1. EU ETS after one year and prospects for the future Workshop 4 April NCM, Climate Change Policy Group

2. 2 Outline of presentation Experiences so far The second trading period  Links between the periods Post-Kyoto

3. 3 Carbon price development 2005 Source: Point Carbon Cold spells Mild weather Cuts in Polish NAP 141,3 Mt (16,5%) Cuts in Italian NAP 69 Mt (9%) Last NAP approved High gas price UK Court ruling on UK NAP Imports of CDM credits ? Expectations are important!

4. 4 Observations and explanations Allowance prices much higher than most expected before the system was launched Potential explanations: Changes in net demand due to:  Changes in allocation (supply)  ”Errors” in estimation of BAU emissions  Changes in underlying economic conditions Changes in abatement costs  Changes in fuel prices  ”Errors” in estimation of MAC curves

5. 5 Changes in allocations During review process cuts of almost 300 Mt were made  Poland: 141 Mt  Italy: 69 Mt  Czech rep: 31 Mt  France increased the allocations with ca. 100 Mt due to inclusion of more facilities Late submissions and decisions

6. 6 Changes in allocations

7. 7 Other changes to net demand Some differences in BAU estimates between submissions of national communications to UNFCCC and national allocation plans:  Higher estimates in NAPs Economic conditions reduced emissions  Reduced steel production (8-10 Mt)  Labour market conflict in Finland (10 Mt) Weather  Dry year in Spain –Hydro inflow reduced by 14 TWh, nuclear with 7 TWh  Wet in Nordic area –Hydro inflow 35 TWh above normal

8. 8 Abatement costs Substantial changes in fuel prices  Affect cost of fuel switching Large uncertainties about the actual abatements costs in different sectors

9. 9 Fuel switching depends on fuel prices Coal Gas Coal Marginal carbon cost Price Volume Full price effect Realized price effect

10. 10 Fuel price developments during 2005

11. 11 Development of the market Delays in national registries Growing trade  Jan/Feb -05: 0.6 to 3 Mt/week  Nov/Dec – 05: 10 Mt/week  Total trade during 2005: 250 Mt

12. 12 CER Expectation: Lower price in next period P exp next period P Allowances/gap MAC MAC = Marginal abatement costs Max short-term abatement 40 € Supply curve Carbon supply curve 2005-2007

13. 13 Changes within EU ETS for Phase II Price of allowances No opt out 10% auctioning 100€ penalty JI credits New gases/sectors Little impact Little/no impact May reduce price Ambiguous price effect BUT mandatory inclusion of new sector/gases may affect the price  Aviation may be included in Phase II

14. 14 Import of credits – uncertainties about supply Nov. 15, 2005: 35 CDM projects registered (7.8 million CERs) 400 projects at validation stage 20 avaiting regitration 57000 CERs issued into CDM registry To 2012: 500 Mt CO2e not unlikely  But to whom? And when? And JI from 2008

15. 15 The Kyoto period gap Commission:  A number of countries not sufficiently on track  Unlikely that it can be closed without the ETS  Some MS will have to reduce – other keep unchanges  Allocation 6% below phase I (~130 Mt lower) Imports of credits: Share to EU?

16. 16 Summary of price shapers First trading period Kyoto period Beyond Kyoto Relative fuel prices Supply of CDM credits Restrictions on imports Supply strategy AAUs Binding target? Back-stop technology 2005 – 2007 2008 – 2012 2012 – … Expected price Main price drivers:

17. 17 Preview of model results Allowance price

18. Model simulations Workshop 4 April NCM, Climate Change Policy Group

19. 19 Model simulations for 2005-07 Three cases  Base case with normal weather and actual fuel prices  Sensitivity with low gas prices in 2006 and 2007  Sensitivity with actual events in 2005 ECON’s carbon market model  Built on ECON’s European power market model  Added heat and industrial sectors in ETS  Covers the three year period 2005-07

20. 20 ECON Carbon market model

21. 21 Assumptions Allocation of allowances  According to NAPs  Norwegian allowances added Import of CERs  The level of import uncertain  Not analysed separately – but can be done through varying the gap Economic growth  Assumptions based on ECON in-house analysis and forecasts from Deutsche Bank Weather  Not modelled demadn varations due to weather, but analysed through sensitivity analysis

