Memorandum submitted by Shell
Shell strongly supported the creation of the
European Emissions Trading Scheme before its passage in the EU
Parliament and has confidence that the scheme is the right first
step in pursuing stable, market-based policies that help energy
users and suppliers pursue innovative energy solutions. We have
nearly 50 installations in the trading system, covering some 30
million tonnes of CO2 emissions.
Shell has built a trading team to manage its
position in this important market and we executed the first ever
trade in EU allowances (in February 2003) and the first ever trade
in 2008-12 EU allowances.
What are the key lessons to learn from Phase I
of the Scheme?
— The first 18 months of operation
of the EU ETS should be considered a success for such a complex
and important undertaking. This is despite the concerns over allocation
in the first year and the recent price volatility.
— The market is liquid, responsive
to supply demand information and is sending a clear carbon price
signal to industry that is being responded to.
— Mitigation projects will take time
to develop but operational changes (eg fuel switching where possible,
process optimization etc) are happening.
There are some areas for enhancement as outlined
in our comments to some of the questions below.
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 UK reduction target for Phase II is an ambitious
one, as it is set at the higher end of the range originally proposed.
Since the EU ETS is a market-based mechanism companies must weigh
the cost of abatement against energy costs and the (forward) market
price of allowances. If the marginal cost of abatement for UK
companies is perceived to be higher than the market price, then
companies will choose to buy allowances. The price of allowances
in Phase II will be driven by the perceived supply and demand
balance, which is very dependent on the toughness or otherwise
of the caps set by other Member States.
The legal obligation on installations in the
UK and elsewhere in the EU is to hold allowances equal to or greater
than their verified emissions for each compliance year. There
is not a legal obligation to reduce emissions per se. Legal compliance
with the EU ETS was 99.999% across the EU in 2005. It is profoundly
unlikely that Shell and other UK companies will be non-compliant
in Phase II.
There are 9,106 installations participating
under the EU ETS with 4.64 billion allowances allocated (source:
EC).
With daily traded volumes of 300,000-1 million
and more than 100 active participants so far, it is clear that
trading is a reality now. The Phase 1 NAPs are reasonably consistent
with the types of reductions that industry can make in the relatively
short (three years) first commitment period of the EU ETS. An
emissions reduction strategy for an industrial facility will typically
consist of three tranches:
1. Operational changes as a result of a renewed
focus on energy efficiency—such changes can be implemented
over a one year time frame but may only lead to improvements of
3-5%.
2. Small to medium projects which will deliver
results in two to four years after inception.
3. Large projects which may take three to
five years to fully develop and bring on line. Some of these projects
could bring considerable reductions (eg 10%+ at unit level).
The NAPS for the first period can therefore
only be based on the delivery of Tranche 1 type reductions. Nevertheless,
industry needs a driver to incentivise the development of Tranche
2 and especially Tranche 3 type reductions. Ideally this would
come from a clear future price signal that indicated a demand
for such reductions in the period 2008-12. The current market
structure and NAPs do not fill this role and hence present industry
with a dilemma regarding the emissions reduction strategy to undertake.
Once trading in the first period is fully established and a good
number of the 7,000+ facilities in the EU are involved in such
trade, we may see a second period price develop, which in turn
will help guide a reduction strategy.
What have been the effects of the method chosen
for allocating allowances in Phase I?
At the start of the emissions trading scheme,
grandfathering offered a smooth and relatively easy transition
from business as usual to carbon managed businesses. Grandfathering
is an allocation methodology that is free of charge based on historical
emissions. However in Phase I there was an issue of over allocation,
which occurred partly because historical emissions data in some
Member States was not robust and there was a lack of understanding
what the application of specific allocation rules might result
in. This has changed for the second period because we now have
a better understanding of the allocation rules and also robust
verified data on which to base future allocations.
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?
Shell would support the auctioning of allowances
provided this is designed to avoid perverse effects. However we
do not support the type of auctioning that is currently being
proposed for Phase II because there are no provisions in the Directive
for dealing with the process and addressing the following issues:
— The political hurdle of making companies
pay for any percentage of their allowance requirements. This may
often be seen as a tax.
— The recycle or use of the funds in
general. We propose recycling to avoid this being another tax,
but this will add complexity and a secondary allocation debate
with the associated issues of harmonisation.
