Memorandum submitted by Drax Power Limited
INTRODUCTION
1. Drax Power Limited ("Drax Power")
is the owner of Drax Power Station, the largest, cleanest and
most efficient coal-fired power station in the UK. Drax Power
trades its electricity in the wholesale electricity market, and
at current output levels it supplies some 7% of the UK's electricity
needs.
2. Drax Power is pleased to have the opportunity
to participate in the Committee's inquiry, as a major player in
the carbon market, indeed, the largest independent thermal generator
with trading experience and perhaps one of the largest "short"
installations in the UK, we consider that we are well placed to
comment on lessons learned from Phase I of the EU ETS and the
future of the Scheme.
GENERAL COMMENTS
The Electricity Industry and the EU ETS: An Unfair
Burden?
3. Drax Power is a strong advocate of the
need to price carbon in the market in order to deliver environmental
benefit and we are also mindful of the need to maintain the economic
strength of the UK. However, the problem of carbon is societal,
it affects all sectors and to address it the effort of compliance
with targets must be distributed across all emitters.
4. Power stations contributed 29.8% of the
total CO2 emissions in the UK in 2005 and from 1990
to 2004 single-handedly delivered 33.4 million tonnes of CO2
savings while other sectors have increased their emissions of
CO2 by 2.2 million tonnes over the same time period.
All emitters must be treated equitably if we as a country are
to deliver against our carbon reduction targets in the most economic
and effective way.
5. All effort on CO2 reduction
in Phase I and II has been allocated to the power sector on the
assumption that fuel switching was fairly easy and possible. In
reality, the sector did not respond in the manner that had been
assumed and little switching occurred from coal to gas. Indeed,
over the last few years the sector has seen an increase in coal
burn. By setting a range of emissions reduction beyond what is
technically and economically feasible for the sector, operators
have had to purchase additional allowances in the market, leading
to a considerably higher than anticipated cost of EU ETS compliance
which in turn has fed through to increased electricity prices
for the UK consumer.
6. Other sectors have been allocated allowances
on a "business as usual" basis and have, in fact, been
over-allocated with the result that these sectors have been provided
with a windfall as well as being exempted from the discipline
of carbon reduction. There is a need to spread the compliance
requirement over a wider set of participants to avoid dependency
on a single sector.
7. Allocating all the effort on a single
sector makes it unlikely that the maximum possible reductions
will be made. Given the nature of the sector in terms of the scale
of the investment and the long term investment cycles, the actual
extent of CO2 reduction in Phase I and II (rather than
the extent of reduction in allocations) will depend principally
on the extent of closure of coal-fired plant under the Large Combustion
Plant Directive and the extent of gas-fired plant construction.
Neither of these factors are related to the introduction of the
EU ETS and indeed the current market conditions are still not
favourable for new gas-fired entry. As a result, the success of
the Phase II NAP will, as for Phase I, depend entirely on the
ability of the power sector to purchase sufficient allowances
to accommodate the CO2 cap.
8. Further, if the UK power sector takes
a greater burden than its European competitors, it will diminish
the relative value of generating capacity in the UK and capital
available for new build will be more likely to go to continental
Europe in an effort to capture allowance value. This is particularly
important given the need for new capacity post implementation
of the Large Combustion Plant Directive.
Short Term Policies in a Long Term Industry
9. The electricity industry is characterised
by major, long term, investment with typical payback periods of
10 to 15 years. Through such investment generators can address
the main environmental constraint of carbon but only if there
is a certain and stable long term energy policy framework. Clarity
and long term stability in the regulatory framework is needed
to minimise the risk of future intervention, which would simply
serve to destabilise the regime, increase uncertainty and disrupt
the associated traded commodity markets.
10. The EU ETS is a policy with a short
term outlook. Despite the Government's CO2 aspirations
being clear, the necessary long term regulatory and economic framework
to deliver against these objectives is not in place. The EU ETS
should provide a clear framework for CO2 reduction
over the long term, well beyond 2012, such that the future value
of carbon can be assessed to enable a more informed view on the
significant investment decisions needed within the sector.
11. Carbon targets need to be agreed into
the long term, sufficiently far ahead to provide a degree of confidence
in investment. A 15 year time horizon should be sufficient to
complement the investment cycles typical of the electricity industry.
