1. Next steps for ETS - The 2007 review Karsten Neuhoff University of Cambridge European Wind Energy Conference Milan 9 th of May 2007 www.climate-strategies.org/ www.electricitypolicy.org.uk/tsec/2

2. Karsten Neuhoff, 2 (I) Objective: effective and efficient (II) Objective: investment security (III) Interaction with renewables policy Next steps for the European Emissions Trading Scheme

3. Karsten Neuhoff, 3 Increased expenditure on extending plant-life Inefficient fuel choice Less efficiency improvements Auction Capacity only X Capacity by fuel/plant type XX Output only XX Output by fuel/plant type XXX Emissions XXXX Discourage plant closure Shields output from average carbon cost Reduce incentives for Efficiency-improving investment Impacts Updating from Previous periods Benchmarking X X Distortion biased towards coal These distortions from repeated free allowance allocation can be ranked in a pyramid Source: Neuhoff, K., Keats, K. and Sato, M., 2006, Allocation, incentives and distortions: the impact of EU ETS emissions allowance allocations to the electricity sector, Climate Policy, 6 (1) Objective: Effective and efficient – process optimisation

4. Karsten Neuhoff, 4 … and we seem to have made little progress moving on Source: Neuhoff, K., Rogge, K., Schleich, J., Sijm, J., Tuerk, A., Kettner, C., Walker, N., Åhman, M., Betz, R., Cludius, J., Ferrario, F., Holmgren, K., Pal, G., Grubb, M. and Matthes F., 2006, Implications of announced Phase 2 National Allocation Plans for the EU ETS, Climate Policy 6(5) pp. 411-422. Installed capacity PPP Projection for production PP Historic production PO Installed capacity Projections of production P Historic Production Projections OOP / O P Historic Emissions OO-Not defP / O O AT*BE -WBE - FBE - BCYCZ**DEDK**EEES*FIFRGR Installed capacity Projection for production P P / O Historic production Installed capacity P Projections of production P PP / O Historic Production Projections P / O O P O Historic Emissions P P / OO P HU*IEIT*LTLULVMTNLPLPTSESISKUK Benchmarking Uniform Tech / Fuel spec. Emission based Increasing Distortion NAP II not analysed yet / No translation available NAP II not available Uniform Benchmarking Emission based Tech / Fuel spec. Objective: Effective and efficient - process optimisation

5. Karsten Neuhoff, 5 And the level of allocation is not trivial Source: Neuhoff, K., Rogge, K., Schleich, J., Sijm, J., Tuerk, A., Kettner, C., Walker, N., Åhman, M., Betz, R., Cludius, J., Ferrario, F., Holmgren, K., Pal, G., Grubb, M. and Matthes F., 2006, Implications of announced Phase 2 National Allocation Plans for the EU ETS, Climate Policy 6(5) pp. 411-422. Objective: Effective and efficient - process optimisation

6. Karsten Neuhoff, 6 Prices drive substitution (with regulatory/institutional support) Source:Newbery, D. M. (2003) Sectoral dimensions of sustainable development: energy and transport. Economic Survey of Europe 2(73-93). Objective: Effective and efficient – substituting (intermediary) products

7. Karsten Neuhoff, 7 Phase I 2005-07 Phase II 2008-12 Develop options for different international outcomes Global or sectoral agreements Efficient production Environmental costs reflected in price Innovative market response Border tax adjustment* Allocation pro- portional to output We will find the best solution in an international dialogue. *Ismer/Neuhoff, 2004, Border tax adjustments: A feasible way to address non-participation in emission trading, CMI/DAE WP 36. How do address competitiveness effects?

8. Karsten Neuhoff, 8 (I) Objective: effective and efficient –Emissions reductions from process optimisation –Emissions reductions from substitution effects –> Auctioning (II) Objective: investment security (III) Interaction with renewables policy Next steps for the European Emission Trading Scheme

9. Karsten Neuhoff, 9 Stern 2006 In the next 10 to 20 years … transition... to [a world] where carbon pricing is universal and is automatically factored into decision making. … avoids the risks of locking into a high-carbon infrastructure … additional measures may be justified to reduce the risks." Objective: Investment security

10. Karsten Neuhoff, 10 Projection uncertainty implies price uncertainty Source: Emissions Projections 2008-2012 versus NAP2 (2006) by Karsten Neuhoff, Federico Ferrario and Michael Grubb. Published in Climate Policy 6(5), pp 395-410. Create mid-term confidence in CO 2 price to facilitate low Carbon investment

11. Karsten Neuhoff, 11 10% auctions with price floor could facilitate investment Free allocation Coordinated auction with price floor can reduce risk of low prices Price set by price floor Free allocation Source: Emissions Projections 2008-2012 versus NAP2 (2006) by Karsten Neuhoff, Federico Ferrario and Michael Grubb. Published in Climate Policy 6(5), pp 395-410. Create mid-term confidence in CO 2 price to facilitate low Carbon investment

