The implications of EU carbon trading23 May 2004
The EU’s CO2 cap and trade scheme gets under way next January. The first of its kind in the world, it will cover more than 12000 installations, in five sectors, with power generation accounting for 55% of the total emissions. What are the challenges for European utilities?
Six months away from the introduction of the EU Emissions Trading Scheme (ETS), on New Year’s day 2005, utility companies throughout the 25 EU member states will be focusing on the challenges and opportunities that the first international trading initiative of its kind presents.
Key considerations for energy utilities can be defined in five areas – trading, fuel switching, international company markets, plant efficiency and innovation. Together, they provide a snapshot of emissions strategy considerations and the implications of carbon trading for energy sector participants.
Ratification of the Kyoto Protocol by the EU obliges member states to reduce emissions of greenhouse gases by eight per cent of their 1990 levels during the years 2008 to 2012. Companies who fail to do so will need to purchase the necessary allowances to cover their emissions, or incur significant fines. Kyoto initially covers carbon dioxide emissions but in 2008 this will be rolled out to include the other five greenhouse gases.
Emissions allowances will be bought and sold on an open market influenced by numerous factors. Weather, demand for energy, the coal to gas price spread and the level of absolute scarcity of carbon credits will all affect the price of emissions allowances. A drought, for example, may reduce hydropower output forcing a fuel switch to coal that would raise emissions levels and subsequent demand for emissions allowances.
Wider implications of trading trends are significant for companies and investors with interests in carbon prices and are critical to any emissions allowance trading strategy: ‘The advent of emissions allowance trading will provide a further spur to the development of derivatives based around the weather and coal/gas spread risks. Certainly the geographic scope and volume of participants is sufficient for a fully developed marketplace to emerge that moves beyond compliance activity to more dynamic trading.’ (PricewaterhouseCoopers, Emission Critical: 31 March 2004).
Industry attention is now on the European Commission’s (EC) decision on whether or not to make member states comply with EU law. This decision, and the variety of compliance routes available, will determine whether the trading market is liquid, volatile or static. Some will pin their hopes on the EC being lax and the ETS becoming a non-event. Others will take the view that regulation to reduce climate change is here to stay and that early adoption of a strategy to reflect that will place their businesses in a leading position.
Fuel switching to reduce emissions will be a favoured tactic of many players. Through the Linking Directive, companies based in Western Europe are able to implement global fuel switching projects on a more cost effective basis by importing carbon credits from a range of host countries. It is crucial to look at ways to maximise this opportunity for best returns.
Many utilities will actively pursue a fuel switching strategy through coal to gas conversions or through a portfolio with more bias given to CCGT plant. There are, however, major concerns about the impact this compliance strategy will have on security of supply, the ‘spark spread’ for gas vs coal plants and the risk of utilities profiting if higher marginal gas and power prices are passed to consumers. We are likely to see fewer coal plants being retired by operators who may trade coal plant power using reduced load factors and play a game of ‘wait and see’.
Renewable energy sources offer some attractive propositions for fuel switching strategies. Fluctuations in the price for fossil fuels have little impact on the economics of renewable energy sources. The operating costs for renewable options tend to be lower than those for traditional sources, while renewables also attract a range of financial support incentives. They strengthen the position of portfolio players by offering security of supply and the ability to switch away from carbon emitting fuel sources according to the market dynamic.
But as well as the combined appeal of renewable energy sources – demonstration of a commitment to sustainability, reputation enhancement and financial incentives – there are significant questions around what will be required from renewable energy sources and what they can actually deliver in practical terms. The place of renewables within an emissions reduction strategy will depend upon technical considerations as well. For example, increased co-firing regimes demand greater volumes, which in turn drive up fuel diversity, fuel quality and infrastructure problems.
EU member states are at varying degrees of preparation in the run up to January 2005, but most large company players will already be considering the impact the ETS will have on their company throughout their international markets. International presence, along with plant viability, will need reassessment as the full implications of each country’s individual Kyoto obligation becomes known.
A portfolio with breadth will, in many ways, provide some protection in the new environment. The newly approved EU Linking Directive, allowing utilities to develop projects that generate carbon credits from projects outside the EU, is a positive to be used to maximum effect.
Where a utility has, in the past, concentrated on the marginal cost of a power plant, the Linking Directive’s Joint Initiative and Clean Development Mechanism project approaches could provide a lower cost route to securing carbon credits and ETS compliance. Economic modelling, scenario planning and project development have already begun with international carbon credit eligible projects in the oil and gas, power, chemical, metal, cement and paper sectors. These projects are opportunities to gather best practice knowledge. They will drive supply chain and cross-sector alliances as companies strive to maximise opportunity while reducing new venture risk.
It is also inevitable that nuclear energy new builds and closures will hit the individual agendas of EU member states following 1 January. These will vary from country to country. Demand for more energy at cheaper prices, coupled with emission reduction pressures and emerging gaps in renewable energy generation, will put the spotlight back on the nuclear question.
Despite confidence in the market that wholesale energy prices will rise as a result of carbon trading, opinion is split on whether this can easily be passed on to the consumer. It is no forgone conclusion that governments will accept higher prices as an outcome of climate control measures. It will be important for energy companies to demonstrate efficient and sustainable management at company and plant level if they are to persuade regulators to maintain a ‘hands-off’ approach.
The level of plant efficiency will inform individual plant viability, a company’s international market presence, and fuel switching tactics. If a plant has sufficient investment, and is well maintained and runs efficiently, it will create more energy, consume less fuel and emit less carbon. As already discussed, some installations may simply be uneconomic within the emissions trading environment, but inspection, analysis and capability studies are essential to get the big picture upon which to make valuable strategic decisions.
As always, technology through innovation will provide answers, and smart players are preparing early. BP, for example, are partnering with engineering companies like Mitsui Babcock on investment led contracts. Under these projects, the engineering company will invest in the refinery or offshore facility and share in the returns once efficiency savings and direct carbon reductions are delivered. Using the energy sector supply chain in this way will offer valuable assistance to utilities.
Another good example of technology led solutions is using supercritical retrofit technology to produce plants capable of delivering carbon reductions equivalent to hundreds of wind turbines. Not only does it reduce harmful emissions and the amount of coal burned, but it also protects security of supply by reducing the need for significant infrastructure disruption and loss of land and sea to large-scale wind farms. China offers a case study of a country using these solutions in answer to increased environmental awareness. For coal-fired plants in China, ninety per cent of orders are for supercritical equipment. This focus is driving much of our work in the area on plant retrofitting and upgrading, and this type of technology can deliver real carbon reductions in the EU.
Advanced coal plant technology is an important element in the mix of alternative energy solutions as plants are increasingly required to cope with demands for large surges in output.
The most successful companies beyond January 2005 will be those making preparations now that place these five considerations at the top of their agenda. Too few are preparing themselves to exploit the new environment to their advantage and using their supply chain to assist them. The value to utilities of working with innovative supply partners may be one of the most crucial success factors under carbon trading.
TablesTable 2. Status of NAP submissions 31 March 2004