Carbon Derby

7/27/2019 Carbon Derby

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Electricity

Europe / Equity 7 March 2005

Decision on NAPs

Chris Rowland+44 (0)20 7475 7489

[email protected]

Martin Brough+44 (0)20 7475 2362

[email protected]

Carbon Derby: crunch time

Dresdner Kleinwort Wasserstein Securities Limited, Authorised and regulated by the Financial Services Authority and a Member Firm ofthe London Stock Exchange PO Box 560, 20 Fenchurch Street, London EC3P 3DB. Telephone: +44 20 7623 8000 Telex: 916486Registered in England No. 1767419 Registered Office: 20 Fenchurch Street, London EC3P 3DB. A Member of the Dresdner BankGroup.

PLEASE REFER TO THE TEXT AT THE END OF THIS REPORT FOR OUR DISCLAIMER AND ALL RELEVANTDISCLOSURES. IN RESPECT OF ANY COMPENDIUM REPORT COVERING SIX OR MORE COMPANIES, ALLRELEVANT DISCLOSURES ARE AVAILABLE ON OUR WEBSITE www.drkwresearch.com/disclosures OR BYCONTACTING DRKW RESEARCH DEPARTMENT, 20 FENCHURCH STREET, LONDON, EC3P 3DB. Online research: www.drkwresearch.com Bloomberg: DRKW<GO>

Carine Salvy+44 (0)20 7475 1096

[email protected]

Geraint Anderson+44 (0)20 7475 2535

[email protected]

Emission trading

Clarity about the size of Europe’s CO2 constraint will follow the EC’s

verdicts on NAPs from Poland, Italy and the Czech Republic, all due

in days/weeks. If the cuts are as we expect, CO2 could top €15/tonne

over 2005-07 and be higher from 2008. The resulting boost to

German power prices supports our bullish view on German utilities.

• Europe becoming carbon constrained? With CO2 prices responding

to the weather, Europe looks like it is CO2-constrained. That may be too

premature a conclusion until we see if the EC will curb the outstanding

National Allocation Plans (NAPs). The EC could make a 100mt/yr

difference, enough to push CO2 prices from zero to over €30/tonne.

• A weak EC could result in a CO2 price slump: Four NAPs are yet tobe approved by the European Commission. If these four are approved

unchanged and the UK wins its battle to increase its allocation, we do

not believe Europe would be CO2-constrained over 2005-07. In that

scenario, we would expect the recently strong CO2 price to slump.

• Poles apart: The European Commission is set to approve the Polish

National Allocation Plan on Tuesday, March 8. There are arguments to

say that a strict interpretation of the rules could take up to 57mt/yr (20%)

out of the Polish NAP. We look for cuts of 30mt/yr (10%) from the

proposed level of 286mt/yr over 2005-07.

• Curbs also seen for NAPs from Italy, Czech Republic and UK: Cuts

in the Polish NAP would pave the way for stricter treatment elsewhere.

We look for cuts from the (recently increased) Italian NAP (15mt/yr or

6%) and from the Czech Republic NAP (10mt/yr or 9%). Finally, we

assume the EC denies the UK’s request for a 6.6mt/yr increase (3%).

• Prices further to rise: We look for the EC to curb the outstanding NAPs

by 62mt/yr, in aggregate. In our view, this would push CO 2 prices to

more than €15/tonne and take German baseload prices to €40/MWh.

C02 allowance price

0

2

4

6

8

10

12

14

1 8- Ap r- 03 1 7- Ju l- 03 1 5- Oc t- 03 1 3- Ja n- 04 1 2- Ap r- 04 1 1- Ju l- 04 9 -O ct -0 4 7 -J an -0 5

CO2

allowance price (€/tonne)

0

2

4

6

8

10

12

14

1 8- Ap r- 03 1 7- Ju l- 03 1 5- Oc t- 03 1 3- Ja n- 04 1 2- Ap r- 04 1 1- Ju l- 04 9 -O ct -0 4 7 -J an -0 5

CO2

allowance price (€/tonne)

Source: PointCarbon



7 March 2005 Carbon Derby

2

Poland’s NAPA highly strict interpretation might lead to 57mt/yr of cuts out of the

Polish NAP. We think that looks too demanding. Instead, we expect

the EC to approve Poland’s NAP with a cut of around 30mt/yr (10%).

This should set the scene for a CO2-constrained Europe, although

decisions on other NAPs are also relevant. We should know March 8.

