1. Performance based emissions trading post 2012 IIR Conference “CO 2 in the Industry” Carlton Oasis Hotel Spijkenisse, Netherlands, 19-20 September 2007 Vianney Schyns Manager Climate & Energy Efficiency Utility Support Group Utility provider for a.o. DSM and SABIC Vianney.Schyns@usgbv.com Jan Berends Manager Environment & Product Safety Royal DSM Jan.Berends@DSM.com

2. 2 Contents 1.Present political situation 2.Failures present EU ETS rules – examples at DSM & SABIC 3.Key aspects of benchmarks 4.Benchmarks ex-ante or ex-post 5.Setting the total cap 2013-2020 – effectiveness 6.Conclusion 7.Annexes

3. 3 Present political situation (1) Historical grandfathering was a historical mistake =Recognised by EU Commission 3 rd Trading period: perhaps auctioning for electricity & (partial?) auctioning and/or benchmarking for industry EU Commission will come with a proposal December 2007 – then co-decision EU Parliament & Council –Takes 1.5 – 2 years, is no decision for single Member State Benchmarking for allocation to operators =Ex-ante: based on historical production =Ex-post: based on actual production

4. 4 Present political situation (2) Industry is against auctioning –Auctioning electricity =Electricity prices remain high  bad for competitiveness / leakage =Windfall profits nuclear, hydro (EU 45%)  what about France (90%)? =Revenue recycling poses problems with effectiveness of EU ETS –Auctioning industry =Bad for competitiveness, “leakage” by production relocation –Auctioning with Border Tax Adjustments at EU borders is neither practical (huge bureaucracy) nor politically desired

5. Failures present rules of the EU Emissions Trading Scheme Examples DSM & SABIC

6. 6 Chemelot examples of ineffective allocation Incumbent plants –Efficiency factor ß (total energy worldtop / total energy actual) of all plants and all energy use/CO 2 -emissions is related only to local emission of few plants  Incentive CO 2 reduction largely taken away  SEE ANNEX for example Chemelot New entrants (new plants or extensions existing plants) –Dutch rule = “never more allowances than needed”, zero incentive for investments in cleaner technology  New DSM melamine plant: 70% better than Best Practice  Previous design work new SABIC large scale plant

7. Key aspects of benchmarks Few benchmarks – high coverage Suitable benchmark formula Benchmarks take account of all energy carriers Benchmarks in a direct emission scheme Same effectiveness as auctioning Examples chemical industry

8. 8 Few benchmarks – major coverage, Pareto Few benchmarks – major coverage, Pareto Benchmarking Netherlands: about 90 100% Coverage of emissions under the EU ETS Electricity (1) and for CHP (Combined Heat & Power) (1 for heat) Steel (6-7) Cement (2) Refineries (1) Major chemicals (20-30) Policy recommendation: include (co-)firing biomass Allocation: Vital few: about 40 benchmarks Trivial many: basis is own efficiency, “be generous”, give incentive to reduce emissions

9. 9 Suitable benchmark formula Benchmark = WAE – CF x {WAE – BP}

10. 10 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.

11. 11 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

12. 12 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 = 150 + 150 = 300 Year n, BM = 700: incentive = 200 + 100 = 300  Predictability of investment climate

13. 13 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)

14. 14 Examples chemical industry prove it works Once defined, benchmarks are quite straightforward

15. Benchmarks ex-ante or ex-post Quality of historic production data & forecasts Guarantee of total cap Solution of “production subsidy”

16. 16 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, SEE ANNEX

17. 17 Quality of historic data & forecasts for states What means a historic cap: many new plants enter the market? –Many new power plants in Italy around 2009.. Germany.. NL What means a historic cap: import or export of product? –More electricity import NL from Germany – Is NL then doing well? –New CHP in Luxembourg – Is Luxembourg doing bad? What means a historic cap: economy is strongly recovering? –Forecast of growth in central Europe, seven legal cases European Court of Justice against EU Commission: Czech Republic, Estonia, Hungary, Latvia, Poland, Slovakia, Lithuania –Influence Burden Sharing on allocation is perverse Solution: benchmarks linked to actual production

18. 18 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

19. 19 Benchmarking in the product chain Benchmarking with ex-post adjustment to actual production provides incentives in the product chain … avoids “production subsidy” effect (= higher electricity demand by lower electricity prices) Electricity and heat generation Industrial manufacturing plant with use of electricity and heat Fuel Electricity Product Heat, from CHP or from boilers Fuel … the efficiency of the production of electricity & heat … the efficiency of the use of (fuel), electricity & heat Feed

20. Setting the total cap 2013-2020 while maintaining an effective CO 2 -price Ex-post cap maybe too stringent: exploding CO 2 -price Ex-post cap maybe too soft: collapse CO 2 -price What is the solution?

