Next steps for ETS - The 2007 review

1. TSEC 2 www.electricitypolicy.org.uk/tsec/2 Next steps for ETS - The 2007 review European Wind Energy Conference Milan 9th of May 2007 Karsten Neuhoff University of Cambridge www.climate-strategies.org/

2. Next steps for the European Emissions Trading Scheme (I) Objective: effective and efficient (II) Objective: investment security (III) Interaction with renewables policy

3. Objective: Effective and efficient – process optimisation These distortions from repeated free allowance allocation can be ranked in a pyramid Auction X Capacity only Benchmarking Capacity by fuel/plant type X X X X Output only Updating from Previous periods X X X Output by fuel/plant type X X X X X Emissions X Reduce incentives for Impacts Discourage plant closure Distortion biased towards coal Distortion biased towards coal • Increased expenditure on • extending plant-life Shields output from average carbon cost Efficiency-improving investment • Inefficient fuel choice • Less efficiency improvements Source: Neuhoff, K., Keats, K. and Sato, M., 2006, Allocation, incentives and distortions: the impact of EU ETS emissions allowance allocations to the electricity sector, Climate Policy, 6 (1)

4. Objective: Effective and efficient - process optimisation … and we seem to have made little progress moving on Installed capacity P P P Uniform Projection for production P P Historic production P O Benchmarking Installed capacity Fuel spec. Projections of production P Tech / Increasing Distortion NAP II not available NAP II not available Historic Production Projections O O P / O P / O P Emission based P / O Historic Emissions O O-Not def P / O P / O P / O O P / O P / O AT* BE -W BE - F BE - B CY CZ** DE DK** EE ES* FI FR GR Installed capacity Uniform P Projection for production P / O Historic production NAP II not analysed yet / No Benchmarking Installed capacity P Fuel spec. P Projections of production P P / O P / O Tech / translation available Historic Production O Projections P / O P P / O P / O O Emission based P P / O Historic Emissions P / O O P / O P / O P P / O P / O P / O P / O P / O P / O HU* IE IT* LT LU LV MT NL PL PT SE SI SK UK Source: Neuhoff, K., Rogge, K., Schleich, J., Sijm, J., Tuerk, A., Kettner, C., Walker, N., Åhman, M., Betz, R., Cludius, J., Ferrario, F., Holmgren, K., Pal, G., Grubb, M. and Matthes F., 2006, Implications of announced Phase 2 National Allocation Plans for the EU ETS, Climate Policy 6(5) pp. 411-422.

5. Objective: Effective and efficient - process optimisation And the level of allocation is not trivial Source: Neuhoff, K., Rogge, K., Schleich, J., Sijm, J., Tuerk, A., Kettner, C., Walker, N., Åhman, M., Betz, R., Cludius, J., Ferrario, F., Holmgren, K., Pal, G., Grubb, M. and Matthes F., 2006, Implications of announced Phase 2 National Allocation Plans for the EU ETS, Climate Policy 6(5) pp. 411-422.

6. Objective: Effective and efficient – substituting (intermediary) products Prices drive substitution (with regulatory/institutional support) Source:Newbery, D. M. (2003) Sectoral dimensions of sustainable development: energy and transport. Economic Survey of Europe 2(73-93).

7. How do address competitiveness effects? Efficient production Environmental costs reflected in price Innovative market response Global or sectoral agreements Border tax adjustment* Allocation pro-portional to output Develop options for different international outcomes Phase I 2005-07 Phase II 2008-12 We will find the best solution in an international dialogue. *Ismer/Neuhoff, 2004, Border tax adjustments: A feasible way to address non-participation in emission trading, CMI/DAE WP 36.

8. Next steps for the European Emission Trading Scheme (I) Objective: effective and efficient • Emissions reductions from process optimisation • Emissions reductions from substitution effects • > Auctioning (II) Objective: investment security (III) Interaction with renewables policy

9. Objective: Investment security Stern 2006 In the next 10 to 20 years … transition ... to [a world] where carbon pricing is universal and is automatically factored into decision making. … avoids the risks of locking into a high-carbon infrastructure … additional measures may be justified to reduce the risks."

10. Create mid-term confidence in CO2 price to facilitate low Carbon investment Projection uncertainty implies price uncertainty Source: Emissions Projections 2008-2012 versus NAP2 (2006) by Karsten Neuhoff, Federico Ferrario and Michael Grubb. Published in Climate Policy6(5), pp 395-410.

