Memorandum submitted by Climate Change
Capital
1. SUMMARY
— Phase 1 of the EU ETS should be regarded
as a learning phase. It has been successful because it has placed
a value on carbon and enabled a functioning international carbon
market to be put in place prior to the Kyoto compliance period.
However, the impact of the EU ETS may have been disappointing
to some observers, since the major impacts have been:
— Windfall profits for the utility
sector.
— Little change in operating behaviour.
— No investment in Europe yet.
— Large scale investment in developing
countries.
Three are three major drivers for this outcome.
First, the over-allocation of allowances, caused by incomplete
emissions data at the outset. Second, the availability of low
cost allowances from the developing world due to the ability to
import allowances created by reducing emissions of exotic gases
in the developing world, but not within the European scheme. Third,
the lack of any price visibility post-2012.
These shortcomings may be remedied. The actual
emissions data for 2005 should allow better allocation of allowances
for Phase 2 and clarity on the post-2012 framework should do much
to improve the financial attractions of investments to reduce
CO2 emissions, especially as the cheaper exotic gas
opportunities are exhausted.
2. INTRODUCTION
TO THE
AUTHORS
Climate Change Capital is a specialist investment
banking group that occupies a distinctive position. With access
to a substantial and flexible capital base, we focus on businesses
created or affected by the convergence of laws and polices on
energy and the environment. Our dedicated team of 90 professionals
located in London, Washington, Madrid and Beijing are experts
in the fields of renewable energy, clean technology, biofuels
and emissions reductions markets.
Kate Hampton is responsible for our relations
with the policy community. She is a Sherpa to the EU High Level
Group on Competitiveness, Energy and Environment, advising the
European Commission. She rejoined the company in January 2006
from a year's secondment as a Senior Policy Advisor to Defra for
the UK's G8 and EU Presidencies where she worked on the future
of international climate change policy. Before joining CCC, Kate
was Head of the Climate Change Campaign for Friends of the Earth
International. She is the former Convenor of the Green Globe Network,
an expert advisory group funded by the Foreign and Commonwealth
Office. She was a research associate at the Institute for Policy
Studies in Washington DC and an EU policy consultant for Environmental
Resources Management. Kate holds a BSc from the London School
of Economics and a Masters in Public Policy from the Kennedy School
of Government at Harvard University.
Dr Tony White, MBE is Climate Change Capital's
Head of Advisory. Tony has been involved in almost all aspects
of the energy industry, ranging from renewable energy research
through to strategy, finance, international development and policy.
He has made major contributions to the evolution of the industry
during this time. Having been the analyst for the UK Government's
broker during the liberalisation and privatisation of the England
& Wales electricity industry in 1990, he recognised the different
role required of network companies serving competitive power markets.
This led to the introduction of the Transmission services scheme
in England & Wales and was the driving force behind the UK
Government's recent review of distributed generation. During the
period 1996 to 2003, he was the head of the pan European Utilities
Equity Research team at Kleinwort Benson, then Citigroup. Under
his leadership, the team became ranked as the "team of teams"
in the Extel survey of equity research and was ranked top European
utility team by "Institutional Investor". He has been
at the forefront of understanding the impact of liberalisation
on the generation sector, correctly forecasting the path of power
prices in Europe and the USA. He is a non Executive Director of
the New and Renewable Energy Centre at Blyth and a member of the
Advisory Boards of the United Kingdom Energy Research Centre and
the Energy Centre at Sussex University. He has a BA in Physics
and D.Phil in Biophysics from Oxford University and an MBA in
Finance from the City University Business School.
3. DETAILED RESPONSE
3.1 What are the key lessons to learn from
Phase 1 of the scheme?
Phase 1 of the EU ETS has established a price
for emissions reductions, which should be regarded as being helpful.
The first period of the scheme has been set
for just three years and, although the outline for the second
phase's five years has been determined, the amount of abatement
required of the scheme will not be determined until late 2006.
This is the fundamental driver of the market. Investors have not
regarded the price for the first five years as a firm indicator
for the second and so are not taking investment decisions based
upon it. The corollary of this is that investments based on savings
from emissions reductions alone require a three (now one) year
payback. There are not many opportunities that provide such immediate
returns.
This leads to the realisation that most decisions
are being taken on the basis of short run marginal cost considerations.
As such, the simplest way for the European traded sectors to reduce
emissions is for coal-fired stations to cut back their output
and for production to be increased at gas stations to compensate.
Thus the allowance price should be related to the prices of coal
and gas, as well as their associated emission factors and efficiency
of conversion to electricity. Figure 1 shows that until verified
emissions data was released in May 2005, the "implied price"
(ie the price of an allowance that equalises the cost of generating
power from coal and gas at particular efficiencies) did follow
the observed price of EU allowances. However, the actual price
was about one third of the implied price. (With the release of
verified data, the correlation became weaker, although it appears
have re-established itself.) There are many possible reasons for
this discrepancy, but what really matters, from an investment
point of view, is that the allowance price is currently driven
by fossil fuel prices. For example, the price of gas has fallen
in the past month from 101 to 91 p/therm; the price of 2006 allowances
has also fallen from €16 to €12 over the same period.