— The negative impact on market functioning.
Auctioning reduces overall liquidity and hence efficiency. Furthermore
the conduct of multiple auctions in the course of a continuous
and free market has the potential to lead to price spikes and
collapses.
— The actual administration of auctions.
Auctioning would be a serious undertaking because participation
must be open to the international public but must also involve
financial checks so that auction participants can guarantee to
be able to pay for the allowances they bid for. This is a costly
and resource heavy process that has no current precedent in any
Government.
— Even auctioning a small amount of
allowances incurs nearly all the costs of a full blown auction.
Please see Annex A for a discussion on the issues
around allocation and auctioning.
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?
The current level of reductions asked for in
Europe by 2012 is unlikely to impact adversely on EU company competitiveness.
The reductions amount to good housekeeping and enhanced energy
efficiency and there is still much that can be achieved through
projects with a positive payback. Many US companies also operate
within the EU and vice versa.
A renewed focus on energy efficiency across
the EU, being the principal toolkit for emissions reductions,
could well enhance industry competitiveness in the medium term.
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?
It is essential that the caps are chosen so
that they do not drive investment away from the EU. Whilst this
might not drive industry away from the EU in the short-term, eg
during Phase II, it will affect its long-term prospects when industry
is looking at portfolio rationalisation and long-term investment
decisions. We therefore believe it is essential to ensure a more
global approach in future. This will also avoid the CO2
emissions simply being moved to another part of the world.
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 evidence is that CDM is a strong success.
Based on the data published by the UNFCCC we can calculate that
approximately 200m CERs will be issued by the CDM Executive Board
through Phase 1 of the EU ETS, ie before the end of 2007. This
means that 200 million tons of CO2e will have been
reduced beyond Business as Usual. At an average of USD 15 per
CER this results in a capital flow of USD 3 billion from Annex
1 to developing countries and is accompanied by significant technology
transfer. The implementation of the underlying projects generates
local employment and improves local environmental conditions and
the result is a lower cost of compliance for European companies
under the EU ETS.
The CDM is already a strong impact on the EU
ETS with CER supply factored into EU Allowance pricing. It is
important to note that the CDM process has successfully issued
CERs to the CDM registry account. In effect we know that the CDM
works. However, in order for CERs to physically flow into the
EU ETS it is essential that the International Transaction Log
project is completed by the UNFCCC. This is scheduled for Q2 2007
and the UNFCCC states that the project is on schedule, but EU
Governments should ensure that this timeframe is adhered to in
order to ensure efficient and timely linkage between the CDM and
the EU ETS.
The CDM rationally flows capital to those projects
that reduce emissions at lowest cost. So long as the underlying
project methodology is approved through the CDM process then the
project can be implemented and generate CERs. It is certainly
not appropriate for any government to unilaterally apply constraints
to CDM projects beyond the already onerous restrictions of the
CDM process itself and the EU Linking Directive.
JI remains far less developed than the CDM and
cannot issue ERUs before 2008.
How should aviation be included within the ETS?
What are the latest indications of when it will be included?
— An emissions trading system should
be widely inclusive for reasons of lowest cost reductions to the
economy, environmental benefit and scale and liquidity of the
market. However, a certain minimum size for an individual participant
is sensible so as not to introduce high transaction and participation
costs into such a system (currently the EU ETS is set at 20 MW
thermal rating or equivalent, which appears appropriate).
— Emitting participants in an emissions
trading market must be driven by the basic model of "make
or buy"—ie an emitter has the necessary control over
such emissions to manage compliance both through trade in allowances
and the implementation of a range of abatement projects.
— The aviation business fits these
criteria and should therefore be included within the EU ETS (vs
passenger road transport which does not fit these criteria).
— We do not support the expansion of
aviation emissions to include the radiative forcing factor (emission
impacts at various levels in the atmosphere)—this issue
is entirely separate from the aims of the UNFCC and the Kyoto
Protocol and the specific mandate of the EU ETS.
— We do not have a specific position
on the details of inclusion of aviation—such as the applicability
of different allocation models, the types of flights to be included,
measurement and verification of emissions etc. as yet on how any
system would work from 2008, as the rules have not been set or
agreed.
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?
