Memorandum submitted by the Association
of Electricity Producers
The Association of Electricity Producers (AEP)
represents large, medium and small companies accounting for more
than 90% of the UK generating capacity, together with a number
of businesses that provide equipment and services to the generating
industry. Between them, the members embrace all of the generating
technologies used commercially in the UK, from coal, gas and nuclear
power, to a wide range of renewable energies. Members operate
in a competitive electricity market and they have a keen interest
in its success—not only in delivering power at the best
possible price, but also in meeting environmental requirements.
The Association welcomes the opportunity to
respond to the Environmental Audit Committee's inquiry. Contact
details for the Association are given at the end of this paper.
We note that this inquiry is designed to assess
the prospects for the remainder of Phase 1, and the lessons that
should be applied to Phase 2 of the EU Emissions Trading Scheme
(EUETS). However, with Phase 1 under way and the arrangements
for Phase 2 now largely complete, it is essential for governments
to drive forward the preparatory work for the continuation of
the EUETS beyond 2012 at international, EU and national level.
1. What are the key lessons to learn from
Phase I of the Scheme?
Firstly, it is essential that caps on CO2
emissions across all Member States are sufficiently tight to deliver
the EU's Kyoto commitments. Most Member States were "long"
on allowances in 2005. Secondly, it must also be recognised
that all sectors in the EUETS must share the burden of reducing
emissions. These two issues are fundamental to establishing an
efficient market which will drive businesses to internalise the
cost of carbon and underpin a robust carbon price to support new
investment at scale.
2. How likely is it that UK firms would successfully
reduce emissions by at least 7MtC by 2012, in line with the proposed
Phase II NAP?
The Association supports the use of market mechanisms
and considers that the EUETS can deliver cost-effective emissions
reductions across the EU up to, and beyond, 2012. However, it
is a fundamental feature of the trading scheme that it will deliver
emission reductions most rapidly at the sites across the EU where
they can be achieved at least cost. It is therefore important
that the Government makes it clear that, while the EUETS has the
potential to deliver reductions in CO2 within the UK
in due course, and play its part in helping to achieve UK domestic
targets, it may not do so immediately. The least-cost compliance
route may be for UK operators to buy allowances.
UK generators have been required by the Government
to shoulder the burden of emissions reductions in Phase 1 of the
Scheme unilaterally and, on the basis of the UK National Allocation
Plan (NAP) that was submitted to the European Commission in August
2006, are most likely to be required to do the same in Phase 2. There
is not enough time for power station operators to invest to achieve
the physical reductions required in Phase 1, or a sufficiently
high allowance price for them to deliver the necessary reductions
by switching fuels from coal to gas, so operators will have to
purchase allowances to achieve compliance. Based on analysis of
current Member States' NAPs, it is quite possible that a similar
situation will arise in Phase 2.
Even so, the Sector routinely continues to seek
gains in efficiency through, for example, the re-fit of boilers
and turbines, and the existence of EUETS will add to the incentives
to undertake these projects. Putting a value on carbon has also
aided the economics of achieving emissions reductions through
the co-firing of biomass with coal or oil, and in 2005 this resulted
in the sector generating about 3 TWh that were eligible for Renewable
Obligation Certificates. In addition, one plant in the Sector
was converted from a CCGT to a CHP plant with significantly improved
efficiency.
There is evidence that the price of CO2
is being factored in to the wholesale power price and therefore
affecting the merit order for generation, but the overriding influence
on decisions to use coal or gas in most of 2005 was the high price
of gas. There were signs of some level of switching during the
summer last year, but with the very high gas prices seen in Q4,
output from coal-fired stations increased compared to 2004, thereby
raising overall CO2 emissions for the Sector.
3. What have been the effects of the method
chosen for allocating allowances in Phase I?
The Power Station Sector was the only sector
in the UK Phase 1 NAP that was not allocated allowances equivalent
to its projected emissions. The Sector therefore carries the responsibility
of delivering all UK emission reductions within Phase 1 of the
EUETS ie 67 Mt CO2, or procuring further allowances
from the traded market. That figure includes 19.8 Mt CO2
that the UK Government had intended to allocate to the sector,
based on revised projections of emissions published by DTI in
November 2004, but was prevented from doing so by the European
Commission. The UEP 26 projections published in July 2006 indicate
that electricity demand and the emissions from the Sector in 2010
will be higher than were projected in 2004. This means that
the expected decrease between 2005 and 2007 will be less than
was projected for the Phase 1 NAP.