Because fossil fuel prices tend to be volatile, so the value of
allowances is also likely to continue to be volatile, making investment
decisions problematic.
Layered on top of this, we now know from 2005
verified emissions data that Phase 1 of the EU ETS may be on track
to have a 40 Mt excess of allowances. Given this is the case the
allowance price should fall to zero. The reason it has not is
due to a lack of liquidity in the market. In around half the EU
Member States, the power sector was short of allowances along
with a handful of industrial installations. Where there is a shortage,
there is demand for allowances. The power companies have tended
to be the only businesses with the capability to hedge on a month-by-month
basis. Their natural trading partners are other industries, with
the surplus allowances. However, currently industry tends to have
a compliance mentality, so excess allowances have not been released
onto the market, contributing to a lack of liquidity. Allowance
prices have already started to slide in the past month due to
more clement weather and therefore reduced fuel demand and prices.
With the release of the next round of verified data in May 2007,
the allowance price is likely to decline further as industry players
confirm they have enough allowances to cover emissions to the
close of Phase 1. An excess of allowances released onto the market
will probably make it long, driving the price to zero.
All these factors are not conducive to stimulating
investment and underline the need for tight caps across the EU
in Phase 2 and beyond.
Figure 1
PHASE 1 TO AUGUST 2006
Source: CCC analysis
3.2 What have been the effects of the method
chosen for allocating allowances in Phase 1?
Member States have set their own emissions caps.
Allocations in Phase 2 were largely made based on a grandfathering
basis linked to business as usual (BAU) assessments rather than
auctioning. Because historic emissions data had not been collected
on a systematic basis for all the installations covered by the
EU ETS, many of the Member States had to rely on estimates
of BAU emissions data from the installations themselves and trade
organisations. Not surprisingly, they tended to overstate their
requirements. This has led to an overallocation of allowances
and an excess not shortage of allowances in Phase 1.
But Phase 1 can be regarded as a learning phase,
and the published emissions data viewed as a calibration of the
baseline data on which to allocate permits for subsequent trading
phases. In light of the published information, Member States should
be better able to set effective allocations for Phase 2. Domestic
agendas have seen some Member States set caps in their Phase 2
NAPs that are far higher than those requested by the European
Commission or that their verified data merits, putting the integrity
of Phase 2 of the EU ETS at risk. The Commission has a significant
role to play in reducing the caps, although their powers are limited.
Looking forward, a remedy to this situation
for Phase 3 will be to set an overall absolute EU cap that is
then subdivided among Member States and allocated at sector and
installation level through auctioning.
3.3 Has the Government identified the correct
proportion of allowances to be auctioned in Phase 2? 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?
The power sector in the UK is relatively shielded
from international competition and therefore best able to pass
on the cost of carbon onto customers, thereby minimising the affect
on competitiveness. This, combined with the sector's historic
overestimation of allowance requirements, provides a reasoned
basis for the auctioning of allowances from the power sector's
allocation.
Auctioning even just 7% will be useful in terms
of a degree of price discovery. However, its potential effect
on the price of carbon will be difficult to determine at least
until Phase 2 NAPs across the EU are finalised. In principle,
there should be no impact on the price, as it is the total number
of allowances in circulation that should determine price, not
who holds them initially.
3.4 How well are the EUETS and CDM working
together? What needs to be done to better integrate these markets?
Is CDM funding the right projects?
There are two types of carbon abatement:
— Low capital cost options involving
end-of-pipe solutions, operating behaviour, efficiencies; and
— High capital cost options involving
long-term technological transformation.
With respect to the links between the EUETS
and the CDM mechanisms, the question should focus less on how
well are they working together per se and more on are they working
to deliver the desired outcomes? The CDM aims to deliver economically
efficient emissions reductions and facilitate technology transfer
to developing countries. However, this should not be to the detriment
of introducing emission reductions within the EU through, ideally,
investment in a low carbon infrastructure, the "supplementarity"
concept. Thus far, the first type of carbon abatement is occurring
very successfully but the second remains elusive. This issue is
discussed further later in this submission.
On integration—a technical point. CERs
(credits from CDM projects) and ERUs (those from JI projects)
can only be used in the EUETS if the international transaction
log (ITL) is functional. The contract for building the ITL has
only been awarded in the last month or so—timely delivery
of the log is critical to integration of the two mechanisms.
On investment in the "right" projects.
Investors will wish to maximise returns on their investments and
there can be significant overheads to the CDM project approval
process. These reasons, combined with the absence of certainty
over the post-2012 framework, mean investors will be drawn to
the "low-hanging fruit", for example end-of-pipe solutions
to emissions of exotic gases from industrial plants. While these
projects make a significant contribution to the reduction of GHG
emissions globally they are not contributing to the development
of a global low carbon infrastructure.
