Emissions Performance Standards

MEMORANDUM SUBMITTED BY E.ON UK (EPS 19)

SUMMARY

In the EU, the EU Emissions Trading Scheme (EU ETS) has been adopted to ensure that emissions across the EU from the sectors covered do not exceed a level consistent with the EU’s overall climate change targets.

Concerns about the effectiveness of the EU ETS could be addressed by moving to a tighter EU emissions cap for the third trading period which begins in 2013, and extending the period from 2020 to 2030 or later. This would significantly sharpen price signals and ensure these were maintained over the longer timescales needed for new investments.

Emissions Performance Standards (EPSs) have drawbacks of their own. Any reductions in CO2 emissions achieved through the implementation of an EPS in the UK additional to those that would have been achieved through the EU ETS would be entirely offset by higher emissions elsewhere in the EU within the overall EU ETS cap, so there will be no net reduction in EU emissions.

An EPS can also create new risks which can substantially increase the discount rates applied to new investments, and ultimately determine whether an investment proceeds or not. The fundamental problem is whether companies will be confident that the market or the energy policy framework will fund the required investment to achieve the EPS.

These risks need to be addressed if an EPS is to play a role. There is no point having an EPS which energy companies are unable to meet because they are not confident of their ability to recover the costs involved. This issue has already been recognised in the US.

An EPS will not drive the development of carbon capture and storage (CCS) technology at all unless investors believe they will recover the costs associated with the investment needed. The key issue then is less the EPS but more whether there will be sufficient incentives to support the required investment to deliver CCS.

The main risk for security of supply arises from the effect of implementing an EPS without establishing first whether the necessary investment is capable of being funded by the market or by Government policies. This means that consideration of EPSs and electricity market reform need to be considered together.

We agree that Government should also consider the case for demonstrating CCS on gas-fired plant, although in our view the priority is to demonstrate CCS on coal as new coal plant is already required to fit CCS and this has much wider international relevance.

Overview

1. EPSs have been adopted in California and a number of other states in the western US to ensure that CO2 emissions from new baseload power stations or imports from outside the state are below a given level, typically 1100lbCO2/kWh (499kgCO2/kWh). The EPS does not apply to new capacity operating at load factors below 60%, so allows the construction of higher carbon plant which might be needed to maintain security of supply during periods of high demand. The level of the EPS prevents the construction of new coal plants, while still permitting the construction of gas-fired CCGTs and appears intended to shift the fossil fuel mix over time to a lower carbon content as new plant is built. However, while the measure is designed to incentivise developers to come forward with low carbon generation, it does not appear to have been focused primarily at incentivising development of CCS. There are also no state proposals to set an EPS which requires CCS on new gas plant.

2. In the EU, the EU ETS has been adopted to ensure that emissions across the EU from the sectors covered do not exceed a level consistent with the EU’s overall climate change targets. This approach is consistent with a single European market, and leaves the market to identify the most economic options for achieving the reduction targets, taking account of other factors such as security of supply and affordability for consumers. This approach has merit from a climate change perspective given the need to achieve climate change, security of supply and affordability goals together.

3. Broadly speaking, support for an EPS in the UK has reflected a lack of confidence by NGOs initially, and subsequently by the Climate Change Committee, in the ability of the EU ETS to provide sufficient incentives to support the delivery of new low carbon generation and to ensure that CO2 emissions from the UK power sector are sufficiently restricted to meet the UK’s national targets, which go beyond those set at EU level. This is understandable, given the limited economic incentives so far provided by the EU ETS, but these concerns could be addressed by moving to a tighter EU emissions cap for the third trading period which begins in 2013, and extending the period from 2020 to 2030 or later. This would significantly sharpen price signals and ensure these were maintained over the longer timescales needed for new investments.