21. 21 Setting total cap 2013-2020 – effectiveness Total cap may appear to be too stringent –Renewables behind target, delay phase-out German nuclear, 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  Target is to maintain a realistic CO 2 -price to ensure a robust and predictable EU ETS for companies to reduce emissions

22. 22Conclusion  Performance-based allocation -Can be realized with guarantee of the total cap -Creates same incentives for emission reduction as auctioning -Can be the basis for a stable & gradually increasing CO 2 -price

23. 23 Transition for a global trading scheme Benchmark: Specific energy use or CO 2 emission 2012201720222027 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

24. Annexes What’s wrong with present EU ETS rules

25. 25 Benchmarking 2008-2012 to Chemelot incumbent plants B. Combined heat & power Swentibold in ETS C. Utility production site Chemelot “EdeA” in ETS A. External power Plants in ETS D. Plants outside ETS 2008-2012: ammonia, nitric acid, fertilisers, melamine, polymers, etc. E. Plants in ETS 2008-2012: two steam crackers CO 2 Electricity Steam Permit site Chemelot = C + D + E Allocation permit site Chemelot = ß D + E x emission E + ß C x emission C while for example: emission C could be too high, although ß C = 1.0 Ineffective allocation – lack of incentive – no true benchmarking

26. 26 Benchmarking 2008-2012 to Chemelot incumbent plants Assume for Chemelot –Units A, B, C, D, E all 20 PJ and all 1.2 Mton –Total = 100 PJ and 6 Mton (Chemelot footprint) –Benchmark worldtop = 80 PJ = 4.8 Mton Present allocation Chemelot –ß D + E (= 80/100 = 0.8) x 1.2 + ß C (=1.0) x 1.2 = 2.16 Mton Assume projects to reduce emissions –Units A, B, C, D, E all 15 PJ and all 0.9 Mton –Total = 75 PJ and 4.5 Mton (Chemelot footprint) –Saving: 1.5 Mton Future allocation Chemelot –ß D + E (= 80/75 = 1.07) x 0.9 + ß C (=1.0) x 0.9 = 1.86 Mton –Allocation incentive: 0.3 Mton versus 1.5 Mton realised

27. 27 Present ETS rules: new entrants & closures  Unsolvable dilemmas new entrants (NE) & closures (C) (see e.g. also Grubb and Neuhoff, Stern, Egenhofer, Weishaar, Matthes, Schyns, Ecofys report for the EU Commission)  Theory: freeze allocation [all allowances after C & zero for NE]  Zero for NE actually hinders low carbon investments/competitiveness  Retaining allowances after C – how long? – is worse than transfer rules as it enhances market concentration  Withdrawal allowances after C: perverse incentive keeping inefficient plants in operation  Most authors elaborate these problems, but fail to conclude that within individual ex-ante frozen caps solutions are simply impossible  search for squared circle

28. 28 Basics of shortcomings present allocation Existing plants: allowances ex-ante frozen cap based on historical emissions – rewarding pollution – 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

29. 29 Ex-ante rules prevent electricity liberalisation State interference prevents competitive market –At gross margin of opportunity-cost, winning and losing market share: zero sum game; at higher gross margin: distortions –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 € 40-50 billion/year or double (EU-27)

30. 30 Cap & trade: market price > opportunity-cost Euros for an equal total production volume Companies A & B A wins market share from B Companies A & B: same production, efficiency and same quantity of allowances Gross margin cash flow Opportunity cost Mark-up Cost of buying allowances: = distortion Profit of sales of Allowances = distortion Net profit A B Net loss

31. Annexes Benchmarking

32. 32 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

33. 33  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

34. 34 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 Buying allowances Best Practice IncentiveWeighted average Incentive High market liquidity

35. 35 Performance-based 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 Buying allowances Free allocation Best Practice IncentiveWeighted average Incentive Selling allowances benchmark = total cap High market liquidity

36. 36 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

37. 37 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

38. 38 Misunderstandings power market cleared Fuel specific benchmarks: against objective function =With ex-post: high fuel-switch prices, e.g. € 300-500/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) =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 at same CO 2 -price as cap & trade & auctioning =In fact more gas if more new coal and less CHP (given a total cap) =We need a controlled transition (CCS needs time)

39. 39 References References: http://www.dsm.com/en_US/html/sustainability/emission_trading.htm “Climate change challenges and the search for a sustainable policy”, 21 June 2005, 8th International Conference on Carbon Dioxide Utilisation (ICCDU- VIII) 20-23 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 21-22 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”.