EU ETS after one yearand prospects for the future

Workshop 4 April

NCM, Climate Change Policy Group

2

Outline of presentation

Experiences so far

The second trading period Links between the periods

Post-Kyoto

3

0

5

10

15

20

25

30

35

01-jan

29-jan

26-feb

26-mar

23-apr

21-maj

18-jun

16-jul

13-aug

10-sep

08-okt

05-nov

€/tC

O2

Carbon price development 2005

Source: Point Carbon

Cold spells

Mild weather

Cuts in Polish NAP141,3 Mt (16,5%)

Cuts in Italian NAP 69 Mt (9%)

Last NAP approved

High gas price UK

Court ruling on UK NAP

Imports of CDM credits

?

Expectations are

important!

4

Observations and explanations

Allowance prices much higher than most expected before the system was launched

Potential explanations:

Changes in net demand due to: Changes in allocation (supply) ”Errors” in estimation of BAU emissions Changes in underlying economic conditions

Changes in abatement costs Changes in fuel prices ”Errors” in estimation of MAC curves

5

Changes in allocations

During review process cuts of almost 300 Mt were made Poland: 141 Mt Italy: 69 Mt Czech rep: 31 Mt France increased the allocations with ca. 100 Mt due to

inclusion of more facilities

Late submissions and decisions

6

Changes in allocations

0

1 000

2 000

3 000

4 000

5 000

6 000

7 000

8 000

Final allocation Cuts compared to notifiedplans

Emission projections

Mt

CO

2 (

20

05

-07

)

Emission projections

Cuts compared to notified plans

Reserves

Final allocation

Net demand

0

50

100

150

200

250

300

350

400

Net demand final allocation Net demand final allocation without cuts

Mt

CO

2 (2

005-

07)

7

Other changes to net demand

Some differences in BAU estimates between submissions of national communications to UNFCCC and national allocation plans:

Higher estimates in NAPs

Economic conditions reduced emissions Reduced steel production (8-10 Mt) Labour market conflict in Finland (10 Mt)

Weather Dry year in Spain

– Hydro inflow reduced by 14 TWh, nuclear with 7 TWh

Wet in Nordic area– Hydro inflow 35 TWh above normal

8

Abatement costs

Substantial changes in fuel prices Affect cost of fuel switching

Large uncertainties about the actual abatements costs in different sectors

9

Fuel switching depends on fuel prices

CoalGas

Gas Coal

Marginal carbon

cost

Price

Volume

Full price effect

Realized price effect

10

Fuel price developments during 2005

0

20

40

60

80

100

Oct-04

Nov-04

Dec-04

Jan-05

Feb-05

Mar-05

Apr-05

May-05

Jun-05

Jul-05

Aug-05

Sep-05

Oct-05

Nov-05

Dec-05

Jan-06

Feb-06

Mar-06

Apr-06

May-06

$/to

nn

e (c

oal

), p

/th

(g

as),

€/t

on

ne

(CO

2)

Coal Gas CO2 CO2 break even

11

Development of the market

Delays in national registries

Growing trade Jan/Feb -05: 0.6 to 3 Mt/week

Nov/Dec – 05: 10 Mt/week

Total trade during 2005: 250 Mt

0

5

10

15

20

25

30

35

40

Mt

12

CER

Expectation: Lower price in next period

Pexp next period

P

Allowances/gap

MAC

MAC = Marginal abatement costs

Max short-term abatement

40 €

Supply curve

Carbon supply curve 2005-2007

13

Changes within EU ETS for Phase II

Price of

allowances

No opt out

10% auctioning

100€ penalty

JI credits

New gases/sectors

Little impact

Little/no impact

Little/no impact

May reduce price

Ambiguous price effect

BUT mandatory inclusion of new sector/gases may affect the price Aviation may be included in Phase II

14

Import of credits – uncertainties about supply

Nov. 15, 2005: 35 CDM projects registered (7.8 million CERs)

400 projects at validation stage

20 avaiting regitration

57000 CERs issued into CDM registry

To 2012: 500 Mt CO2e not unlikely But to whom? And when?