4. EPSs also bring their own set of problems. First, at the EU level, any reductions in CO2 emissions achieved through the implementation of an EPS in the UK additional to those that would have been achieved through the EU ETS would be entirely offset by higher emissions elsewhere in the EU within the overall cap. This will raise the overall cost to the EU of achieving the target as the emission reductions achieved in the UK could probably have been achieved at lower cost elsewhere. In other words implementation of an EPS in the UK will not give rise to lower net CO2 emissions globally, although proponents may argue that there are indirect effects from the UK taking a position which prohibits the construction of unabated coal plants.

5. Second, from the perspective of an investor in new generating capacity, an EPS can create new risks which can substantially increase the discount rates applied to new investments, and ultimately determine whether an investment proceeds or not. The fundamental problem is whether companies will be confident that the market or the energy policy framework will fund the required investment to achieve the EPS and equally, if it is later tightened further, whether it will be able to fund that. To the extent that this depends on the development of a technology such as CCS, which is yet to be demonstrated at commercial scale and which has an uncertain cost, the risks associated with any investment will be substantially higher.

6. This problem becomes more severe if an EPS is set at a level which requires CCS on gas as well as coal as energy companies would not have the option to invest in unabated gas-fired CCGTs.

7. These risks need to be addressed if an EPS is to play a role. There is no point having an EPS which energy companies are unable to meet because they are not confident of their ability to recover the costs involved. While companies would continue to be able to invest in renewable or nuclear capacity, it will deter investment in the more flexible new coal and CCS capacity or new gas-fired plant which will be required to maintain security of energy supply from 2017 onwards.

8. This factor was recognised in the US in the work done by the US Climate Action Partnership (USCAP). USCAP comprised leading industrial brands, including utilities, and environmental organisations. It came together before the US election to seek to devise a route-map to a US legislative programme on climate change. They collectively devised a blueprint covering a range of issues, in which coal was a major consideration. The parties agreed a package comprising of three points of a triangle:

· Cap and trade;

· An EPS for new coal-fired plant;

· Enhanced financing package seeing CCS through from demonstration to deployment.

9. Importantly, USCAP made the different parts of the triangle conditional on one another – thereby ensuring the package was not unpicked. Therefore, when they suggested an EPS of 1100lbCO2/MWh for all plant permitted after 2015 and 800lbCO2/MWh for those permitted after 2020, these EPS steps were conditional on the government adopting the USCAP financing proposals. If the finance was not in place for some reason, the EPS would be delayed until it was.

10. The following paragraphs respond to the specific questions raised by the Committee.

What are the factors that ought to be considered in setting the level for an Emissions Performance Standard (EPS) and what would be an appropriate level for the UK? Should the level be changed over time?

11. Consideration needs to be given to a wide range of factors. What is the basic policy intent – is it simply to prevent construction of unabated coal plant or is it also to incentivise lower carbon technologies including CCS? If the latter, is the technology commercially available to deliver the EPS and, if not, what are the prospects of it becoming available and by when? What is the right timescale for introduction to allow companies to factor the requirement into investment decisions? The form it takes – is it in gCO2/kWh or, say, a limit on annual operating hours – also needs to be addressed as does the period of operation over which it is applied. For example, is the EPS applied continuously or averaged over a longer period to provide some flexibility? In our view, the cost of compliance needs to be understood before setting an EPS (and this will not be known for some years until we have successfully demonstrated CCS technology), as well as whether the electricity market and the policy framework within which it operates will incentivise the required investments. This may not be clear until the process of electricity market reform is complete and the costs of compliance are known.

12. Whether an EPS should be tightened over time depends on the policy goal. If a decision is taken to introduce an EPS, it could either be set at a fixed level to prevent construction of higher carbon plant with the EU ETS driving investment below that level. Alternatively, if the EPS is adopted as the main driver, it could be tightened over time as and when CCS technology becomes available and as CCS costs reduces, subject to the market and the policy framework incentivising the necessary investment. However, energy companies would want to be clear what future requirements will apply to proposed new plants before they take an investment decision. The EPS should not be changed for new plants after the investment has been committed, unless the investor can fully recover the related costs.

