Climate change: challenges & the search for a

sustainable policy

Clim. change tech.& policies Tue 31May05.PPT

Vianney SchynsManager Climate & Energy EfficiencyUtility Support GroupEnergy provider for DSM & SABIC

Symposium Sustainable EnergyEindhoven University of TechnologyDesigners association “Octave Levenspiel”31 May 2005Eindhoven, Netherlands

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Contents

• History of a successful change– Political views early 21st century – Shaping a carbon constrained economy

• Where we are today– Technology & policy challenges– Policy cap & trade emissions trading: fitness for purpose– Electricity & opportunity cost

• Alternative policy: Performance Standard Rate (PSR)– Policy objective: effective trading scheme– How it works

History of asuccessful change

How we might look back

in 2030

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Political views beginning 21st century

• Climate change increasingly perceived as a potential significant threat to our way of life

• Climate change policies far from coherent– Kyoto protocol nations adopted absolute caps– USA & developing nations reluctant

• The riddle of absolute caps was questioned– Would acceptance of an absolute cap be responsible behaviour

for a developing nation?– What scientific method exists for establishing a cap?

– What is the influence of actor decisions on climate change when

building a new installation in country A or B?

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Shaping a carbon constrained economy

• Consensus: in a carbon constrained world sustainable progress needed in all fields e.g.– Energy efficiency– Carbon sequestration (capture & underground storage)– Biomass– Renewables– Nuclear (inherent safe & fusion)

• Needed is … and … and– No single solution (yet) to curb greenhouse gas emissions– Leaving coal & nuclear no realistic scenario

• Immense challenge: absolute lowering of emissions while maintaining growth of worldwide welfare

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The world of our grandchildren

• Welfare growth: 50%• Energy efficiency improvement: 40%

– Buildings, installations, transportation

• Carbon sequestration: 30% – Capture technology breakthroughs, international CO2 pipelines, 2nd

lifetime of coal & lignite using immense reserves

• Biomass economy: 20% – New impulse to co-operation industrialised & industrialising nations

(sustainable plantations, concentrating technologies, use for electricity plants, industrial raw materials, transportation)

• Comeback of other renewables – Wind, solar, tidal

• Hydrogen – Upcoming energy carrier

• Greenhouse gas emissions: -35%

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Drastic policy changes

• Innovation priority 1– Two drivers: emissions trading + support breakthrough technologies

• Kyoto targets adapted– Caps for nations abandoned; worldwide sector & product targets– First industry initiatives (Al, cement, steel, chemicals …) moving to

same requirements for similar plants in whatever nation

• One standard for electricity (kg CO2/MWh)

– Otherwise not to combine: carbon constraint, future for coal by carbon sequestration and (co-firing) biomass, adequate CHP reward

• Fundamental obstacles CDM tackled– Arbitrary baselines changed: harmonised standards (growing list)

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Leading to concrete actions

Meaning for industrial actors• Inefficient plants undertook improvement investments or

closed earlier than BAU (Business As Usual)

• Production shift to efficient plants (new or existing)

• Fast growth of gas for CHP (industrial heat use)• Development & implementation innovative technologies

(reward front runners)• Carbon sequestration

• Biomass

Climate change policyWhere we are today

Technology challenges

Policy challenges

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Technology challenges

• Large improvement potential of most processes– Exergy efficiency most often still 10%-20%– Innovative processes: much lower capital investment, but …

= But takes time, huge efforts & risk taking

• Intensified carbon capture technologies (clean coal) – Achieve € 20-25/ton CO2 for sequestration by 2015 or earlier

• Wind & solar need further development– Subsidy currently at € 100-150/ton CO2 if all investments included

(grid, back-up capacity); solar x 2-3 more expensive

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Vision on process intensification

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Example of (new) PI equipment

• Higee separators– Application example: separations & extractions

(carbon capture?)– Compact equipment, very short residence time

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Policy challenges

• Immense support for renewables – Spurs significant (too fast) growth; although also sudden changes:

wind in Denmark & NL (subsidy stop off-shore, 2005)

• Still much scope for CHP (Combined Heat & Power)– EU wants to double penetration (9% to 18% in 2010), but …

allowances in Europe make no difference

• Acceleration need innovation (“clean, clever, competitive” EU Council) – Reward frontrunners with emission allowances & special support

• European Union started cap & trade scheme in 2005– Theory of cap & trade is based on incorrect assumptions– Challenge to reform the transposition of the Directive

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Cap & trade: assumptions of the theory

• Scientific literature: advocates argue cap & trade superior to PSR (Performance Standard Rate)

• Cap & trade versus PSR would offer– Certainty of environmental outcome– Better or necessary for market liquidity– Significant lower transaction costs– Better or necessary for investments to reduce

emissions

• Postulation: assumptions are not based on facts

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Cap & trade: the conventional picture

Emission

Energy use

Allowances under a cap

Claim: certainty of outcome

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PSR: the conventional picture

Emission

Energy use

Allowances under a PSR

Claim: no certainty of outcome

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Reality of combined picture: law of physics

Emission

Energy use

Allowances under a PSR

Allowances under a cap

Emission breaks through cap if energy > forecast

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Target setting

• Any target, via cap or PSR, must take account of– Lead time of investments to reduce emissions– Forecasted economic growth

• Cap & trade– Postulation: there is no scientific method for a justified

target as an ex-ante cap

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Cap & trade: the real picture

Emission

Energy use

Maximum fuel switch electricity,determines CO2-price

Forecasted energy use

Cap

Energy use > expected margin:export emissions or paying penalty

Very lowCO2-price

High CO2-price, possibly> penalty price

EmissionBusiness asusual

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Cap & trade & historical grandfathering

