APPENDIX A
THE CARBON
HEDGE
Long term financial instruments to secure investment
in low carbon technologies in the electricity sector
INTRODUCTION
The EU ETS as currently structured is not capable
of underwriting the investment needed to reduce CO2
emissions in the electricity sector and move the UK to a low carbon
economy. The primary reason for this is that the policy timescales
of the EU ETS do not match the investment life cycles of the sector
and investors are unwilling to accept the regulatory uncertainty
surrounding future CO2 abatement targets. Furthermore,
the timescales of policy development must recognise the need to
achieve significant carbon dioxide reductions in the next capacity
replacement cycle in the electricity sector to deliver the carbon
dioxide reductions that Government aspires to.
Although considerable efforts are being made
to agree long term abatement targets across the EU (Phase 3 and
beyond) and internationally, these are unlikely to be agreed in
the near future. The challenge we face is to find a mechanism
capable of bridging this gap in regulatory certainty to galvanise
early investment in low carbon technologies.
The EU ETS also currently excludes carbon free
technologies such as carbon sequestration and nuclear from the
scheme. Although these technologies can benefit from higher electricity
prices driven by CO2 prices in the EU ETS, the time
scales of the EU ETS and the visibility and certainty of future
prices do not match the investment life cycles of these assets.
The potential risks faced by investors investing in low carbon
or carbon free technologies are:
— the EU ETS being discontinued
leading to a collapse in CO2 prices;
— EU or individual Member State
governments implementing or influencing policy in a manner that
leads to a low or non significant price for CO2; and
— Governments providing assistance
to carbon emitting technologies by allocating free carbon allowances
to new entrants under the EU ETS.
EDF Energy believes that commercial market based
instruments, such as the "carbon hedge" explained below,
can be used to underpin the significant capital investment required
to lower the carbon intensity of the electricity sector without
exposing the UK Government to unacceptable financial risks.
PROPOSED MECHANISM
FOR THE
CARBON HEDGE
The Carbon Hedge has the capability of hedging
the risk for "low carbon technology" investors related
to low carbon prices and can be designed to be consistent with
existing policy mechanisms. The hedge has the further advantage
of allowing Government "to bite off as much as it wants to
chew" by allowing it to control its liabilities under the
hedge by controlling the volume of abatement it is willing to
underwrite using this mechanism. Government can further limit
its liabilities by influencing wider policy development and retaining
the carbon price within a reasonable range that minimises its
financial exposure. The carbon hedge is also attractive because:
— it can be designed to allocate
the regulatory risk associated with carbon markets more evenly/fairly;
and
— It can provide certainty on
delivering known CO2 reductions.
The following section sets out a framework for
this mechanism and examines some of the commercial and regulatory
features of the carbon hedge.
How does the Hedge work?
— Electricity companies would
bid in to supply a fixed volume of carbon free electricity from
a certain date in the future for a number of years based on an
assumption that each unit of carbon free electricity would displace
the need for a unit of electricity from other forms of generation.
— The bid price submitted to secure
the hedge would determine a guaranteed floor price for CO2.
— If the market price for CO2
fell below the agreed floor price during the term of the hedge
then the investor would be compensated for the difference between
the floor price in the hedge and the actual market price of CO2.
— Any payments to investors that
did arise in the event that the carbon market price fell below
the contract price could be recovered from customers through a
top-up carbon levy on electricity prices.
— The investor would not receive
any payment if the market price remained above the floor price
agreed in the hedge.
— The carbon hedge is designed
purely to mitigate the political risk associated with the uncertainty
of future CO2 emission reduction targets and does not
seek to mitigate any other risk, such as fossil fuel price or
electricity market risks.
— The hedge would be a transitional
instrument designed to reinforce the functioning of the EU ETS
and enable it to galvanise the early investment in low carbon
technologies.
— Once the EU ETS and global carbon
market are put on a sufficiently long term basis, it may no longer
be necessary for the government to offer any further carbon hedge
contracts.
Life cycle of the carbon hedge
The timeline for developing and delivering low
carbon investments using the carbon hedge and the key activities
in each phase are illustrated below.
Terms of delivery and failure to deliver
The Government will have a legitimate expectation
that as a policy measure the carbon hedge will deliver specific
carbon reductions. The contracted reductions are likely to inform
future Government targets for emissions reductions. The hedge
is therefore likely to include expectations of minimum and maximum
performance levels and associated penalty or bonus payments based
on actual performance levels.
SUMMARY
In summary:
— Commercial market based instruments
in the form of a carbon hedge have the capability of underwriting
long-term capital intensive investments required to move the UK
to a low carbon economy.
— A one way contract for difference
format would be suitable for the electricity sector.
— The form of the hedge should
be adapted if the Government policy is to continue with allocating
free allowances to new entrants under the EU ETS.
— There are some policy issues
and some of detailed design that will have to be addressed in
finalising the form of the carbon hedge.
EDF Energy
May 2007
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