EU ETS and other Climate Change Policies
12. The EU ETS and similar legislation cannot
be considered as purely environmental in nature. Currently the
EU ETS is viewed as a stand-alone piece of legislation with its
own sets of targets and objectives which have a strong potential
to conflict with other social and/or economic goals. It should
be recognised that, for the power sector, environmental and energy
legislation are closely intertwined. Other sectors are also impossible
to manage by trying to separate out the environmental drivers
from the rest. Hence we should be viewing EU ETS as just one of
the mechanisms to deliver a well thought out and coherent policy
delivering change throughout the economic spectrum.
PHASE I
Lessons from Phase I
13. The UK submitted its NAP to the European
Commission on 20 April 2004 and did so on a provisional basis,
making it clear that the figures were subject to change. Subsequently,
on 10 November 2004, the Government submitted amendments to the
Commission increasing the number of allowances from 736 to 756Mt
CO2. Following the Commission's refusal to accept amendments
to the UK NAP, the UK Government challenged the Commission's Decision
in the European Court of First Instance (CFI). The CFI found in
favour of the UK Government and annulled the Commission's Decision.
In February 2006, the Commission took a new Decision in which
it rejected the amendments proposed by the UK Government on different
grounds. In April 2006, the UK Government decided not to pursue
further action, a decision which left the power sector with a
further shortfall of 20 million allowances.
14. This lack of an accurate estimate of
emissions from which to develop an appropriate baseline cost the
power sector, and hence the electricity consumer, some €300
million (assuming a requirement to purchase allowances at €15/tonne).
15. A key lesson to learn is that the Government
needs to listen to industry and other stakeholders regarding the
probity of data and assumptions used for basing projections and
allocations. The process has improved somewhat for Phase II, but,
the lesson for introducing other, less well characterised sectors,
into any future EU ETS is evident.
16. There needs to be a better assessment
of what emissions reduction is technically and economically feasible
across the traded sector and the assessment of emissions reduction
on the competitiveness of UK industries. The rationale for targeting
the power sector in Phase I was that the industry was somehow
protected from international market pressures due to limited physical
links. This was not, and still is not, justifiable. The power
sector is primarily driven by the price and availability of fuel,
by the time Phase II arrives we will have significantly increased
international fuel links—upgraded gas interconnectors, LNG
import terminals and enhanced coal import facilities—and
the UK power sector will be a completely reliant upon and subject
to the operations of international fuel markets.
17. Installations/sectors should not be
allocated more than their need. We are disappointed that, in Phase
II, Government has not set allocations below the "business
as usual" case, particularly since many sectors' allocations
(apart from electricity) were more than their actual emissions
in Phase I.
PHASE II
Auctions
18. The Government should allocate allowances
in such a way that allows all sectors to contribute equitably
towards emissions reduction targets and provides more incentive
to introduce less carbon intensive processes. Drax Power does
not believe that the power sector should bear the entire burden
of emissions reductions and, perhaps more importantly, accommodate
all the uncertainties and inaccuracies in the allocation plan.
19. Allowances for auctioning should not
be taken solely from the power sector in Phase II. This simply
translates to a lower cap for the sector and a greater need for
generators to make up shortfalls across the market. The need for
a wider base of effort is especially valid in view of the proposals
towards greater auctioning across all sectors and towards a reduction
in allocation for industrial new entrants. The signal needs to
be sent to all incumbent installations in industry sectors so
that they can develop the discipline of accounting for carbon.
It is even more important for UK industry (that is, non power
sector) to pick up this signal in Phase II since they have not
been required to consider carbon and, indeed, have benefited from
large cash injections as a result of over-allocations during Phase
I.
20. We have concerns about too rapid a movement
towards high levels of auctioning and believe that an inappropriate
use of auctioning could distort the market. In addition, it would
be risky to introduce any radically new allocation process without
having much more understanding of the implications. We should
not be using Phase II to test the auction philosophy whilst there
are still so many other unknown factors surrounding the implementation
of the overall EU ETS.
21. Auctions are not an appropriate mechanism
for the power sector. Auctions work best when the marginal value
of that commodity can be determined by market participants and
in extremis they can decline to bid and effectively cease
supply. In the case of electricity supply that marginal value
is very difficult to determine and non supply is not acceptable,
auction prices in a balanced/short market can therefore be extreme.
This produces instability which is a barrier to new entry.