22. 22 Assumptions, cont. Abatement costs and fuel prices  Power sector most important sector (in the short run)  Fuel prices based on observed spot prices for 2005 and forward prices for 2006 and 2007  Seasonal variation in gas prices

23. 23 Assumptions, cont. Generation and transmission capacities are actual capacities in 2005 and adjusted for known investments and closures in 2006 and 2007. No endogenoues investments (short run) Lower price elasticity of power demand in the short run (-0.2 to -0.4)

24. 24 Results – allowance price Base case Allowance price

25. 25 Results – allowance price Sensitivity: Low gas price Allowance price

26. 26 Results – allowance price Sensitivity: Events in 2005 Allowance price

27. 27 The Kyoto period No model simulations made Simulations for 2005-07 indicate that a change in the gap (over three year) of 1 Mt change the allowance price with €0.1 Price range: €15-70  Without imports MAC likely to be lower with more abatement possibilities

28. 28 Cost of CO 2 emissions Short term power price effect Produce if: Power price > Marginal cost of fuel plus carbon Carbon allowances have an alternative market value Total capacity Fuel costs P>F+C: Sell power F<P<C: Sell credits P<F: Sell credits 100% free allocation: 100% windfall profit Different plants in different hours

29. 29 Effect on average price level No effectSmall effect Large effect Small effect Effect on average prices depends on capacity mix and load pattern Price Volume

30. 30 Electricity price – base case

31. 31 Electricity price in Sweden 2005:

32. 32 Distortions of short-term price effects Market power  Monopolists and oligopolists do not pass through the full marginal cost effect in bids Withdrawal of allowances (within trading period)  Reduced emissions t1  reduced allocation t2:  Reduced value of selling credits/additional value of generating ”Grandfathering” (between trading periods)  Emission level period 1 determines allocations period 2 (or 3)  Additional value of generating Rules are not harmonized  Different rules in different countries affect trade

33. 33 Long term power price effect Invest if: Expected average price > Long-term marginal costs Capital costs Fuel costs O&M costs Purchase of Credits ”Need” for allowances What is BAU? -Benchmarking? -BAT? -Same allocation for all kWh Long-term price effect: -Share of free allocations important High share of free allocations -Smaller average price effect -Abatements on the supply side (more gas power) Long-term (expected) average price level (Expected) cost per kWh

34. 34 Allocation rules distort investment decisions Outcome of free allocations: Investments are realized “too early”  Do not take into account the full cost Distortion towards consumption  Reduced price effect reduces incentives for abatements and measures on the demand side Distortion towards carbon-free capacity  Premium for fossil fuel plants (free allowances)  No premium for renewables and CO2 capture and storage Distortion in choice between gas and coal?  DK: Same amount of free allowances NO  DE: Higher amount to coal YES

35. 35 Power price effects in the model Full pass-through of marginal costs in short term (hourly) prices  Demand effects taken into account!  Different plants marginal in different hours  different cost increases in different hours  General pass-through: Average of all hours Long-term pass-through determined by average cost effect on new plants  High share of free allowances: Small price effect  increased gas power investments and generation  Low share of free allowances: Large price effect  reduced consumption (and some new gas) New investments and the gap  Assume free allowances are taken from NER and left- overs are cancelled

36. 36 Contacts Niclas Damsgaard Partner, ECON Analysis niclas.damsgaard@econ.se

37. 37 ECON – Contact information Oslo ECON Analysis Headquarter/ ECON Management P.O.Box 5, N-0051 OSLO Biskop Gunnerus’ gate 14A Phone: +47 45 40 50 00 Fax: +47 22 42 00 40 (Analyse) Fax: +47 22 41 41 44 (Management) e-mail: oslo@econ.nooslo@econ.no Copenhagen Nansensgade 19, 6. sal DK-1366 København K Denmark Phone: +45 33 91 40 45 Fax: +45 33 91 40 46 e-mail : copenhagen@econ.no Stockholm Artillerigatan 42, 5 tr SE-114 45 STOCKHOLM Sweden Phone: +46 8 528 01 200 Fax: +46 8 528 01 220 e-mail : stockholm@econ.se Stavanger Kirkegaten 3 4006 STAVANGER Telefon: +47 45 40 50 00 e-post: stavanger@econ.no Paris 18, rue de la Perle F-75 003 PARIS Frankrike Telefon: +33 1 45 78 70 03 Telefaks: +33 1 48 87 44 39 e-post: paris@econ.no