IFIEC Europe International Federation of Industrial Energy Consumers Member State choices and effects of greenhouse gas emissions trading systems for the energy intensive industries With special attention for the effects on the electricity market IFIEC Europe Forum 21 October 2003

IFIEC Europe International Federation of Industrial Energy Consumers 2 The context of emissions trading The objective of ET – to promote reductions of GHG emissions in a cost-effective and economically efficient manner – has to be checked against three main issues of any energy policy: SECURITY OF SUPPLY ENVIRONMENTAL PROTECTION ECONOMY Increasing dependence on energy imports within the EU: Today50 percent After 20 to 30 years70 percent Necessity: a well balanced fuel mix policy Kyoto-Protocol: obligation for a CO 2 reduction of 8 % within the EU (1990 – 2010), with a role for a renewables’ and Security of Supply fuel mix policy The major challenge: to avoid competition distortions including dramatic effects on the markets for electricity and gas The correct choice of emissions trading mechanisms will be vital for the future of energy intensive industries and the sustainability of emissions trading in the EU and abroad

IFIEC Europe International Federation of Industrial Energy Consumers 3 Contents 1.The judgement of allocation options Universal criteria Legal requirements 2.Problems with cap & trade Electricity market Further problems in general 3.The alternative of relative targets General principles Roadmap for the future 4.Conclusions 5.Recommendations

IFIEC Europe International Federation of Industrial Energy Consumers 4 Universal criteria for allocation options Reduction potential (*) Annex III (3) –The scheme is intended to promote reductions Polluter-pays principle(*) Article 11 (3) –Legal requirement EC Treaty; –Key principle for this Directive, greatest internalisation scheme ever; Level playing field (*) Annex III (5) –No distortions between companies and sectors; Transparency and objectivity (*) Article 9 –Self-evident but not always obeyed in the practical interpretation; (*) Included in the Directive

IFIEC Europe International Federation of Industrial Energy Consumers 5 Universal criteria for allocation options Security of Supply of energy –Sudden and immediate punishment of carbon rich fuels would affect this emerging policy by an uncontrolled drive towards natural gas; Correct trade-off between purchase of allowances & investment in emission reductions (*) Article 1 –Self-evident but not always obeyed in the practical interpretation; Allowances related to the direct emissions (*) Article 12 –Elegant system choice, which gives an easily extendable scheme. Deviation from target must be related to the direct emissions; Liberalisation of the energy markets –Proportionality of price effects must be guaranteed; Support Lisbon strategy (*) Recital 20 –Stimulation of innovation, EU as the most competitive market place. (*) Included in the Directive

IFIEC Europe International Federation of Industrial Energy Consumers 6 Level playing field and the Directive “Community provisions … necessary to contribute to preserving the integrity of the internal market and to avoid distortions of competition” (recital 7) “This Directive will encourage the use of more energy efficient technologies, including [but not limited to] CHP technology, producing less output per unit of product, …” (the new recital 20) “The [national allocation] plan shall not discriminate between companies and sectors in such a way as to unduly favour certain undertakings in accordance with the requirements of the Treaty, in particular Articles 87 and 88 thereof” (Annex III, 5)

IFIEC Europe International Federation of Industrial Energy Consumers 7 Requirements of the EC Treaty (1) The EC Treaty aims for an open, equal and free common market. Numerous concerted practices are “prohibited as incompatible with the common market” (Article 81); Also the legislator is not allowed to cause distortions: “In the case of public undertakings and undertakings to which Member States grant special or exclusive rights, Member States shall neither enact nor maintain in force any measure contrary to the rules contained in this Treaty, in particular to those rules provided for in Article 12 [principle of non-discrimination] and Articles [rules on competition & state-aid]” (Article 86);

IFIEC Europe International Federation of Industrial Energy Consumers 8 Requirements of the EC Treaty (2) Polluter-pays principle required by the Treaty: “Community policy on the environment … shall be based on the precautionary principle and on the principle that preventive action should be taken, that environmental damage should as a priority be rectified at source and that the polluter should pay” (Article 174, 2);

IFIEC Europe International Federation of Industrial Energy Consumers 9 Requirements of the EC Treaty (3) “The protective measures adopted pursuant to Article 175 shall not prevent any Member State from maintaining or introducing more stringent protective measures. Such measures must be compatible with this Treaty. They shall be notified to the Commission” (Article 176); –Therefore only a temporary derogation allowed in case this leads to competition consequences; –Ultimately the level playing field must be obeyed.