3.5 What work needs to be done now to help
design a third phase of the EUETS? How can the experience of the
EUETS be used to help the design of the post-2012 Kyoto mechanism?
Or what needs to be done to ensure the EUETS
and other mechanisms catalyse investment in a global low carbon
economy?
The process of investors establishing an internal
rate of return (IRR) is highly subjective due to the number of
assumptions that need to be made in appraising a new project,
particularly when dealing with long-term infrastructure projects
in complex risk environments. What is obvious is that increasing
the minimum carbon price and the time over which carbon value
can be recovered improves project returns. This was always going
to be the case. The key question is by how much does price and/or
period have to increase? This depends on the asset class.
With time, as investors and companies become
more familiar with the movement of allowance prices, they may
be willing to make investments whose return will be determined
by allowance prices alone, much in the same way as developers
invest in gas and oil fields. However, like gas and oil, investors
are unlikely to commit to a project requiring for example a €25/tCO2
allowance price to make a return, much as the petroleum industry
makes decisions based on oil prices of around $30/bbl, despite
the current spot price being closer to $60/bbl. This has been
observed in the carbon market. CDM projects are currently being
developed at costs of $0.5-8/tCO2e, despite the current
higher allowance price. Moreover, with these projects there are
considerably greater delivery risks than associated with corporate
oil industry deals.
The consequence is that, to date, there has
been little capital investment in the EU to reduce emissions.
This presents a perception that the impacts of the EU ETS are
negative—windfall profits for the utilities, rising customer
prices, and no investment in Europe. However, it is important
to recognise that the windfall profits are a consequence of the
free allocations, which was a political construct to improve the
palatability of the scheme. This is not a failure of a trading
as a means to reduce emissions. With time, investors may become
more comfortable with the price behaviour of allowances and so
investment may be forthcoming. Initially, we expect that investments
are unlikely to be made on the basis of emissions alone but, should
a company wish to build new capacity on the basis of demand for
its product, the choice of technology may be influenced by emissions
values.
However, recent reports from among others the
Tyndall Centre indicate responses to the threat of global warming
are required on a timescale more urgent than previously thought.
Therefore, some adjustments will be required to the emissions
trading scheme beyond 2012 to bring forward the required investment.
Essentially, what investors need is greater regulatory certainty
from the EUETS in order to establish something like a minimum
carbon price that they can plug into spreadsheets for long investment
periods when they assess new projects. Whether this needs to be
an indication of the level of ambition or an actual price floor
depends upon timing in the policy cycle and upon the investor.
Some of the problems that are being encountered
by the current scheme will be easily rectified. For example, the
lack of high quality emissions data covering the traded sector
has vanished now that verified emissions data have been received
for 2005. Furthermore, the uncertainty introduced by the absence
of banking between periods will not be repeated between Phases
2 and 3. Moreover, the practice of providing grandfathered allowances
to existing installations could be removed for Phase 3, or at
the very least for sectors that are not exposed to international
competition and so are able to pass on allowance costs to their
customers.
Nevertheless, the climate for investments would
be greatly improved were the trading periods extended. Could not
the abatement targets be set for 15-30 years, compatible with
the investment cycles of the large emitting industries? This is,
perhaps, the real crux of the matter. Investment likes certainty,
yet democracy requires that politicians can change laws. Is democracy
(in the form of frequent changes to legislation) incompatible
with trading? We think not. Investors recognise that trading regimes
that are not delivering policy objectives will be changed. So
a mechanism needs to be developed that allows, on the one hand,
investors to be given a framework for trading that could last
into the long term, yet may also be altered if these objectives
are not being met. For climate change, this requires confidence
that the goal of achieving substantial emission reduction targets
will be maintained for the long term.
Finally, the idea of full auctioning in Phase
3 is now gaining acceptance among the large utility companies.
The benefits of auctioning are that it will give full price discovery—the
full cost of carbon will be incorporated into the market; improved
liquidity with the market (which currently trades at only around
10% volume, which is keeping the carbon price artificially high);
and would also provide a steady revenue stream for Government.
But auctioning must be combined with tighter caps—to create
confidence in the carbon value. But with a number of draft NAPs
for Phase 2 already published, this prospect is not yet secure.
Governments will have another chance to address
this problem as they design the post-2012 regime. Hopefully, the
abatement required for the post-2012 will be greater, suggesting
that allowance prices will be higher, all other things being equal.
The trouble is that such things are not always "equal".
A fall in gas prices, or an increase in coal prices, could cause
allowance prices to fall. So it may be necessary for Governments
to take action, either unilateral or multilateral, to increase
confidence that prices will not fall below a level that would
render investments uneconomic. Of course, the most obvious way
to increase the market's confidence in the scheme would be to
ensure that the scheme is expanded to include the USA and Australia.
October 2006
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