And JI from 2008

15

The Kyoto period gapCommission:

A number of countries not sufficiently on track Unlikely that it can be closed without the ETS Some MS will have to reduce – other keep unchanges Allocation 6% below phase I (~130 Mt lower)

0 50 100 150 200 250 300 350

EU-15

EU-25

EU-27

"Com guidelines"

2005-07 gap

Mt CO2

ETS sector share

Annual gap

Imports of credits: Share to EU?

16

Summary of price shapers

First trading period

Kyoto period

Beyond Kyoto

Relative fuel prices

Supply of CDM credits

Restrictions on imports

Supply strategy AAUs

Binding target?

Back-stop technology

2005 – 2007

2008 – 2012

2012 – …

Expected price

Expected price

Main price drivers:

17

0

5

10

15

20

25

30

35

40

0 50 100 150 200 250 300 350 400 450

Emission reductions from BAU (Mt)

Eur

o/to

n

Base case Low gas price Events in 2005

Gap = 314 Mt

Preview of model results

Allowance price

Model simulations

Workshop 4 April

NCM, Climate Change Policy Group

19

Model simulations for 2005-07

Three cases Base case with normal weather and actual

fuel prices Sensitivity with low gas prices in 2006 and

2007 Sensitivity with actual events in 2005

ECON’s carbon market model Built on ECON’s European power market

model Added heat and industrial sectors in ETS Covers the three year period 2005-07

20

ECON Carbon market model

21

Assumptions

Allocation of allowances According to NAPs Norwegian allowances added

Import of CERs The level of import uncertain Not analysed separately – but can be done through

varying the gap

Economic growth Assumptions based on ECON in-house analysis and

forecasts from Deutsche Bank

Weather Not modelled demadn varations due to weather, but

analysed through sensitivity analysis

22

Assumptions, cont.

Abatement costs and fuel prices Power sector most important sector (in the short run)

Fuel prices based on observed spot prices for 2005 and forward prices for 2006 and 2007

Seasonal variation in gas prices

0

5

10

15

20

25

30

35

40

1 9 17 25 33 41 49 5 13 21 29 37 45 1 9 17 25 33 41 49

Week No. (2005-2007)

€/M

Wh

Continent - base case (TTF) UK - base case (NBP)

Continent - low gas price UK - low gas price

23

Assumptions, cont.

Generation and transmission capacities are actual capacities in 2005 and adjusted for known investments and closures in 2006 and 2007.

No endogenoues investments (short run)

Lower price elasticity of power demand in the short run (-0.2 to -0.4)

24

Results – allowance priceBase case

0

5

10

15

20

25

30

35

40

0 100 200 300 400

Emission reductions from BAU (Mt)

Eu

ro/to

n

Gap = 314 Mt

Allowance price

25

0

5

10

15

20

25

30

35

40

0 50 100 150 200 250 300 350 400 450

Emission reductions from BAU (Mt)

Eur

o/to

n

Base case Low gas price

Gap = 314 Mt

Results – allowance priceSensitivity: Low gas priceAllowance price

26

0

5

10

15

20

25

30

35

40

0 50 100 150 200 250 300 350 400 450

Emission reductions from BAU (Mt)

Eur

o/to

n

Base case Low gas price Events in 2005

Gap = 314 Mt

Results – allowance priceSensitivity: Events in 2005Allowance price

27

The Kyoto period

No model simulations made

Simulations for 2005-07 indicate that a change in the gap (over three year) of 1 Mt change the allowance price with €0.1