In 2005, the difference between allowances allocated
to installations in the Sector and the actual emissions from those
installations was 36.6 Mt CO2. This situation is likely
to be replicated in the remaining two years of Phase 1, leaving
the Sector with a shortfall of allowances in excess of 100 Mt
CO2. Given the relatively short timescale of Phase
I, any emission reductions in the power generation sector are
most likely to result from fuel switching from coal to gas, as
there is insufficient time in Phase 1 for electricity producers
to effect major investment in low-carbon technologies. Therefore,
given relative coal and gas prices, operators have been, and will
continue to be, obliged to purchase additional allowances in the
market to cover the significant shortfall allocated to the electricity
sector.
4. Has the Government identified the correct
proportion of allowances to be auctioned in Phase II? Should these
be drawn solely from the power sector's allocation? What will
the effect of this auctioning be on industry and the price of
carbon?
We are disappointed that the electricity producers
have, once again, been singled out to bear the entire shortfall
of emissions allowances in Phase 2, including the impact of auctioning.
Based on our experience of Phase 1, we expected that we would
be called upon to make a significant contribution to emissions
reductions in Phase 2, but had formed the impression from discussions
with officials that a high level of emissions reduction within
the Government's stated range of effort would be offset by a low
percentage of auctioning and vice versa. It is now clear that
we are the only sector being asked to make any level of effort
and to bear single-handedly a high percentage of auctioning.
It is clear from the results of trading in 2005
that other sectors in the Scheme have been allocated more than
they need and we are disappointed that the Government has not
given those sectors the slightest encouragement to participate
fully in the EUETS by reducing their allocation below "Business
As Usual" in Phase 2. Similarly, other sectors should
be required to bear a proportion of the auctioning burden. We
believe that over-allocation to other sectors is undermining the
scheme. Over-allocation results in industrial installations not
being motivated to manage their carbon allocation. This has two
major consequences: (a) limited incentive to seek emissions reductions
and (b) limited release of surplus allowances into the market
which results in allowance price volatility and higher compliance
costs to those required to buy allowances to meet their obligations
under the trading scheme.
5. What have been the effects of Phase I
so far on the competitiveness of (1) business in the UK, and (2)
business across the EU?
We consider that the direct impacts of the EUETS
on the competitiveness of EU industry in Phase 1 have been minimal.
This is backed up by the work of a number of analysts, drawing
on the limited international mobility of some of the sectors currently
covered by the EUETS and the limited costs incurred, if any, by
businesses outside the electricity sector in complying with the
EUETS.
All sectors in the EUETS must share the burden
of reducing emissions. Competitiveness issues have been overplayed
in Phases 1 and 2 to justify "Business As Usual" allocations
for the majority of sectors. A BAU approach is not sustainable
if the UK is to achieve a 60% reduction in CO2 emissions
by 2050. These issues must be fully understood and addressed
at an EU level in Phase 3. They are fundamental to establishing
an efficient and transparent market which will underpin a robust
carbon price to support new investment at scale.
6. What are the key issues for Phase II in
terms of ensuring that emissions reductions from EU states are
not cancelled out by the transferring of industry to developing
economies?
There are two main impacts on EU industry arising
from putting a price on CO2 emissions. These are the
direct requirement for industry to buy allowances to meet any
shortfall in allocation compared with emissions, and the indirect
impact of carbon allowance prices on electricity prices. The apparent
over-supply of allowances based on current Member State NAPs suggests
that the CO2 allowance price will be insufficient to
have any adverse impact, so the transfer of industry to developing
countries will be driven by factors other than EUETS, if it occurs
at all.
Electricity producers will not close their operations
in the UK and transfer to developing countries. However, companies
have to compete for capital and if the policy framework and details
of the EUETS are not right, investment in low-carbon technologies
will not be made in the UK. Consequently, emissions will not reduce,
electricity producers will face additional costs for purchasing
allowances and both the environment and customers will suffer.
The experience of the first year in Phase 1 of the EUETS is that,
despite year-end returns recording an over-supply of allowances,
the UK electricity sector purchased over 30 million tonnes at
prices between €10 and €30 per tonne CO2.
7. How well are the EU ETS and the Clean
Development Mechanism working together? What needs to be done
to better integrate these markets? Is the CDM funding the right
projects?
The Joint Implementation and Clean Development
Mechanism are good interim measures for transferring capital and
technology. We are therefore disappointed that a disproportionate
limit (9.3%) on the use of project credits has been placed on
installations in the Large Electricity Producers Sector in the
UK's NAP for Phase 2. We estimate that more than 50% of the
potential to use JI and CDM may be lost through the means of applying
the limit. This would in effect result in the UK meeting a relatively
small proportion of effort through JI/CDM which would in turn
put upward pressure on the EUA price. The proposed arrangement
will at the very least encourage arbitrage of project credits
by companies in sectors with no shortfall of allowances. This
will inevitably raise the effective cost of ERUs/CERs, will not
promote the efficient functioning of the Scheme, and will reduce
the overall credibility of the Kyoto framework.