"Tough" is an entirely subjective
term. We see the UK wanting to go further than Kyoto with its
CO2 emissions reduction programme but the aim must
be to ensure that a well functioning ETS market operates through
to 2012 and that it has sufficient bite to encourage trading activity
and to encourage CDM and JI project investment. A weak oversupplied
market will see those systems stalling, which nobody wants. Good
investment in CDM and JI will see a substantive flow of CERs and
ERUs flow into the EU ETS to meet the demand and hence keep prices
in check.
How well integrated are the ETS and other EU climate
change policies?
So far the EU ETS is not well integrated with
other EU climate change policies and there is still a lot of work
to be done on:
— the ETS and renewable power generation
objectives;
— the ETS and possible biofuel manufacture;
— the ETS and transport; and
— the ETS and carbon capture and storage
objectives.
We would also like to see the EU ETS linked
with other trading systems.
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?
Shell supports the general approach being taken
on the structure of Phase III of the EU ETS. In our view it is
not necessary to make significant changes in the structure of
the EU ETS. The following are the elements that we consider important
for Phase III and subsequent phases:
— To ensure long-term investment decisions
can be made, there is a need for confirming that carbon trading
is here to stay. This does not mean that there must be allocation
for tens of years ahead, but that there will be a market in tens
of years ahead.
— It is important that there are no
artificial limits (eg on the carbon price, use of CERs/ERUs) placed
in the system, which in the longer term can lead to market distortions
or even market failure and thus counteract any incentivising effect.
— The infrastructure needs to be fully
functioning, ie all relevant registries as well as the International
Transaction Log (ITL) are in place.
— As the EU ETS links to more diverse
international carbon markets in the coming years, the infrastructure
(eg registries etc) will need to be delivered in a timely manner
and then well maintained in the future.
— Even if companies do not have a specific
individual allocation, it is important to know what the system
is driving towards in the longer term.
— In order to avoid competitive distortion,
further harmonisation is required, inter alia on allocation methodologies/rules,
the definition of (combustion) installations, the treatment of
small emitters.
— The EU ETS needs to be linked to
other trading schemes as they develop in order to encourage the
use of such market mechanisms and improve the liquidity of the
market. This will further level out CO2 prices and
optimise overall allocation of resources.
— Shell believes that emissions trading
is an important mechanism to incentivise the deployment of clean
technologies such as carbon capture and storage (CCS). Recognition
of CO2 stored as part of a CCS operation from installations
included in the EU ETS, via approval of appropriate monitoring
and reporting guidelines for CCS, is a critical part of Shell
utilising market mechanisms to cost-effectively reduce emissions.
Our Principal Scientist for CO2 Mitigation has been
involved in the European ad hoc Group of CCS experts established
to develop draft interim monitoring and reporting guidelines for
the inclusion of CCS within the EU ETS. These were subsequently
presented by the DTI to the European Commission and are endorsed
by us.
Annex A
ALLOCATION AND
AUCTIONING
The objective of an emissions trading system
is to direct capital within the covered sector to the point at
which it can be most effectively used to mitigate emissions. Conversely,
the objective is not to withdraw capital from the economy and
redistribute it to projects according to some subjective or non-market
based set of criteria. This means that allowances should be distributed
without cost to the emitters.
But an essential requirement of an emissions
trading system remains the allocation of allowances to the participating
installations. Once the total number of allowances in the system
has been determined and fixed (which then sets the overall environmental
objective of the system), there are broadly three ways to do this:
1. Grandfathering: Free ex ante
allocation of allowances based on some percentage of the historical
emissions of the facility.
2. Benchmarking: Free ex ante
allocation of allowances against a projected emissions rate (based
on a technology standard or benchmark) and projected (or historical)
production level of the facility.
3. Auctioning: The available allowances
are sold to the participants by the government.
Grandfathering is a useful and simple tool to
start an emissions trading system, in that with free allocation
based on historical emissions, there is minimal disruption to
the economy and the likelihood of shocks is diminished. However,
most see that grandfathering is not sustainable, as a fixed base
year (eg 2006) eventually becomes distant and irrelevant to future
emissions from an installation and a moving base year does not
encourage emissions reductions (ie higher current emissions could
give more future allowances). Grandfathering also poses problems
for new entrant allocation, since the new entrant faces a considerable
barrier to entry unless a new entrant reserve is created.
