as the alternative to auctioning 5.What may happen next?

Introduction EU Emissions Trading Scheme What would be expected of ETS What says the EU Directive EU ETS in Dutch & UK Parliament Facts EU GHG Emissions Trading Scheme

What would be expected of emissions trading Note: each site must surrender after each year the allowances equal to the direct emissions of that year (direct emissions scheme) Effective rules allocation of allowances –Robust, predictable –Incentive for investments to reduce emissions, for low carbon technologies Level playing field across Europe Stimulates activities, employment … Lisbon strategy … competitiveness Fair & free competition See for example: PhD thesis 1992 Ass. Prof. Marjan Peeters, Maastricht University PhD thesis 2006 Anja Pauksztat, Rheinisch-Westfälischen Technischen Hochschule Aachen

What says the EU Greenhouse Gas Directive Aim: … to promote reductions of GHG emissions in a cost-effective and economically efficient manner (art. 1) –The Directive will encourage the use of more energy efficient technologies, including CHP (combined heat & power) (recital 20) –Quantities of allowances shall be consistent with the potential to reduce emissions (Annex III (3)) Community provisions necessary: …integrity of the Internal Market & to avoid competitive distortions (recital 7) –The allocation shall not discriminate between companies or sectors … state aid EC Treaty art (Annex III ((5)) Aim: … effective European market with least diminution of economic development & employment (recital 5)

EU ETS in Dutch Parliament March 2007 MP Mrs Helma Neppérus, liberals (VVD) –Present cap & trade implementation rules are unfair –They cause (a.o.) “windfall profits” for electricity producers –Performance Standard Rate (PSR) trading, with a PSR for each product (electricity, cement, steel, etc.) =Allowances according to PSR, less production means less allowances =Eliminates the “windfall profits” =Less efficient than PSR means buying of allowances, an incentive to invest in reductions of emissions =More efficient than PSR means sales of allowances, further improvement investments means more sales

EU ETS in UK Parliament January 2007 MP Mr Adrian Bailey sees 3 basic flaws of present cap & trade rules, allowances based on historic emissions: –History of low efficiency rewarded with more credits –Production growth means buying of credits –Production shrinkage means sales of allowances –By decoupling the allowances’ system from energy efficiency and relating it purely to levels of production the scheme has developed a number of perverse incentives that hamper investment and production in the UK while contributing little to the reduction of carbon emission Steel industry advocates average oriented baseline, to be multiplied by the volume of steel produced –That system reverses the existing perverse incentives.

Facts EU GHG Emissions Trading Scheme Fast start by : 1 st 3-year period Biggest scheme ever worldwide, a great achievement –50% of EU emissions –12,000 installations (production sites) –Fossil-fuelled electricity, cement, steel, refineries, paper & pulp, glass, ceramics, major part of chemical industry Rules virtually unchanged for 2 nd 5-year period –Allocation: frozen cap, basis historic emissions 1) EU committed -20% in 2020 compared with 1990, EU ETS confirmed as central instrument 1) “Historical grandfathering”

What did we learn, what are we heading to? Remarkably, economists said: scarcity of allowances sufficient for an effective market 1) What did we learn: allocation is also vital What are we heading to? Review of EU Directive for post 2012 period underway –Other allocation rules: benchmarking and/or auctioning –Will it be ex-ante frozen caps, or with ex-post following production? –Further: –Expansion participants: aviation (2010?), other sectors & gases –Linking with other schemes: Norway, Switzerland, California, North East USA, Japan, Korea, Australia …. ? 1) And adequate monitoring, reporting and verification (MRV) of emissions

Shortcomings present implementation EU ETS Directive The EU Emissions Trading Directive is the centrepiece of EU Climate change policies, rightly so, but structural improvements are urgently needed

Basics of shortcomings present allocation Existing plants: allowances ex-ante frozen cap based on historical emissions – rewarding pollution – frozen quantity, frozen quantity whether production in- or decreases (“static, frozen economy”) New plants and debottleneckings: theory says buying (inhibits efficient industry renewal); repair = allowances from a new entrants’ reserve, also an ex-ante frozen cap (“plan-economy”) This principle = root cause of shortcomings, PLUS, as result: –Insecurity investments in new plants (finite reserves) –The allocation habit of few allowances for new plants versus many allowances for existing plants : LACK OF EFFECTIVENESS to invest to reduce emissions –Repair: “transfer rules” (allowances closed plant to new efficient plant), but new problem: high distortions, reinforcing market concentration –Lowering production & selling freed allowances is declared equally legitimate as investing to reduce emissions

Complications of ex-ante frozen caps What means a historical cap when many new plants enter the market ? –Many new power plants in Italy around 2009 What means a historical cap when an economy is strongly recovering ? –Growth central Europe, e.g. Poland, etc. What means a country cap when import or export of product changes ? –More electricity import NL from Germany, is NL then doing well ? –New CHP in Luxembourg, is Luxembourg doing bad ?