What benefit would an EPS bring beyond the emissions reductions already set to take place under the ETS?

13. We have already pointed out that any reduction in emissions achieved in the UK would be offset by higher emissions elsewhere in the EU within the overall EU ETS cap. From a purely national perspective, it is difficult to say what benefit, if any, the UK would secure in terms of lower emissions from implementing an EPS compared to the EU ETS, not least because this depends on what assumptions are made about future carbon prices and the level of the EPS. If the EPS is set at a level which requires CCS on coal but not on gas, this would only lead to lower emissions if the EU ETS carbon price and relative coal and gas prices otherwise incentivised unabated coal plant. Of course it is possible to set an EPS which prevents construction of any unabated coal or gas plant. While this would avoid the emissions from the unabated plant which would otherwise have been built, the emission savings from an EPS need to be considered against the impact on power prices and security of supply.

14. Overall these outcomes could be achieved more efficiently by tightening the EU ETS cap which would give rise to a higher carbon price in which case the effect would be EU wide and the cost of delivering lower emissions would be spread more evenly across Member States. It could also be achieved by introducing more effective policies to incentivise construction of nuclear plants or CCS which would achieve the desired goal of accelerating investment in low carbon plant, accelerating the closure of existing plant and disincentivising investment in new unabated coal plant without imposing an EPS. This should be the goal of the Government’s electricity market reform process.

How effective is an EPS likely to be in driving forward the development of CCS technology? Should the UK’s CCS demonstration programme cover gas-fired as well as coal-fired power stations?

15. An EPS will not drive the development of CCS technology at all unless investors believe they will recover the costs associated with the investment needed. The key issue then is less the EPS but more whether there will be sufficient incentives to support the required investment to deliver CCS.

16. The recommendation by the Climate Change Committee (CCC) that the Government should seriously consider including CCS gas demonstration reflects the view that gas-fired plant may make up a significant proportion of new capacity operating in the 2020s, that some of this will need to be retrofitted with CCS to achieve its recommended goal of largely decarbonising the power sector by 2030, and that new gas-fired plant with CCS may be a more economic option than coal with CCS particularly for plant operating flexibly at relatively low load factors. We agree that the Government should consider this issue in more detail and should consult fully before reaching a decision.

17. The issue on gas CCS is perhaps more one of timing than whether CCS should be demonstrated on gas in principle. For coal, there is a requirement already that any new coal plant has a CCS demonstration project and an expectation that new coal plant would be retrofitted with CCS by 2025. In addition, from an international perspective, the priority is to fit CCS to new coal plant, which is still accounting for the majority of new build in developing countries such as China, rather than gas. All these arguments suggest that gas CCS demonstration should proceed later than for coal with the common engineering lessons from coal CCS demonstration then applied to gas.

18. For gas, the CCC is not arguing that new gas plant should have to be fitted with CCS until 2020. It is also not arguing that retrofit should be mandated on gas plants commissioned before that date, which would risk chilling any proposed investment between now and then. This raises the question of whether it is actually sensible to demonstrate gas CCS now, when no CCS would be operating on gas plant until 2020 at the earliest.

19. The volume of new gas plant that will in fact be built from 2020 and the need for gas CCS will depend in part on relative coal, gas and carbon prices at the time which are of course highly uncertain but may become somewhat clearer by the mid 2010s. How much new nuclear and renewable plant is operational in the 2020s will also be an important factor in determining the future role of gas plant on the UK system and whether CCS on gas plant will be required to achieve the CCC’s target of largely decarbonising the power sector by 2030.

20. The CCC view that a new gas-fired plant with CCS may have lower levelised costs than a new coal plant with CCS needs to be assessed more fully. This view is based on the Mott Macdonald report published by DECC on 1 June 2010 but is particularly dependent on assumptions about the relative price of gas and coal for power generation in the future. Relative capital costs are also a significant factor and in our view the report may underestimate the capital cost of a gas-fired plant with CCS. The following ‘phase diagram’ gives our very rough estimate of what plant is the cheapest to build against varying gas and CO2 prices assuming a constant price of coal.