The other free alternative, benchmarking, is
worthy of consideration, but it too has difficulties. The benchmark
system requires that an industrial process can be described in
relatively simple mathematical terms, eg xx tonnes of CO2
per unit of output, such that the allocation can be calculated
based on readily available and transparent operating data. However,
simple benchmarks for complex industrial processes such as refining
are very difficult, if not impossible, to achieve. That means
a single installation might have its allowances calculated on
the basis of multiple benchmarks, markedly increasing the complexity
of the approach and the data collection requirement. Some industrial
sectors say that benchmarking is ideally suited to their particular
sector.
If grandfathering and benchmarking become problematic,
only auctioning remains. From an allocation outcome perspective,
auctioning has the benefit of simplicity, transparency and equitable
treatment of new entrants and incumbents and automatically answers
the question of how to harmonize allocation. However, auctioning
also raises significant concerns:
— Payment for allowances withdraws
capital from the economy that might otherwise be used to invest
in emissions reduction projects.
— If the revenues from auctioning are
to be recycled then there is the immediate issue of an (secondary)
allocation process to support the recycling. It is unlikely that
such a process would be as efficient as a market-based approach
in directing the capital to the best projects.
— The conduct of multiple auctions
in the course of a continuous and free market has the potential
to lead to price spikes and collapses.
— The administration of auctions is
a serious undertaking because participation must be open to the
international public but must also involve financial checks so
that auction participants can guarantee to be able to pay for
the allowances they bid for. This is a costly and resource heavy
process that has no current precedent in any government.
Putting aside the last two bullets (but still
recognizing they remain significant hurdles), this raises the
question of how the transparency of an auction can be utilized,
without the capital distribution problems presenting themselves.
Two key elements would need to be in place:
— The funds generated from the auction
need to be 100% recycled to the emitting participants within the
trading system, with little or no lag between payment and receipt
so as to avoid working capital issues.
— The mechanisms for recycle need to
be contained within the trading system auction structure and not
left to the later discretion of Government.
Such an approach is possible and is described
in the example given below.
Example: "Cap and Trade"
Structure with 100% Auctioning and Recycling of Funds
1. The auction takes place at the start
of each year for 100% of that year's allowances. The market knows
the total number of allowances available from the government some
years before. The government runs the auction with the aim of
100% clearance—eg the reverse process can deliver this—the
price is dropped each day and participants take what they need
at a price of their choice until no more allowances are left.
2. Payment does not immediately take place
even though the allowances are immediately distributed. However,
the government calculates its revenue from the auction process
for that year. Say in this example the government sells 1 billion
tonnes of allowances at $10 each, ie $10 billion. Company A has
one facility in this MS, emitting 950,000 tpa. They buy 800,000
tonnes in the auction.
3. In April of the same year the Government
collects allowances for emissions in the previous year. This becomes
the mechanism for redistribution of the auction funds, with the
government in effect buying back the allowances from the previous
year. Say the emissions in the previous year are 1.04 billion
tonnes and this number of allowances are deposited on the national
registry. Therefore, each allowance is worth 10 billion/1.04 billion,
or $9.62 each.
4. The Government then bills or pays for
any differences as necessary. In the case of Company A, it emitted
961,000 tonnes in the previous year. The government would pay
Company A 961,000*9.62—800,000*10 = $1.24 million. Had Company
A bought 1 million allowances it would have paid the government
$755,000.
5. Rules for new entrants and shutdowns
can also be simplified and eliminate the need for structures such
as a "new entrants reserve":
For a new entrant: New entrants also have
to buy all their allowances, either in the government auctions
or from the market. However a new entrant is granted the equivalent
of one year's emissions (eg as per their planning application)
of "recycle allowances" upon start-up of the facility.
These allowances cannot be used against emissions and cannot be
traded. They simply allow the new entrant to obtain (additional)
recycle funds from the first auction they participate in.
Facility shutdown: Once a facility is shutdown,
recycle funds cannot be received.
Although further detail and rules for special
cases would still need to be developed, this outline illustrates
that an auctioning approach could be put into practice. In this
approach, the key financial concerns of the auction process are
effectively addressed, ie:
1. Much less financial exposure for individual
parties and less financial exposure for the government to individual
participants.
2. No complex reallocation process.
3. No drain on funds from the private sector.
New entrants are also effectively catered for.
October 2006
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