IFIEC Europe International Federation of Industrial Energy Consumers 10 Problems with cap & trade Electricity market Further problems in general

IFIEC Europe International Federation of Industrial Energy Consumers 11 Cap & trade for individual companies: dramatic effects on the electricity markets Cap & trade results in price increases caused by the opportunity cost principle Especially for electricity operating in regional markets (in contrast with industries on the world market) How works the opportunity cost principle: –Case 1: short run marginal cost plant is above its cap Additional sales requires producer to purchase allowances, i.e. the integral cost of allowances is part of the variable cost; Perhaps now the surprise: –Case 2: short run marginal cost plant is below its cap The producer has the opportunity to sell the excess of allowances. Any new contract below the cap means less sales of allowances, i.e. the integral cost of allowances is again part of the variable cost;

IFIEC Europe International Federation of Industrial Energy Consumers 12 Illustration cap & trade Integral effect is € 17/MWh at € 20/ton CO 2 for coal Source: Finnish Energy Industries Federation, April 8, 2002

IFIEC Europe International Federation of Industrial Energy Consumers 13 Electricity price effects EU market

IFIEC Europe International Federation of Industrial Energy Consumers 14 Discontinuities under cap & trade Switches from one short run plant to another; Coal partly switched off and partly to peak demand at about € /ton CO 2 ; This leads to discontinuities for producers (shareholder value) and consumers of electricity (price); After ET Before ET Short run marginal cost Coal Gas Opportunity cost allowances

IFIEC Europe International Federation of Industrial Energy Consumers 15 Electricity distortions under cap & trade Threat for electricity intensive industries (aluminium, electrolysis, low density polyethylene, etc.) –Also for companies with self generation of electricity, opportunity principle also valid within the company; Price increases may vary widely from one Member State to another: –Distortions between consumers; –Distortions between producers; An uncontrolled drive from coal and lignite towards gas –Upward price pressure on gas, up to 15%, leading to another 10% price increase of electricity (Source: McKinsey, 2003); –Punishment of coal and lignite, e.g. capital value loss of RWE of 29% at € 20/ton CO 2 (Source: Dresdner Kleinwort Wasserstein, 2003); Conflict with the liberalisation of the energy markets Conflict with Annex III (5), distortion between sectors (buyers- producers of electricity)

IFIEC Europe International Federation of Industrial Energy Consumers 16 Further problems of cap & trade (1) Two other critical issues for any product: –Enhancement of frozen market shares: Cap & trade acts like a cartel: winners of market share by better marketing or by technology innovation are required to pay costs for additional allowances, while losers of market share enjoy additional income; –Efficiency: Capped efficient companies are deprived from the possibility of having the same cost per unit of product as the capped inefficient competitor; Cap & trade seems therefore a “concerted practice” imposed by the legislator

IFIEC Europe International Federation of Industrial Energy Consumers 17 Further problems of cap & trade (2) “Correct” behaviour of all producers assumed: drive for direct and indirect energy savings (indirect savings through the price mechanism). However, for mediocre & laggard plants: –There is no need to buy allowances, poor incentive for action and innovations, they have their allowances & can wait and see; –Lower production means additional cash flow by sales of allowances. Therefore, inefficient plants will survive longer!

IFIEC Europe International Federation of Industrial Energy Consumers 18 Further problems of cap & trade (3) Frozen caps based on historical emissions are contrary to the polluter-pays principle –“… firms who polluted the most are then “rewarded” with the biggest transferable rights … not a “polluter pays, but a polluter earns” principle” (Dr. Marjan Peeters, METRO Institute, European Environmental Law Review, March 2003); –Taking the reduction potential into account counters this problem only initially; –However, with market dynamics of changing market shares the inherent conflict with the polluter-pays principle persists.