Why NAP over-allocatingPoland is proposing to issue 286.2mt/yr of CO2 allowances over 2005-07. This

comprises sector-by-sector estimates aggregating to 263mt/yr plus 23.2mt/yr of

allocations for ‘Early Action’, cogeneration, new entrants and other (contingencies).

Poland's proposed National Allocation Plan

(Mt/yr) 1999-2002

2005-07

forecast

Base

allocation Early action Cogen NER

Other

reserve

Total CO2

allowances

Power 116.6 137.6 142.7 0.0 0.9

CHP 37.3 41.7 41.0 3.1 3.1 0.7

Heat 12.7 13.8 13.5 0.5 0.0 0.3

Refineries 6.8 9.0 8.8 0.7 0.5 0.1

Coking 3.5 4.7 4.6 0.5 0.0 0.1

Iron & steel 13.7 18.0 17.8 0.9 0.0 0.3

Cement 9.4 13.0 13.4 0.3

Lime 1.9 2.7 2.6 0.1 0.1

Glass 1.4 1.9 1.8 0.3 0.0

Ceramic 1.3 1.6 1.5 0.1 0.0

Paper 2.3 2.8 2.8 0.1 0.1 0.0

Sugar 2.2 3.0 3.0 0.1 0.0 0.0

Chemicals 6.1 7.7 7.6 0.1 0.2 0.2

Other 4.6 5.4 5.3 0.3 0.1

Total 219.8 263.0 266.4 7.0 4.0 3.3 5.5 286.2

Source: Polish Ministry of Environment, DrKW Equity research estimates

We would expect the EC to question at least two aspects of this overall allocation (as

well as some of the specific allocation rules to various sectors and installations).

• First, the Directive is clear that allocations should not exceed projected emissions

– as that would be ‘more than is likely to be needed for the strict application of the

[Directive’s] criteria’ including the criterion that ‘the total quantity ... shall be

consistent with assessments of actual and projected progress’ (Annex III, Criteria

1 and 2 of the Directive). If allocations are earmarked for ‘Early Action’ or

cogeneration, the EC’s guidance is that these would have to come off the total

amount. Furthermore, it is doubtful if Polish generators have undertaken ‘Early

Action’ – emission reductions that were not for commercial reasons or to comply

with other legislation (such as sulphur limits).

Poland seeking 286mt/yr...

... through generous use of

‘Early Action’ and highprojected sectoral growth rates




3

• Second, projected emissions in the NAP may be over-egged. According to the

projections agreed with the European Environment Agency, greenhouse gasemissions in Poland are seen increasing at 1.5% per annum from 2001 to 2010,

although CO2 on its own is seen growing at around 3%. Applying this range of

growth rates to the CO2 covered by the trading scheme (212.8mt/yr in 2001) would

leave projected emissions for the 2005-07 trading period at 229-246mt/yr. This is

17-34mt/yr below the projections in the NAP.

Projected CO2 covered by trading scheme on different growth assumptions

(mt/yr) 2001

2006 assuming

1.5% growth

2006 assuming

3.0% growth

Proposed NAP

2005-07

CO2 covered by trading scheme 212.8 229.2 246.7 286.2

Source: DrKW Equity research estimates

Basis for assessmentTotal cuts might then need to be anywhere between 23mt/yr and 57mt/yr (8-20%). We

assume cuts towards the bottom end of this range will be made (some 30mt/yr or

10%), taking Poland’s approved allocation to around 256mt/yr.

A 10% cut would not be out of line with the cuts required from other new Member

States that are also below their Kyoto targets. To date, cuts have averaged 11%

(weighted by size of NAP, or 16% unweighted).

Approved NAPs where Member State below its Kyoto target

Original submission Approved by EC Reduction Reduction versus original

submission (%)

Estonia 21.7 19.0 (2.7) (12.5)

Hungary 31.3 31.3 (0) (0)

Latvia 6.4 4.6 (1.9) (29.0)

Lithuania 14.2 12.9 (1.2) (8.7)

Slovakia 35.5 30.5 (5.0) (14.0)

Total 109.0 98.2 (10.8) (11.0)

Source: Various Member States NAPs, European Commission, DrKW Equity research estimates

We look for 10% cut – at

bottom end of other new

Member States




4

Italy’s NAPGreenhouse gases in Italy were 14% above Italy’s Kyoto target in

2000, yet the originally submitted NAP proposed a 7% increase in CO2

in the trading scheme from 2000 to 2005-07. Moreover, the latest

submission has actually upped the proposed allocation to 12% over

2000. Our expectation is that the EC will demand cuts of 15mt/yr (6%).

Last minute increase in NAPItaly’s Kyoto target is to reduce greenhouse gases by 6.5% from the 1990 level.