Preserving the European Economy
22. The key issue for the EU as well as
for the UK Government is to ensure that Phase II provides the
correct signals for moving towards a low carbon future at a rate
which does not impair the European economy but which stimulates
new, and economically viable, low carbon technologies and techniques.
23. Such a judgement needs to take into
account the extent of progress in developing countries where CO2
emissions are currently increasing at a significant rate and where
a low level of controls and constraints may act to encourage high
carbon emissions. This is clearly a long term issue which has
to be addressed in the post 2012 regulatory regime and hence the
focus in Phase II should be about encouragement and implementation
of low carbon technologies rather than focusing on headline-grabbing
CO2 reduction targets.
EU ETS and the Clean Development Mechanism
24. Phase II will provide data on how well
the EU ETS and the Clean Development Mechanism interact. Currently
the aim is to assess how Project Credits (CERs and ERUs) can be
procured and the risks associated with them.
25. The UK Phase II NAP has capped the amount
of project credits at a percentage of the "free" allocation.
This seems to counteract the actual effort that has been imposed
on sites such as Drax to meet its necessary level of purchase.
To meet its target Drax will have to source and purchase an extra
5 million tonnes of carbon each year in Phase II and its ability
to source the carbon has further been hampered by the imposition
of a very restrictive cap on the level of credits that can be
submitted for compliance.
26. We support the argument that the limit
for use of project credits should be based on effort. Hence our
view is that companies in the power sector should be allowed to
purchase their entire shortfall using project credits. The current
proposals disadvantage Drax whilst providing advantage to a number
of others outside the power sector who, having been allocated
their complete "business as usual" allowances will be
able to obtain an additional windfall by substituting their ordinary
allowances with CERs, which trade at a discount.
PHASE III
Looking Ahead
27. Drax believes that the EU ETS has the
potential to move from a policy with a short term outlook to a
programme providing a clear framework for CO2 reduction
into the long term, well beyond 2012. However, this will only
happen if the Government regards it as a part of a much wider
programme such that the future value of carbon can be assessed
to enable a more informed view on the significant investment decisions
needed within the power, and all other, sectors.
28. Carbon targets need to be agreed into
the long term, sufficiently far ahead to provide a degree of confidence
in investment. A 15 year time horizon should be sufficient to
complement the investment cycles typical of the electricity industry.
29. Carbon reduction targets need to be
stable, with wide political acceptability across the whole of
the EU to prevent subsequent modification. They also need to be
realistic; we note that the outcome of the first year of the EU
ETS sent a price shock throughout the carbon market, discrediting
the Scheme and casting doubt on its future. Long term, stable
basic rules for, inter alia, benchmarking for allocations,
new entrant reserve and auctions are essential if the objectives
of the EU ETS are to be achieved.
30. Harmonisation of effort across the EU
and across industry sectors is vital. A process to develop a consensus
around the structure of the Scheme is required to deliver a robust,
transparent and effective decision making process. Independent
decision making by each of the 25 Member States is not conducive
to an efficient and effective market mechanism.
31. There should, if possible, be a relationship
between emission reduction efforts in Europe and other countries
to encourage the development of low carbon technologies in the
developing world.
CONCLUSIONS
32. The following summarises the key conclusions
of this submission:
(i) The problem of carbon is societal, it
affects all sectors and to address it the effort of compliance
with targets must be distributed across all emitters.
(ii) Carbon targets need to be agreed into
the long term, sufficiently far ahead to provide a degree of confidence
in investment.
(iii) The EU ETS should be viewed as just
one of the mechanisms to deliver a well thought out and coherent
policy delivering change throughout the economic spectrum.
(iv) It is essential that accurate data and
assumptions are used for establishing an appropriate baseline
from which to base allocations.
(v) Installations/sectors should not be allocated
more than their need.
(vi) Allowances for auctioning should not
be taken solely from the power sector in future Phases.
(vii) The focus in Phase II should be about
encouragement and implementation of low carbon technologies rather
than focusing on headline-grabbing CO2 reduction targets.
(vii) The limit for use of project credits
should be based on effort and the power sector should be allowed
to purchase their entire shortfall using project credits.
(ix) Harmonisation of effort across the EU
and across industry sectors is vital and a process is required
to develop a consensus around the structure of the Scheme to deliver
a robust, transparent and effective decision making process.
October 2006
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