IFIEC Europe International Federation of Industrial Energy Consumers 19 New entrants and cap & trade Non-paper on national allocation plans: –(A) “Member States may choose to let new entrants buy [all required] allowances …” –Or: (B) they get allowances from a state reserve. Option A acts as a restriction on the right of establishment and implies unequal treatment with existing producers –No Member State is really considering this; –New recital 20 clearly abandons option A; The concept of cap & trade is fully undermined by giving allowances to new entrants from a state reserve (potential blow-up of the system)

IFIEC Europe International Federation of Industrial Energy Consumers 20 Conclusions cap & trade A dramatic & unacceptable price increase of electricity –Average € 8-12/MWh or € billion/year at a price of € /ton CO 2 and a current EU demand of about 2,500 TWh/year; –Windfall profit for the electricity producers at the expense of industrial and domestic electricity consumers; –Violation of the principle of proportionality, the forecasted optimisation advantage of emissions trading is about € 2.5 billion/year; –Associated price increase of natural gas –Conflict with the liberalisation of the energy markets Conflict with the polluter-pays principle, a most relevant principle for this scheme Market distortions cannot be avoided, contrary to the Directive and the EC Treaty Poor stimulator for innovation, contrary to the Directive and the Lisbon strategy

IFIEC Europe International Federation of Industrial Energy Consumers 21 The alternative of relative targets General principles Roadmap for the future

IFIEC Europe International Federation of Industrial Energy Consumers 22 Relative energy efficiency targets CO 2 -efficiency is also possible, but this conflicts with the emerging Security of Supply policies Relative target or PSR(*) based on energy efficiency: –Eff. fuel + Eff.heat use + Eff.electricity use; –The 2 latter terms are converted to primary fuel; –The 3 terms are in principle mutually interchangeable; Basis of the method is, in contrast with frozen cap & trade, actual performance, which needs an ex-post approach: –Actual realised efficiency & actual realised production; –Otherwise we have still cap & trade; Allowances have to be bought only in so far the relative target is not met (or sold if better) Target or PSR is determined to ensure cap whole population of participants: –Taking expected production growth into account; –Target can be adjusted periodically. (*) Performance Standard Rate

IFIEC Europe International Federation of Industrial Energy Consumers 23 The advantages of relative targets (1) Marginal effect of CO 2 -price in product prices, no windfall profits & distortions electricity market; Reward for CHP by a stimulating allocation; No conflict with Security of Supply, different PSRs for different fuels; “Correct” behaviour of all producers: drive for direct and indirect energy savings; the need to buy allowances for laggards provides an immediate incentive for action;

IFIEC Europe International Federation of Industrial Energy Consumers 24 The advantages of relative targets (2) Equal targets comply with the polluter-pays principle; No problems with frozen market shares because of the obligation to deliver efficiency; Relative targets are realistic by taking account of industrial growth to meet demand from society; Clear stimulation of innovation, therefore the best support for the Lisbon strategy.

IFIEC Europe International Federation of Industrial Energy Consumers 25 A possible roadmap for Europe Concept 1: –Use participants data only (EU population now) Concept 2: –Derive targets in order to achieve EU target –Formula: WAE – CF x (WAE – BP) –WAE = Weighted Average Efficiency –BP = Best Practice as a practical value for BAT –CF = Compliance Factor as a concept for equal efforts by each product To ensure contribution to EU target Takes forecasted growth into account Adjustable periodically, for next trading years Recession-proof system if wisely adjusted

IFIEC Europe International Federation of Industrial Energy Consumers 26

IFIEC Europe International Federation of Industrial Energy Consumers 27 Sales or purchases of allowances

IFIEC Europe International Federation of Industrial Energy Consumers 28 A possible roadmap for Europe Concept 3: –Transition period is suggested; –This avoids early punishment of inefficient producers, they get time to adapt; –Each firm starts with targets from national agreements or even their own verifiable efficiency; –Early movers get no reward in 2005, their reward grows gradually; –After the transition period all companies are on equal footing.