Greenhouse gas emissions by 2000 though were up 6.8% from 1990’s level, meaning

that Italy is 14% away from its Kyoto target. Despite this, Italy’s original NAP envisaged

a 7% increase in covered CO2 emissions (from 224mt/yr to 240.7mt/yr).

Moreover, when submitting its installation level NAP, Italy increased its proposed

allocation by 14.7mt/yr to an average of 255.5mt/yr over 2005-07. A part of the

increase reflects more CO2 being covered by the trading scheme – but not much, as

the 2001 CO2 emissions covered by the scheme has expanded from 224mt/yr to

228.1mt/yr. The higher level of 255.5mt/yr in the new NAP would be a 12% rise over

2000. CO2 emissions covered by the trading scheme are now seen to be 19% abovetheir 2000 level by 2010.

Italian CO2 allowances

(Mt/yr)

NAP 2005-07 in

original NAP

NAP 2005-07

in new NAP

2010 Reference in

original NAP

2010 Reference in

new NAP

Power existing facilities 99.6 117.9

Power new entry reserve 37.6 20.3

Power 137.1 138.2 149.9 149.9

Other sectors existing facilities 102.3 115.9

Other sectors new entry reserve 1.3 1.4

Other sectors 103.6 117.3 108.2 121.1

NAP 240.7 255.5 258.1 271.0

Change versus 2000 (%) 7 12 15 19Source: Italian Ministry of Environment, DrKW Equity research estimates

Bringing emissions back to Kyoto target levelWe are not aware of Italy having policies in place to bring this higher level of emissions

into line with its Kyoto target. Two aspects of the way Italy planned to bring its

emissions into line with its Kyoto target may be questionable.

Emissions rising although

Kyoto requires a cut, but

planning on further increases ...

... and latest NAP has even

bigger increases

EC could challenge overuse of

CDMs and lack of policies to

curb emissions




5

• Under the original NAP, Italy planned an extensive use of purchasing credits for

emission reductions (CERs) from CDM projects (emission reduction projects fromdeveloping countries, which if passed by a UN accreditation panel, can be used by

governments to meet national Kyoto targets). Italy has a programme in place to

buy 12mt/yr of CERs but intended to step this up to 46mt/yr (and perhaps more

under the new NAP). It is not clear if Italy has the funds in place to embark on a

programme of buying CERs on this scale or if there are sufficient CERs available

to meet this requirement. To put it into context, this would be more than twice the

size of the next largest purchase programme of project credits (the emission

reduction units from Joint Implementation projects being purchased by the

Netherlands, which has been running since 2000).

Government-funded purchases of CDM/JIs assumed in NAPs

(Mt/yr) Over 2008-12

Austria 7.0

Belgium 3.5

Denmark 3.7

Ireland 3.7

Netherlands 20.0

Portugal 5.1

Spain 20

Total from approved NAPs 63.0

Italy 46.3

Total 109.3

Source: Various member states NAPs, European Commission, DrKW Equity research estimates

• Italy’s original NAP assumed 51mt/yr of emission reductions coming in the

transport and residential sectors. Of this, 12mt/yr were from policies already being

implemented. The other 39mt/yr does not seem to follow from specific policies.

Basis for assessmentCuts in most NAPs from the original EU 15 have not been severe. Luxembourg aside,

the largest cut was the 3% taken out of the Netherlands NAP.

Approved NAPs from original EU15

Original

submission

Approved

by EC Reduction

Reduction versus original

submission (%)

Austria 33.1 32.7 (0.4) (1.2)Belgium 63.6 62.9 (0.7) (1.1)

Denmark 33.5 33.5

Finland 45.5 45.5

France 125.2 123.7 (1.5) (1.2)

Germany 499.0 499.0

Ireland 22.5 22.3 (0.2) (0.7)

Luxembourg 3.5 3.4 (0.2) (4.7)

Netherlands 98.3 95.3 (3.0) (3.1)

Portugal 38.9 38.2 (0.7) (1.8)

Spain 172.3 172.3

Sweden 22.9 22.9

Total 1158.3 1151.7 (6.6) (0.6)

Source: Various member states NAPs, European Commission, DrKW Equity research estimates

Cuts in NAPs from original EU

15 have not been substantial ...




6

Nevertheless, we believe the EC would refuse to approve the Italian NAP until

significant cuts are made. In particular, our assessment is based on halving theunfunded CERs and halving the unexplained emission reductions from transport and

residential sectors. Then we assume that 40% of these cutbacks would be required in

the 2005-07 period. That would equate to a 15mt/yr cut in Italy’s new NAP (6%).