12. Karsten Neuhoff, 12 Proposed approaches to create long-term stability Increased use of banking* Open market intervention Splitting allowances as under US clean air program Longer commitment periods * Newell, R., W. Pizer and J. Zhang (2005) Managing Permit Markets to Stabilize Prices. Environmental and Resource Economics 31(2): P.133 - 157. Create long-term confidence in CO2 price to facilitate low Carbon investment

13. Karsten Neuhoff, 13 Expected (Ex Ante) and Actual (Ex Post) Total Costs of some UK Policies during 1990-2001 * Upper estimate >£8000 mio. Source: AEA Technology Environment, 2005, An Evaluation of the Air Quality Strategy, Report to DEFRA, available at: http://www.defra.gov.uk/http://www.defra.gov.uk/ 0 1000 2000 3000 4000 5000 6000 Lead Free Petrol Euro I petrol Cars* 2000 fuel standards 2005 fuel in 2000/1 Flue Gas De- Sulphurisation (FGD) Low NOX burners Costs (£M) ex ante ex post Create long-term confidence in CO2 price to facilitate low Carbon investment

14. Karsten Neuhoff, 14 Option contracts could create long-term price floor Governments sell option contracts to private parties Creates property right, strong enforceability Investors can call an option: –Hands in option + CO 2 allowance –receives strike price, e.g. 15 Euro/t CO 2 Direct hedge for investment Investors will call options if p CO2 <15 Euro/tCO 2 –Reduces supply, pushes up price, implements price floor Governments avoid buying back allowances –Restricts issuing allowances to retain scarcity price Ismer, R. and Neuhoff, K. (2006) 'Commitments through financial options: a way to facilitate compliance with climate change obligations‘, EPRG WP 06/25 Create long-term confidence in CO2 price to facilitate low Carbon investment

15. Karsten Neuhoff, 15 (I) Objective effective and efficient –Emissions reductions from process optimisation –Emissions reductions from substitution effects –> Auctioning (II) Objective investment security –Why is it an issue? –>Price floor in auctions –>Long term option contracts (III) Interaction with renewables policy Next steps for the European Emission Trading Scheme

16. Karsten Neuhoff, 16 price time, cumulative sales market size existing technology CO 2 price internalisation and technology policy saved costs learning costs reduced by CO 2 policy additional benefits with CO 2 price ETS is no substitute for technology policies (e.g. renewable support) Interactions between CO2 and renewables policy

17. Karsten Neuhoff, 17 Interactions between CO2 and renewables policy What are the implications for renewables investment Price uncertainty from ETS +Price/revenue uncertainty transmission constraints +Intra-annual volatility and balancing costs ---------------------------------------------------------- Significant market and regulatory uncertainty

18. Karsten Neuhoff, 18 Our model outputs: Wind output Wind investment CCGT investment * * * * * * * * Regional build constraint binding – build constraints create scarcity rent Future environment for renewables - congestion and balancing Source: Neuhoff,K Cust, J and Keats,K, 2007, Modeling wind in the electricity sector, EPRG working paper 0702

19. Karsten Neuhoff, 19 Results in more volatile and peaky prices 0 10 20 30 40 50 60 70 80 90 100 Euro/MWh 2005 2010 20152020 0 1 year Illustrative Future environment for renewables - congestion and balancing

20. Karsten Neuhoff, 20 In the real world, it is all about who carries the risk RO design Energy price Balancing costs Impact transmission constraints Project risk and developers margin ROC market Costs Project revenue requirement Performance/operation Regulatory uncertainty Future market evolution Risk from: Profit for inframarginal technologies/locations RO design Energy price Balancing costs Impact transmission constraints Project risk and developers margin ROC market Costs Project revenue requirement Performance/operation Regulatory uncertainty Future market evolution Risk from: Profit for inframarginal Reduce (a) infra-marginal rent (b) regulatory risk (c) re-allocate risk from future technology mix/fuel prices Addressing regulatory risks reduces financing costs Source: Johnston, Kavali and Neuhoff, 2007 Take-or-pay contracts for Renewables Deployment, EPRG Working Paper 0707. Banded ROC Fixed & banded ROC Take or pay contract ROC

21. Karsten Neuhoff, 21 (I) Commit to auctions of most allowances –Avoids delays in emission reductions (early action problem) –Positive for distributional impacts, innovation, credibility (II) Consider instruments to avoid low prices –Price uncertainty delays (low Carbon) investment –E.g. use price floor in auction, long-term option contracts (III) Renewables policy –For many technologies CO 2 price alone too low –In addition significant uncertainty about market design (congestion, balancing, CO 2 ) –Provide long-term stability (e.g. take or pay contracts) Next steps for the European Emission Trading Scheme