IFIEC Europe International Federation of Industrial Energy Consumers 29 The concept of a transition period

IFIEC Europe International Federation of Industrial Energy Consumers 30 A first quantitative study of concept 2 Electricity plays a major role, an annual growth of 1.7% is assumed for Europe Four scenario’s selected: –No fuel switch: significant growth of coal and lignite (+33%), virtually no growth of CHP, renewables and nuclear (all growth from fossil) –Combined Heat and Power (CHP): increase from 9% to 18% penetration according to EU policy desire –CHP, gas & renewables: more gas, renewables as currently planned –Ecofys: a scenario with an extreme growth of renewables (much higher as anticipated now)

IFIEC Europe International Federation of Industrial Energy Consumers 31 Results CF for 2010 current ET sectors Scenario no fuel switch Scenario CHP Scenario CHP, gas & renewables Scenario Ecofys

IFIEC Europe International Federation of Industrial Energy Consumers 32 Results CF for 2010 current sectors + non-ferrous industry & N 2 O (as example) Scenario no fuel switch Scenario CHP Scenario CHP, gas & renewables Scenario Ecofys

IFIEC Europe International Federation of Industrial Energy Consumers 33 Conclusions (1) Frozen cap & trade is regarded in serious conflict with the requirements of the Directive and the EC Treaty –Conflict with polluter-pays principle; –The enhancement of frozen market shares in any case and especially when based upon historic emissions; –Forecasts of production and efficiency are no objective criteria; –Serious distortions between the sector electricity producers and the buying sectors of about € 25 billion/year at € 20-25/ton CO 2 ; –Massive relative changes of electricity producers shareholder value depending on the price of CO 2 ; –Associated price increase of natural gas up to 15%; –Potential blow-up of the system by new entrants; –Poor stimulator of innovation; No compliance with the liberalisation of energy markets

IFIEC Europe International Federation of Industrial Energy Consumers 34 Conclusions (2) Relative targets do comply with EU requirements: –Objectivity for granting allowances as required by the Directive for existing producers and new entrants; –The obligation to deliver efficiency: Provides objectivity by the inherent ex-post assessment of production and efficiency; Avoids the problems to enhance frozen market shares; –A realistic view by taking account of industrial growth to meet demand from society; –Avoidance of unacceptable distortions of the electricity market

IFIEC Europe International Federation of Industrial Energy Consumers 35 Recommendations (1) To adopt a transition period with relative targets in all Member States: –A period of about 5 years seems realistic; –Start of the scheme on efficiencies related to current national agreements or average benchmarks or in absence of data current efficiencies; Targets after transition period based on equal efforts: –Based on difference between average and best practice; –Recommended challenging but achievable target based on a Compliance Factor of about 0.20; Relative targets at least necessary from the start for all major products to avoid the greatest distortions, e.g. electricity, steel, refineries, cement, etc.

IFIEC Europe International Federation of Industrial Energy Consumers 36 Recommendations (2) To adopt Security of Supply policies: –By Member States with Community coordination; –Clear support of EU policy for CHP to increase penetration from 9% to 18% by a suitable allocation of allowances; –A well balanced development of renewables; –The active development and demonstration of carbon sequestration technologies supported by DG TREN to counter an uncontrolled drive towards natural gas and renewables; To announce inclusion as from 2008 of the other greenhouse gases emitted from industrial sources, as soon as possible (latest 31 December 2004) : –To provide an economic incentive which is now absent; –The lower abatement cost – once a technology is proven – ensures abatement and a realistic target for the reduction of CO 2 from industrial sources;

IFIEC Europe International Federation of Industrial Energy Consumers 37 Final remarks Relative targets ensure: –Worldwide environmental integrity of the scheme, the European Union leadership of climate change cannot afford leakage of emissions by relocations of investments outside the EU; –Compliance with the polluter-pays principle and with competition rules, two acid tests for a sustainable scheme when attracting new participants such as Canada, Korea or Japan; –Clear stimulation of innovation, in full support for the Lisbon strategy.