... but we look for a 6% cut




7

Other outstanding NAPsDecisions from the EC are also awaited on the NAPs from the Czech

Republic and Greece. Finally, the UK is seeking an increase, which is

being resisted by the EC. Our assessment is that the Czech Republic

will see a 9% cut while the UK’s increase will be denied.

Rethink in NAP from Czech RepublicThe June 2004 draft of the NAP by the Ministry of Environment had 91.6mt/yr ofproposed allocations. This represented annual growth in CO2 for the covered

installations of 0.5% per year. However, this period will see the commissioning of the

Tremelin nuclear power station. Without this, CO2 would have grown by 2.7% per year.

By summer 2004, the Ministry of Industry took the lead in drafting the NAP and the

proposed allocation went up by 16mt/yr. The Ministry of Industry’s NAP has implied

growth of 5.2% once account has been made of Tremelin commissioning.

Czech Republic NAP

CO2 allowances

(m tonnes/year)

Implied growth versus

average 1999-2001 (%)

Implied growth versus average

1999-2001 (adjusted for

Tremelin) (%)

June public consultation 91.6 0.5 2.7

October submission 107.7 3.3 5.2

Source: Czech Republic Ministries of Environment and Industry, DrKW Equity research estimates

Indeed, in the Czech Republic’s latest submissions on emission monitoring, CO2 is

seen declining by 2010 – in some scenarios by as much as an average of 2% per year.

Even on higher growth scenarios, CO2 emissions are seen flat on 2002’s level (in turn

4% below 2000, which is the reference year used in the NAP). Hence, it looks to us

that a cut of some 20mt/yr might be required to return CO2 allowances to the business-

as-usual level. We assume that a cut of 10mt/yr is stipulated by the EC.

UK trying to increase NAPFinally, the UK is requesting a 6.6mt/yr increase in its allocation to 252mt/yr. The

higher allocation would still leave the UK on course to meet its Kyoto target. However,

the request for a raise came outside the two-month window which the UK had to make

any appeal against the EC’s decision. Our assumption is that this requested increase

is denied.

NAPs see varying rates ofgrowth in emissions ...

... although emissions

projected to be falling

We assume EC denies UK

request for increase




8

Abating CO2 Decisions on the outstanding NAPs will determine if Europe faces a

CO2 constraint. On the one hand, no cutbacks in the outstanding

NAPs would leave total CO2 allowances above CO2 emissions in a

business-as-usual scenario. CO2 prices would then be negligible. On

the other hand, the cutbacks we envisage would require 33mt/yr of

abatement. Whilst less than 2% of CO2 captured by the trading

scheme, to achieve this level of abatement, CO2 prices would need to

be high enough to compensate for the higher fuel costs of generating

electricity from gas – that is, at some €20/tonne.

A CO2 constrained EuropeOur assessment is that without cuts in the outstanding NAPs, Europe would not be

CO2 constrained. However, our central case is that a total of 62mt/yr will be taken out

of the NAPs in aggregate.

CO2 emissions and allocations covered by trading scheme

(Mt/yr)

Annual average

2005-07

Annual average

2005-07

Business-as-usual 2247

Allocations in existing NAPs (includes CDMs) 2276

Cutbacks envisaged by DrKW – Poland (30)

– Italy (15)

– Czech Republic (10)

– UK (from increased submission) (7)

Sub-total of cutbacks (62)

Resulting allocations 2214

CO2 constraint (33)

Source: NAPs from Member States; European Commission; DrKW Equity research estimates

Weather and economic growth also importantTo put this into context, weather conditions and economic growth could make a

similarly sized impact on the level of the CO2 constraint.

• Dry conditions (as defined by a one in ten winter) in both Scandinavia and

southern Europe could cut CO2 by 20-25mt/yr; likewise, wet conditions could ease

the CO2 constraint by 20-25mt/yr. Our estimates are framed on seasonally normal

weather conditions.

• Economic growth is likely to be met by higher generation from coal-fired capacity.

The extra CO2 equates to about 25-30mt/yr if GDP grows by an extra 25 basis

points; conversely, 25-30mt/yr could be taken from the business-as-usual if GDP

growth is weaker. Our estimates are on the basis of a cautious 1.5% annual

average GDP growth over 2004 to 2007.

Abatement needed as EC will

make cuts ...