8. How should aviation be included within
the ETS? What are the latest indications of when it will be included?
As the Aviation sector is not covered by the
Kyoto Protocol, we consider that it should be included in the
EUETS after 2012. The Government should seek to avoid disturbance
to the trading market and to avoid possible price dislocation.
The scope of trading initially should be restricted to CO2
emissions only.
9. The Environment Secretary has said: "we
will support the Commission in its efforts to enforce tough caps".
What exactly should the Government be doing to influence this?
It is essential that we strengthen the resolve
of the Commission in its review of the Phase 2 National Allocation
Plans to ensure that these are sufficient to deliver the EU's
Kyoto commitments across all Member States. Unless we can develop
an efficient and transparent market which engages all participants,
the credibility of the Scheme may be damaged to a point where
it may not incentivise emissions reductions on the scale required.
We have written to the Secretary of State for the Environment
in support of his idea for an "EUETS Manifesto" and
we now await the Government's proposals for taking that forward.
10. How well integrated are the ETS and other
EU climate change policies?
There is relatively little linkage between ETS
and other EU climate change policies at present. In the UK, the
linkage is mainly due the fact that Phase 2 is being used to close
most of the gap on the Government's 2010 target for CO2
emission reductions, due to the failure of other climate change
policies to deliver.
11. What work needs to be done now to help
design a third phase of the EU ETS? How can the experience of
the EU ETS be used to help the design of a post-2012 Kyoto mechanism?
In our response to the Government's consultation
on "Our Energy Challenge" published in January 2006,
we identified that the climate change agenda is critical and called
for "a clear and credible regime for the reduction of carbon
emissions in the form of specific policy mechanisms with long-term
and intermediate targets and aspirations". We were therefore
pleased to see in the Energy Review Report published in July 2006
that "the Government is determined to ensure that the EUETS
develops into a credible long-term international framework for
pricing carbon". Businesses in our sector now face a period
of substantial capital investment, amounting to some £20
billion by 2020, if they are to maintain security of electricity
supply, promote the development of a diverse generating portfolio
and move towards the installation of lower carbon technologies.
It is vital for investment decisions in low/zero carbon technologies
with long development lead-times that a robust carbon pricing
mechanism is in place.
We recognise that international agreements are
unlikely to emerge quickly, but late agreements on burden-sharing
within the EU could lead to the adoption of another short trading
period (without an associated long-term emission reduction trajectory),
which would threaten the viability of the EUETS and fundamentally
undermine the case for large-scale investment in low-carbon technologies.
Whatever emissions reduction target emerges for the EU for the
post-2012 period, it should be possible to begin discussions early
on the means to share that burden between Member States. The metric
for burden-sharing eg on a per capita basis, should be considered
at an early stage because the sooner that is agreed, the more
certainty investors will have. It may also serve as an example
for developing countries and inform debate on the future role
of other Kyoto flexible mechanisms such as Joint Implementation
(JI) and the Clean Development Mechanism (CDM).
Looking ahead, the Government needs to define,
and ideally gain widespread political support for, a clear framework
and trajectory for UK CO2 emissions reductions, within
a wider EU and international context, out to at least 2030. To
build investor confidence, future allocation periods should be
aligned more closely to investment cycles and should run for at
least 15 years. For electricity producers, the five-year period
post-2012 is critical for investment and reducing carbon because
the plant that is deployed then will be "locked in"
for 40 years. Other priorities for the design of the Scheme are:
— All sectors in the EUETS must share
the burden of reducing emissions. Competitiveness issues have
been overplayed in Phases 1 and 2 to justify "Business As
Usual" allocations for the majority of sectors. These issues
must be fully understood and addressed at an EU level in implementing
Phase 3. They are fundamental to establishing an efficient
market which will drive businesses to internalise the cost of
carbon and underpin a robust carbon price to support new investment
at scale.
— The harmonisation of rules relating
to allocation, treatment of new entrants and closures is important
to limit market distortions and minimise competitive impacts,
but this must be addressed soon to be in place in time for Phase
3.
— A key uncertainty in trading post-2012
is the role of the JI and CDM mechanisms, or their equivalent,
and the potential constraints on the use of credits derived from
them by participants in the EUETS. The future of JI/CDM, at least
to 2030, must be agreed in international discussions on the post-Kyoto
period.
— AEP supports the inclusion of other
sectors and gases within the Scheme in principle, provided this
is practical, cost-beneficial and well-signalled. However, initiatives
to expand the EUETS must not undermine confidence in the Scheme
as a firm basis for investment.
October 2006
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