21. There would also need to be a discussion about whether we should be supporting pre or post combustion on gas, or indeed oxy-fuel combustion. Oxy-fuel combustion currently appears likely to be the best option for gas in the long-term but it is the least advanced technology. These issues need to be fully debated before a decision is reached by DECC on whether supporting gas CCS now through the CCS levy is value for money for the consumer.

Could the introduction of an EPS pose any risks to the UK’s long-term agendas on energy security and climate change?

22. The main risk for security of supply arises from the effect of implementing an EPS without establishing first whether the necessary investment is capable of being funded by the market or by Government policies. This would lead to power plant investments, whether on coal or gas, depending on the level of EPS, being deferred until this has been resolved. This also applies to CCS demonstration projects on new plants as investors will want to know how CCS retrofit requirements subsequent to the demonstration will be funded. This means that consideration of EPSs and electricity market reform need to be considered together. Without this an EPS would disincentivise investment in new fossil (gas or coal) plant and could lead to an increased dependence on nuclear and intermittent renewables generation which are less able to operate flexibly to meet variable electricity demand which could significantly reduce energy security.

23. We have already pointed out that an EPS is a fundamentally different approach from emissions trading. We are concerned that the increasing focus on an EPS approach will lead to undermining of the EU ETS which is the principal policy mechanism for tackling CO2 emissions and that EU efforts to reduce emissions will be undermined.

What is the likely impact of an EPS on domestic energy prices?

24. This depends entirely on what assumptions are made about the extent of investment required to deliver an EPS, the level of the EPS set, what plant it is applied to, the extent to which the investment is incentivised by the carbon price or additional incentives such as the CCS levy, and the level of electricity prices had an EPS not been introduced. If the EPS is set at a level which requires more CCS than under current policy, then the effect will be to raise power prices and prices to the domestic consumer.

25. Assuming no policy interventions to fund CCS, investors would in principle only invest in fossil plant with CCS if they believed wholesale power market prices allowed them to recover the cost of the relevant investment. On this basis, and as a very rough estimate, power prices would need to rise by at least 25% to deliver this outcome for first of a kind CCS plant, although this would fall as CCS costs declined. As power prices account for about half of retail prices to domestic consumers, this would lead to an increase in domestic prices of at least 12%. However, wholesale prices would only rise to this level if fossil and CCS plant were the lowest cost new capacity available. In practice new nuclear is likely to be significantly cheaper so market prices would not rise to this level. This means that additional support would be needed to fund fossil plant with CCS. The estimated maximum impact on domestic bills of the Government’s CCS demonstration programme is around 2-3% but this only covers the cost of around four projects of around 300-500MW each.

Are any other European countries considering an EPS? If so, should the standards be harmonized?

26. Not that we are aware of, although the issue has been discussed in the European Parliament. The EU’s principal policy measure for reducing CO2 emissions is through the EU ETS. The Industrial Emissions Directive in fact prohibits Member States from imposing plant specific CO2 limits under the IPPC regime as the EU ETS is intended to be the main driver. Given the lack of wider interest by Member State governments and the Commission’s view that the EU ETS is the priority, we see no need to harmonise EPS standards.

Could unilateral action by the UK to introduce an EPS contribute towards global climate negotiations in Cancun in November 2010?

Can greater use of Emissions Performance Standards internationally help promote agreement on global efforts to address climate change?

27. While the commitment not to permit the operation of unabated coal plant could have a modest impact, it could also be seen as a demonstration of a lack of confidence in the EU ETS and emissions trading. The EU and the UK have hitherto aimed to extend the use of emissions trading from the EU to encompass other countries. The EPS is a fundamentally different approach. The international community would perhaps be more impressed by seeing CCS demonstration proceeding on a commercial scale than statements of policy intent.

September 2010