... although these could be

offset/amplified by

weather/economic growth




9

Abating CO2 To meet 33mt/yr of required abatement, less electricity generation must come fromcoal-fired power stations and more from gas-fired CCGTs. However, on current

forward market prices, there is a cost penalty for making this switch. We calculate the

cost penalty has increased recently to about €12/MWh.

Each MWh saves about one-half a tonne of CO 2, hence CO2 prices would need to be

above €20/tonne to give the appropriate incentives to encourage generators to switch

fuel. This is depicted in the next chart that shows the price of abating a tonne of CO 2

using forward market fuel costs. If the price is below this ‘synthetic price of CO2’,

abatement would not be forthcoming and operators would be faced with paying the

‘late payment’ penalty of €40/tonne.

Cost penalty from abating CO2 must be covered by savings on

allowances

Higher variable cost for generating from gas-fired power stations


A MWh from gas costs €12

more, but only saves about

one-half a tonne CO2, so CO2

need to be above €20/tonne

Synthetic price of CO2 well above CO2 prices


20

25

30

35

40

45

Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05

Coal fuel cost Gas fuel cost

Generation costs (€/MWh)

0

5

10

15

20

25

30

Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05

Synthetic CO2 price (€/tonne) CO2 price

CO2 allowances (€/tonne)




10

Our assessment of the ‘synthetic’ price of CO2 allowances rests on several key

operating parameters.Assumptions for deriving the synthetic price of CO2 allowances

Abatement Spread over whole year

Gas prices - one year forward 39p/therm

Thermal efficiency in CCGTs 52%

Coal prices - one year forward US$67.8/tonne

Thermal efficiency in coal plant 36%


Our medium-term estimates are couched in a world of US$35/bbl oil prices and

US$55/tonne coal prices. This would be approximately a 30% lower oil (and hence

gas) price than in current forward markets and a 20% lower coal price. This reduction

in gas prices relative to coal prices would make abatement cheaper than this‘synthetic’ calculation of over €20/tonne for CO2 allowances. We continue to look for

€15/tonne over 2005-07.

Significance of summer/winter timing for abatementIn particular, we assume abatement occurs over the whole year, and hence the

relevant gas price is the annual average.

Summer gas prices are well below the annual average gas prices (29p/therm rather

than 39p/therm), making abatement much cheaper. However, we would expect the

CCGTs to be running at almost full capacity anyhow to take advantage of cheaper

summer gas prices – required abatement would need to be less than 10mt/yr for it to

be met purely by higher summer load factors on the CCGTs. Even then, abatement

would come with older CCGTs, possibly with thermal efficiencies of 46-47% (rather

than our assumed 52%). Hence, even with lower summer gas prices, abatement might

cost €10-15/tonne. We stress though that these CCGTs are likely to be running at

close to full capacity and hence the scope for any abatement is minimal.

Indeed, it is possible that greater reliance will come from the CCGTs in the UK in winter.

Gas prices then are around 49p/therm, in which case CO2 prices would need to be

above €30/tonne to compensate for the dearer cost of generating from gas over coal.

Beyond 2008

For the 2008-12 period, much will depend on the interplay of two factors.

• On the one hand, the required abatement is likely to be much greater to ensure

the trading sectors contribute materially to the Kyoto targets – we estimate CO2

cuts of some 240mt/yr might be required.

• On the other hand, the availability of emission reduction credits from project-based

mechanisms will also expand. However, we see only 50mt/yr being available.

The net effect will be to push CO2 prices to the level that justifies early retirement of

coal plant and replacement with more gas-fired CCGTs – an estimated €25/tonne.

We continue to look for

€15/tonne CO2 prices over

2005-07

Abatement could be cheaper if

buy gas at low summer prices

– but CCGTs already working at

full load

Tighter constraint could push

CO2 prices above €30/tonne in

2005-07

CO2 prices over 2008-12 seenhoming in on €25/tonne




11

Notes




12 F: 59630 G: 59630

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DRESDNER KLEINWORT WASSERSTEIN RESEARCH – RECOMMENDATION DEFINITION

(Except as otherwise noted, expected performance over next 12 months)

Buy 10% or greater increase in share price Reduce 5-10% decrease in share price

Add 5-10% increase in share price Sell 10% or more decrease in share price

Hold +5%/-5% variation in share price

Distribution of DrKW equity recommendations as of 31 Dec 2004

All co ve re d co mp an ie s

Companies where a DrKW company has provided

investment banking services (in the last 12 months)

Buy/Add 280 49% 39 46%

Hold 202 35% 36 43%

Sell/Reduce 90 16% 9 11%

Total 572 84

Source: DrKW

http://www.drkwresearch.com/disclosures/




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