11. Create mid-term confidence in CO2 price to facilitate low Carbon investment Price set by price floor Free allocation Free allocation Coordinated auction with price floor can reduce risk of low prices 10% auctions with price floor could facilitate investment Source: Emissions Projections 2008-2012 versus NAP2 (2006) by Karsten Neuhoff, Federico Ferrario and Michael Grubb. Published in Climate Policy6(5), pp 395-410.

12. Create long-term confidence in CO2 price to facilitate low Carbon investment Proposed approaches to create long-term stability • Increased use of banking* • Open market intervention • Splitting allowances as under US clean air program • Longer commitment periods * Newell, R., W. Pizer and J. Zhang (2005) Managing Permit Markets to Stabilize Prices. Environmental and Resource Economics 31(2): P.133 - 157.

13. Create long-term confidence in CO2 price to facilitate low Carbon investment Expected (Ex Ante) and Actual (Ex Post) Total Costs of some UK Policies during 1990-2001 ex ante 6000 ex post 5000 4000 Costs (£M) 3000 2000 1000 0 Lead Free Euro I petrol 2000 fuel 2005 fuel in Flue Gas De- Low NOX Petrol Cars* standards 2000/1 Sulphurisation burners (FGD) * Upper estimate >£8000 mio. Source: AEA Technology Environment, 2005, An Evaluation of the Air Quality Strategy, Report to DEFRA, available at: http://www.defra.gov.uk/

14. Create long-term confidence in CO2 price to facilitate low Carbon investment Option contracts could create long-term price floor • Governments sell option contracts to private parties • Creates property right, strong enforceability • Investors can call an option: • Hands in option + CO2 allowance • receives strike price, e.g. 15 Euro/t CO2 • Direct hedge for investment • Investors will call options if pCO2<15 Euro/tCO2 • Reduces supply, pushes up price, implements price floor • Governments avoid buying back allowances • Restricts issuing allowances to retain scarcity price Ismer, R. and Neuhoff, K. (2006) 'Commitments through financial options: a way to facilitate compliance with climate change obligations‘, EPRG WP 06/25

15. Next steps for the European Emission Trading Scheme (I) Objective effective and efficient • Emissions reductions from process optimisation • Emissions reductions from substitution effects • > Auctioning (II) Objective investment security • Why is it an issue? • >Price floor in auctions • >Long term option contracts (III) Interaction with renewables policy

16. Interactions between CO2 and renewables policy CO2 price internalisation and technology policy learning costs reduced by CO2 policy with CO2 price additional benefits saved costs price existing technology market size time , cumulative sales ETS is no substitute for technology policies (e.g. renewable support)

17. Interactions between CO2 and renewables policy What are the implications for renewables investment Price uncertainty from ETS + Price/revenue uncertainty transmission constraints + Intra-annual volatility and balancing costs ---------------------------------------------------------- Significant market and regulatory uncertainty

18. Future environment for renewables - congestion and balancing – build constraints create scarcity rent * * * * * * * Regional build constraint binding * Our model outputs: Wind output Wind investment CCGT investment Source: Neuhoff,K Cust, J and Keats,K, 2007, Modeling wind in the electricity sector, EPRG working paper 0702

19. Future environment for renewables - congestion and balancing Results in more volatile and peaky prices Illustrative Euro/MWh 100 90 80 70 60 50 40 2010 30 2005 20 2015 2020 10 0 0 1 year

20. Addressing regulatory risks reduces financing costs ROC Banded ROC Fixed & banded ROC Take or pay contract In the real world, it is all about who carries the risk Performance/operation Performance/operation Risk from: Risk from: Project revenue Project revenue Regulatory uncertainty Regulatory uncertainty requirement requirement Future market evolution Future market evolution Source: Johnston, Kavali and Neuhoff, 2007 Take-or-pay contracts for Renewables Deployment, EPRG Working Paper 0707. Costs Costs RO design RO design constraints constraints Energy price Energy price ROC market ROC market inframarginal inframarginal Project risk and Project risk and Balancing costs Balancing costs developers margin developers margin Impact transmission Impact transmission technologies/locations Profit for Profit for Reduce (a) infra-marginal rent (b) regulatory risk (c) re-allocate risk from future technology mix/fuel prices

21. Next steps for the European Emission Trading Scheme (I) Commit to auctions of most allowances • Avoids delays in emission reductions (early action problem) • Positive for distributional impacts, innovation, credibility (II) Consider instruments to avoid low prices • Price uncertainty delays (low Carbon) investment • E.g. use price floor in auction, long-term option contracts (III) Renewables policy • For many technologies CO2 price alone too low • In addition significant uncertainty about market design (congestion, balancing, CO2) • Provide long-term stability (e.g. take or pay contracts)