Price range: €15-70 Without imports

MAC likely to be lower with more abatement possibilities

28

Cost of CO2 emissions

Short term power price effect

Produce if: Power price > Marginal cost of fuel plus carbon

Carbon allowances have an alternative market value

Total capacity

Fuel costs

P>F+C: Sell power

F<P<C: Sell credits

P<F: Sell credits

100% free allocation: 100% windfall profit

Different plants in different hours

29

Effect on average price level

No effect Small effect

Large effect

Smalleffect

Effect on average prices depends on capacity mix and load pattern

Price

Volume

30

Electricity price – base case

0

10

20

30

40

50

60

0 3 13 21 29 32 40

Allowance price, €/ton

Ele

ctdr

icity

pric

e, ö

re/k

Wh

Jutland 2005Jutland 2006Jutland 2007Sweden 2005-2007

31

Electricity price in Sweden 2005:

15

20

25

30

35

40

45

50

55

0 5 10 15 20 25 30 35 40

Allowance price (euro/ton)

Po

wer

pri

ce (

öre

/kW

h)

High gas price Low gas price Events in 2005

32

Distortions of short-term price effects

Market power Monopolists and oligopolists do not pass through the

full marginal cost effect in bids

Withdrawal of allowances (within trading period) Reduced emissions t1 reduced allocation t2: Reduced value of selling credits/additional value of

generating

”Grandfathering” (between trading periods) Emission level period 1 determines allocations period 2

(or 3) Additional value of generating

Rules are not harmonized Different rules in different countries affect trade

33

Long term power price effect

Invest if: Expected average price > Long-term marginal costs

Capital costs

Fuel costs

O&M costs

Purchase of Credits

”Need” for allowances

What is BAU?-Benchmarking? -BAT?-Same allocation for all kWh

Long-term price effect: -Share of free allocations important

High share of free allocations-Smaller average price effect-Abatements on the supply side (more gas power)

Long-term (expected) average price level

(Expected) cost per kWh

34

Allocation rules distort investment decisions

Outcome of free allocations: Investments are realized “too early”

Do not take into account the full cost

Distortion towards consumption Reduced price effect reduces incentives for

abatements and measures on the demand side

Distortion towards carbon-free capacity Premium for fossil fuel plants (free allowances) No premium for renewables and CO2 capture and

storage

Distortion in choice between gas and coal? DK: Same amount of free allowances NO DE: Higher amount to coal YES

35

Power price effects in the model

Full pass-through of marginal costs in short term (hourly) prices

Demand effects taken into account! Different plants marginal in different hours different

cost increases in different hours General pass-through: Average of all hours

Long-term pass-through determined by average cost effect on new plants

High share of free allowances: Small price effect increased gas power investments and generation

Low share of free allowances: Large price effect reduced consumption (and some new gas)

New investments and the gap Assume free allowances are taken from NER and left-

overs are cancelled

36

Contacts

Niclas DamsgaardPartner, ECON Analysis

niclas.damsgaard@econ.se

37

ECON – Contact information

OsloECON Analysis Headquarter/ECON Management

P.O.Box 5, N-0051 OSLOBiskop Gunnerus’ gate 14APhone: +47 45 40 50 00Fax: +47 22 42 00 40 (Analyse) Fax: +47 22 41 41 44 (Management)e-mail: oslo@econ.no

Copenhagen

Nansensgade 19, 6. salDK-1366 København K DenmarkPhone: +45 33 91 40 45 Fax: +45 33 91 40 46 e-mail : copenhagen@econ.no

Stockholm

Artillerigatan 42, 5 trSE-114 45 STOCKHOLMSwedenPhone: +46 8 528 01 200Fax: +46 8 528 01 220e-mail : stockholm@econ.se

Stavanger

Kirkegaten 34006 STAVANGERTelefon: +47 45 40 50 00e-post: stavanger@econ.no

Paris

18, rue de la PerleF-75 003 PARISFrankrikeTelefon: +33 1 45 78 70 03Telefaks: +33 1 48 87 44 39e-post: paris@econ.no