Specificenergy useor CO2 emission

Decreasing efficiency order of plants

Cap

Allowances unrelatedto abatement cost

Cap basedon historicalemissions

Market liquidity: great influence of economic growth & weather

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Transaction costs: cap & trade versus PSR (1)

• Cap & trade– Allocation formulas often complicated– Biggest debate Europe: how representative is a

historical reference period; reference periods differ in all countries; therefore: = Negotiations= Serious competitive distortions across Europe= Law suits

– Data collection & verification

• Transaction costs cap & trade – Not negligible, but certainly bearable

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Transaction costs: cap & trade versus PSR (2)

• PSR– Netherlands applied about 100 PSRs: big step forward– Cost 1 PSR: € 25-40,000 (consultant + company efforts),

often shared (multiple producers); total € 2.5-4 mln– Allocation: 5 year period x ~ 100 Mton = 500 Mton

– Additional costs: ~ € 5mln/500 Mton ~ € 0.01/ton CO2

• Transaction costs: additional for PSR– Already low in one small country

– Note: Verification office 10 people (industry experience), also active for data collection & annual emission verification

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Cap & trade: failure for carbon sequestration

Emission

Emission at same production level

Cap trading period 1

Cap trading period 2 (or 3) or immediately as new entrant

Project emission reduction

Failure of allocation rules in all Member States

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EC Treaty & EU Directive emissions trading

Requirements EC Treaty• Principle of equal treatment

– Between: incumbents, new entrants, incumbents & new entrants • Competition rules: free market

– Winners of market share not hindered (innovation)• Polluter-pays principle

– Largest scheme ever of environment to economy

Requirements EU Directive emissions trading• Environmental integrity

– Recital 3• To promote reductions & energy efficiency such as CHP

– Article 1 & recital 20

Current allocations rules: no compliance – Scheme was not allowed to be postponed – benefit of doubt

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Policy challenge EU trading scheme

• Directive transposed as cap & trade– Polluter-earns principle: historical grandfathering (most)– Different rules in different Member States: serious distortions– Limited incentive reduction investments: historic reference later – No incentive for closure: no allowances after same year or period– No or limited incentive for high efficiency new plants – Major uncertainty for new plants: limited new entrant reserve,

first-come-first-serve

• Trading scheme lost track of purpose, lack of incentive

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Example competitive distortions (1)

Ammonia excl. process emissions

Assumption: ammonia in trading scheme (not yet in UK, Germany)

Shortage of allowances ammonia, efficiency EU average, production steady at 1000 kton/year

0

20

40

60

80

100

120

140

1 2 3

Netherlands, UK, Germany

Sh

ort

ag

e k

ton

CO

2/y

ear

Series1

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Example competitive distortions (2)

Other historical reference periods: NL 2001 & 2001; UK average best 5 years 1998-2003; Germany average 2000-2002;

Shortage of allowances ammonia, efficiency EU average, production DSM Agro (2001 & 2002 happened to be low)

0

50

100

150

200

250

300

1 2 3

Netherlands, UK, Germany

Sh

ort

ag

e k

ton

CO

2/y

ear

Series1

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Theory cap & trade: wrong assumptions

• Assumptions scientific literature of advocates of cap & trade not based on facts

• Cap & trade versus PSR does not offer– Certainty of environmental outcome– Better market liquidity– Significant lower transaction costs– Clear incentive for reduction investments

– On the contrary … lack of purpose, major failure of the theory

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Electricity & opportunity-cost principle

• Electricity– No storage, no imports from overseas (regional markets)– Severe demand fluctuations (day/night, weekend), reserve gas-fired

• Opportunity-cost principle under cap & trade– Sell allowances when lowering production (no new sales contract)– Allowances: generally free of charge for 95% of need– Therefore: CO2-price fully in electricity cost-price, windfall profits

• Fundamental problems cap & trade electricity– Polluter-earns principle– Inhibitor of a competitive market: enhancement of frozen

market shares (market share winner must buy allowances)– Trading scheme advantage turns into one-sector winner

• Root cause: frozen caps give opportunity

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European merit order electricity (EU-15)

20

40

60

Short runmarginalcost€/MWh

100 300 500Installed capacity (GW)Source: IEA data

HydroWind

Nuclear

Coal & lignite

CCGTGasBoiler

OCGT

Oil

Range European short run marginal cost

Market priceindications inregional marketsbefore emissions trading

Germany, Belgium, France, UK

Netherlands

Italy

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1st substitution: influence on merit order

20

40

60

Short runmarginalcost€/MWh

100 300 500Installed capacity (GW)Source: IEA data

HydroWind

Nuclear

Coal & lignite

CCGTGasBoiler

OCGT

Oil

Range European short run marginal costCO2-price € 6/ton

Price increase€ 3-6/MWh

1st substitution: Coal by Combined Cycle Gas Turbine

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2nd substitution, same price difference coal - gas

20

40

60

Short runmarginalcost€/MWh

100 300 500Installed capacity (GW)Source: IEA data

HydroWind

Nuclear

Coal & lignite

CCGTGasBoiler

OCGT

Oil

Range European short run marginal costCO2-price € 22/ton

Price increase€ 11-20/MWh

2nd substitution: Coal by gas boiler

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Electricity windfall profits by cap & trade

Substitution price (coal € 2.3/GJ; gas € 3.5/GJ) €/ton CO2 6,64 min max €/ton CO2 22,26 min max

Electrity price increase by opportunity cost €/MWh 2,7 6,1 €/MWh 11,2 20,4

Capacity hrs/year: Assume Fuel Substitution Fuel CO2 Opp. Opp. Substitution Fuel CO2 Opp. