Carbon Derby - Comeback of the Fuel Switch

7/31/2019 Carbon Derby - Comeback of the Fuel Switch

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Sector update 4 December 2006

Carbon DerbyComeback of the fuel switch?

Equity researchUtilities | Europe

Online research:www.dresdnerkleinwort.com/research

Bloomberg:DKIB1

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Research Analyst

Lueder Schumacher

+44 (0)20 7475 2491

[email protected]

The European Commission has demonstrated that it intends to be tough on Phase

II allowance allocations. We now expect average Phase II emissions to exceed

total allowances by 313mt/pa. Even more important is that the ECs proposed cap

on CDM/JIs leaves a net deficit of 19mt/pa. This means that there is a good

chance for the fuel switch to become the marginal form of abatement in Phase II.

Commission gets tough. Last Wednesday the EC ruled on 10 National Allocation Plans

(NAPs), demanding overall cuts of 63.9mt/pa, or almost 7%. The cuts were some 24mt

below our estimates and show that the Commission is serious about creating a carbon

constraint for Phase II. Following the release of Wednesdays data we have cut our

forecast for total Phase II allocations by 76mt to 2,073mt/pa. The cuts are the result of

decisions on the 10 NAPs (where the cuts were 24mt/pa above our forecast) and usingthe methodology the Commission has applied to revise our forecast for the remaining

NAPs.

Phase II total allocation forecasts

Phase I

allocations

mt CO2/pa

Phase II

Draft mt

CO2/pa

Phase II

like-for-like

1 mt CO2/pa

2005 verified

emissions mt

CO2/pa

Linking

directive

(%)

Max amt of

CDM/Jls mt

CO2/pa

Phase II

NCF & DKIB

mt CO2/pa

EC Ruling

on 29 Nov

Phase II

cut vs

prop. mt

CO2/pa

Austria 32.9 32.8 32.5 33.4 20 5.8 29.0 (3.8)

Belgium 62.9 63.2 58.1 55.3 10 5.5 57.3 (5.9)

Bulgaria 67.3 50.5 10 5.6 56.0 (11.3)

Cyprus 5.7 7.5 7.5 5.7 10 0.6 6.2 (1.3)

Czech Republic 97.6 101.9 101.9 81.2 11 9.7 85.5 (16.4)Denmark 33.5 33.5 33.5 26.5 10 2.5 25.0 (8.5)

Estonia 19.0 24.5 24.5 12.6 10 1.2 11.6 (12.9)

Finland 45.5 39.4 39.0 33.1 12 3.8 31.6 (7.8)

France 156.5 156.1 145.6 131.3 10 13.8 138.2 (17.9)

Germany 499.0 482.0 471.0 473.8 12 54.4 453.1 Yes (28.9)

Greece 74.6 75.5 78.8 71.1 9 6.2 69.1 Yes (6.4)

Hungary 31.3 30.8 30.8 25.9 10 2.5 25.3 (5.5)

Ireland 22.3 22.6 22.6 22.4 22 4.6 21.2 Yes (1.5)

Italy 222.0 200.0 200.0 223.1 28 52.1 186.1 (13.9)

Latvia 4.6 7.7 7.2 2.9 5 0.2 3.3 Yes (4.4)

Lithuania 12.3 16.6 16.5 6.6 10 0.9 8.8 Yes (7.8)

Luxemburg 3.4 4.0 4.0 2.6 10 0.3 2.7 Yes (1.3)

Malta 2.9 3.0 3.0 2.9 10 0.2 2.1 Yes (0.9)

Netherlands 95.3 100.8 96.9 80.4 10 9.2 92.2 (8.6)

Poland 239.1 276.2 275.7 195.0 10 20.0 200.3 (75.9)

Portugal 38.2 37.9 37.9 36.4 15 5.1 33.9 (4.0)

Romania 90.4 72.5 10 7.4 73.7 (16.7)

Slovakia 30.5 41.3 41.3 25.2 7 2.2 30.9 Yes (10.4)

Slovenia 8.8 8.3 8.2 8.7 10 0.8 8.3 0.0

Spain 174.4 152.7 152.2 181.1 36 55.0 152.7 0.0

Sweden 22.9 25.2 25.2 19.3 10 2.3 22.8 Yes (2.4)

UK 245.3 246.2 236.7 242.4 9 22.0 246.2 Yes 0.0

EU 27 2,180.5 2,347.3 2,150.6 2,121.9 293.8 2,073.1 (274.3)

Source: New Carbon Finance & Dresdner Kleinwort Equity research estimates


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Carbon Derby 4 December 2006

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JI/CDM limit. Compared to business-as-usual emissions for 2008-12 (on average

2,386mt/pa on our assumptions), total allowances of only 2,073mt/pa would leave a

deficit 313mt/pa. Until Wednesday a lot of commentators automatically assumed that the

marginal form of abatement would come from the use if Kyoto project credits (which can

then be converted to CERs and ERUs that can be used to meet a countries emission

reduction targets). However, on Wednesday the Commission also decided to cap the

inflow of CDMs (Clean Development Mechanism) and JIs (Joint Implementation).

The Kyoto Protocol allows Member States to invest in CDMs (emission reduction

schemes in developing countries without an emission reduction target, eg. China, India)

and JIs (emission reduction schemes in industrialised countries with emission reduction

targets, eg. Russia, Ukraine) to comply with part of their emission reduction

commitments.

What the EC has now determined is just how big that part can be. The EC stated on

Wednesday that: The Commission considers that, as a general rule, installations should

be allowed to use JI and CDM credits to supplement their allowance allocation by up to10%

We believe that this statement is slightly misleading, as there is no overall 10% cap. The

Commission later states that the Commission takes the following approach to assessing

the compatibility of the proposed JI/CDM limits against Annex III to the Directive: The

level of effort to reduce greenhouse gases a Member State is required to undertake is

determined by assessing the amount of reduction it is required to undertake in relation to:

z base year emissions

z greenhouse gas emissions in 2004

z and projected emissions in 2010

In the next step, half of the figure representing the highest effort is calculated. This figure

is considered to be the maximum overall amount of JI/CDM credits that a Member State

can make use of in addition to domestic action.

We believe that this method is the main consideration in determining a Member States

cap on CDM/JIs. Therefore, there can be three different levels of caps:

z countries who want to set a cap of less than 10% on the use of CDM and JI credits

for compliance (through the so-called Linking Directive) can do so (eg. 9% for the UK)

z countries who dont specify a maximum amount will automatically receive a 10% cap

z countries that want more than 10% of their emission reduction targets covered by

CDM and JI credits will have their cap calculated according to the method mentioned

above (eg. Ireland, Spain)

As a result we can already get a good idea of the likely overall cap on CDMs and JIs

because we can use the criteria above to calculate the caps the Commission is likely to

impose. The fifth column in the table above shows the caps under the Linking Directive

and the column next to it shows the resulting overall amount in mt CO2/pa. Even

assuming that every countrys limit is used to the max which is unlikely given that some

countries did even apply for a cap the total amount of credits that would be allowed into

the scheme is 294mt pa, which is less than the 313mt/pa deficit we are currently looking

for.


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Europe likely to face significant carbon constraint

2008

mt CO2/pa

2009

mt CO2/pa

2010

mt CO2/pa

2011

mt CO2/pa

2012

mt CO2/pa

Predicted emissions 2,292.7 2,336.9 2,377.6 2,427.6 2,494.2

Overall Phase II allocations 2,073.1 2,073.1 2,073.1 2,073.1 2,073.1

Surplus / (deficit) (219.6) (263.8) (304.6) (354.6) (421.1)

Maximum CDM / JI supply (E) 293.8 293.8 293.8 293.8 293.8

Net surplus / (deficit) 74.2 30.0 (10.8) (60.8) (127.3)

Average emissions 2008-12 2,385.8

Overall Phase II allocations 2,073.1

Average surplus / (deficit) (312.7)

Maximum CDM / JI supply (E) 293.8

Net surplus / (Deficit) (19.0)

Source: New Carbon Finance & Dresdner Kleinwort Equity research estimates

This means that under our current assumptions for 2008-12 emissions and total

allowances for Phase II the fuel switch running gas fired plants instead of coal fired

ones is set to make a comeback. At current oil prices the cost for the fuel switch is

around 30/t (although it has been almost 65/t earlier in the year). However, this does

not necessarily mean that the actual cost of the fuel switch will set the price. Instead the

necessity for the fuel switch is likely to drive prices towards a level where the industrial

response kicks in, ie the stopping of CO2 intensive processes. Once CO2 prices exceed

the profit margin on a given product it makes more sense for companies to stop the

production process and sell their allowances instead. We believe that this response, or

demand side management (DSM) was already evident when CO2 prices traded between

20-30/t.

However, the above scenario is our base case, and this can vary significantly depending

on movements in fuel prices (+/- 300mt/pa) and GDP growth scenarios (+/- 200mt/pa).

Because of the necessity for regular detailed updates on those, as well as developments

in the CDM/JI market, we have linked up with New Carbon Finance (NCF) in order to be

able to provide as accurate and up-to-date forecast as possible. So while our current

forecast indicates that there will still be a net deficit after taking into account the supply of

CDMs and JIs, it is important to bear in mind that this net position can swing around

wildly. However, while it is far too early to predict the net deficit or surplus with any

degree of certainty at this stage, it is the possibility that the fuel switch could yet be the

marginal form of abatement that is the most important conclusion from last Wednesdays

announcements.

As for Phase I

Well, here the outlook isnt quite as bright. This outlook was not helped by the

Commissions stance on banking, ie. the carry-over of allowances from the first to the

second trading period. Banking of allowances was at each Member States discretion and

23 out of 25 have decided not to allow for it. Only France and Poland both with

significant surpluses (together almost 70mt/pa in 2005) were considering allowing the

transfer of surpluses from Phase I to Phase II.

Given the pricing differential between Phase I and Phase II allowances, the base

assumption was that these surpluses would be transferred into the next trading period,

thereby supporting the price of Phase I allowances. However, the Commission views

banking as a form of State aid and only allows it if it can be proven that the surplus is the

result of successful emission reductions schemes that have been implemented. We

believe that Frances and Polands surplus are the result of a rather generous


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assessment of base emission (ie over-allocation) and DSM due to high CO2 prices.

Therefore it should prove quite a challenge for both countries to get a significant amount

of Phase I allowances moved over to the 2008-12 period. While this further boosts the

price for Phase II allowances, it also increases the chances that Phase I allowances will

eventually drift toward zero.

Impact on the power price plays

As far as the power price plays in the sector are concerned, Phase I is of little

consequence now as the vast majority of 06 and 07 output has been sold long ago. On

the other hand the revival of Phase II allowances presents a welcome boost to the

earnings outlook. While there remains considerable uncertainty over the direction Phase

II allowances will be heading (GDP growth, weather, DSM, fuel prices, actual supply of

CDMs/JIs) last Wednesdays rulings have ensured that Phase II allowances move

towards the mid-range of plausible scenarios. This should benefit the power price plays

in the sector as they sell output for 08 and beyond.

CO2: gap between Phase II and Phase I allowances widens

0

5

10

15

20

25

30

35

11/9/2004 2/17/2005 5/28/2005 9/5/2005 12/14/2005 3/24/2006 7/2/2006 10/10/2006 1/18/2007

(/tonne)

EUA 07 EUA 08

Source: Reuters


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Carbon Derby - Comeback of the Fuel Switch