Cap & trade historical grandfathering Great influence of individual growth or shrinkage & weather Specific energy use or CO 2 emission Decreasing efficiency order of plants Cap Cap based on historical emissions in theory Buying allowances Free allocation Best Practice Uncertain incentive, updating unpredictable Benchmark curve of one product

Cap & trade historical grandfathering Actual allocation 1 st trading period ! Specific energy use or CO 2 emission Decreasing efficiency order of plants Cap Cap & trading position is unpredictable in practice Buying allowances Free allocation Best Practice Uncertain incentive, updating unpredictable

Reality check short / long of real cement installations (courtesy Holcim) Real situation with NAP , Emission Based Allocation High emission is rewarded with excess of initial allowances Low emission is punished with shortage of initial allowances Up to 40 % difference in initial allowances for equal installations Distortion due to Emission Based Allocation (Grandfathering)

Equity of Performance Based Allocation (Benchmarking) Percent short / long of same cement installations as a function of CO2 efficiency Same installations Performance Based Allocation same total allocation, same environmental result Gives the right signals: Performance is rewarded, Polluters pay Discussion on differences between equal installations are futile, compared to differences in case of grandfathering

Ex-ante rules simply kill electricity liberalisation State interference prevents competitive market –At gross margin of opportunity-cost, winning and losing market share: zero sum game –New entrants, vital for more competition, but ex-ante state decision of operating hours determines profitability – plan economy –Transfer rules protect incumbents: barrier to entry can be € 0.25 billion for a 1000 MWe power plant (4 years, or trading period) –Even worse: incumbent does not apply for transfer rule and keeps old plant stand-by (1000 MWe coal-fired plant of € 1.1 billion, distortion ~ € 0.2 billion/year) Fight for allowances overrides fight for market share Price of system: economic rents – windfall profits –Cause is the opportunity to sell allowances when not agreeing a contract (opportunity-costs) –Transfer of wealth to € billion/year or double (EU-27)

Cap & trade: market price at opportunity-cost Euros for an equal total production volume Companies A & B A wins market share from B Gross margin cash flow Opportunity cost Cost of buying allowances: distortion Profit of sales of allowances Company A Killer of a free, undistorted electricity (steel, cement) market No product sales below opportunity-cost: selling allowances Is then more profitable than producing

28€ 20€ 24€ 32€ 49€ 60€ 84€ 46€ 24€ 57€ 70€ (1) (2) (3) World Map electricity prices July 2006 (€/MWh) Sources: (1)Presentation European Aluminium Association HLG-Ad hoc 1 (Long Term Contracts) (2) R.Tarjanne and K. Luostaninen, Lappeenranta University of technology (Long term contract) – 2003 (3)Platts Base load year 2007 (Platts 4 April 2006) (4)Jean Maillard (3) 60€ 67€ < 25€ (4) (4) Courtesy Cefic

Legal aspects EC Treaty: Competition rules State aid rules

Legal aspects EC Treaty (1) Competition rules, art –Cartels, concerted practices prohibited –Frozen cap & trade: works like cartel, winner of market share must buy allowances, loser sells (= penalty payment winner to loser) –But: no jurisprudence (yet) to prohibit this implementation State aid rules, art –State aid problems confirmed by EU Commission –Alternative so far not taken into account, Commission prohibited ex-post adjustment to actual production –This state aid so far admitted, argument: interest for environment Either no support from art. 86: “In the case of public undertakings and undertakings to which Member States grant special or exclusive rights, Member States shall neither enact or maintain in force any measure contrary to the rules in this Treaty, in particular … art ”

Legal aspects EC Treaty (2) UK against EU Commission (verdict 23 November 2005) –EU Commission can only assess NAP against art. 10 & Annex III –A NAP can be changed after Commission’s approval of an earlier notified NAP (no “provisional” notification needed) –But what about the deadlines, now everybody is too late ? Germany against EU Commission (verdict mid 2007 ?) –Germany contests the prohibition of the EU Commission to apply ex-post adjustments (1 st & 2 nd guidance note) –Germany asserts that the whole Directive – also art. 10 and Annex III – does not forbid ex-post, provided total cap ensured –Germany may apply ex-post in 2 nd period if case is won (Protokollnotiz 28 June 2006)

Solution: performance-based allocation as alternative to auctioning Three steps: (1) Performance Standards – benchmarks (2) Ex-post adjustment to actual production (3) Guarantee of total cap

Auctioning: clear incentive low carbon technologies, length trading period irrelevant, but leakage & detrimental for competitiveness Specific energy use or CO 2 emission Decreasing efficiency order of plants Total cap Buying allowances Free allocation Best Practice IncentiveWeighted average Incentive High market liquidity

Performance Standard Rate trading: same incentive as auctioning, length trading irrelevant, (hardly or) no leakage, good for competitiveness Specific energy use or CO 2 emission Decreasing efficiency order of plants Total cap Buying allowances Free allocation Best Practice IncentiveWeighted average Incentive Selling allowances PSR = total cap High market liquidity

A few benchmarks have already major coverage Benchmarking Netherlands: about 90 PSRs 100% Coverage of emissions under the EU ETS Electricity (1 PSR) and for CHP (Combined Heat & Power) (1 additional PSR for heat) Steel (6-7 PSRs) Cement (1 PSR) Refineries (1 PSR) Major chemicals (20-30 PSRs) Policy recommendation: include (co-)firing biomass

Suitable benchmark formula Dutch & Flemish applied “top 10%”: not suitable –Not stable over time & too high shortage of allowances Suitable formula –Benchmark data of plants under the scheme (now EU) –Benchmark = PSR = WAE – CF x (WAE – BP) =WAE = Weighted Average Efficiency =BP = proven Best Practice =CF = Compliance Factor, equal for all products (“equal efforts”) –Formula coincides with Annex III (3): average emissions and achievable progress for each product –Note: misinterpretation guidance note EU Commission: (A) Annex III (3) only for the total allocation to installations, (B) Annex III (7) related to BAT (Best..) for the individual allocations, but sum B « A

PSR = WAE – CF x (WAE – BP) Specific energy use or CO 2 emission Decreasing efficiency order of plants Weighted Average Efficiency 1 PSR 1 Best Practice = proven Best Available Technique Product 1 steep curve Product 2 flat curve Normalised curves CF = Compliance Factor, equal for all products (equal efforts) Weighted Average Efficiency 2 PSR 2

Myths about benchmarking Some notions in literature: High transaction costs (Radov et al, Sijm, etc.) –Practice: € 0.01/ton CO 2 Benchmarking needs decision about activity rate – suggested: pick what you like or pick what is easiest –Standard load factor, or recent historical output, or projected output –Or … actual output –Practice: what else is objective … than actual output ? Benchmarks are very complex – suggested: hardly or not feasible – for integrated sites with multiple products and production steps such as refineries, chemical & steel sites and processes like steamcrackers –Practice: can be done

Key principles of benchmarking What a CEO wants to know? –He wants to know where his plants are – cost-price or CO 2 – then he wants to know why and 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, or with our raw material” (many corrections make everyone equal) Key principles of benchmarks: two relations –Output-related, product related –Related to the objective function – cost or CO 2 or (temporarily & partly) energy efficiency (avoid leakage/shipping carbon-rich fuels) Practical principles for use in ETS –Keep it simple – ignore secondary effects (corrections) –Same benchmarks for incumbents and new plants –Then no transfer rules needed – avoids distortion between new plants of incumbents and real newcomers – barrier to entry

Misunderstandings power market cleared Fuel specific benchmarks: against objective function =With ex-post: high fuel-switch prices, e.g. € /ton CO 2 =Fuel switch limited with at least 50% (in case of 2 benchmarks) =Coal plants without CCS encouraged (Carbon Capture & Storage) One electricity benchmark no deathblow coal-fired power =Coal & lignite very important, climate policy means CCS ! =Cap & trade: opportunity-cost in power price (soft cost) =PSR, so with ex-post: CO 2 -cost in power price (real cost) Dash to gas with one benchmark? =Does not depend on one benchmark, but on total cap =Fuel switch PSR at same CO 2 -price as cap & trade & auctioning =In fact more gas if more new coal and less CHP (given total cap) =We need a controlled transition (CCS needs time)

Benchmark with ex-post + guarantee total cap Novel method for EU demand (EU Directive / linking to other schemes) More stringent benchmarks work exactly like auctioning (& cap & trade) Easy & fast introduction possible on the basis of estimated benchmarks (system is self-adjusting); virtually no interest costs

What may happen next? PSR enabler of a faster global climate agreement

Transition for a faster global trading scheme PSR: Specific energy use or CO 2 emission PSR EU-Japan Transition period (with 3 or more PSRs for same product) avoids high cost in case of auctioning for regions with higher emissions per unit of product (vital: PSRs without differentiation new/old plants) 2032 Incentive low carbon technologies the same in global trading scheme 2008 PSR USA-Canada PSR China-India Global PSR

References References of the author: “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”.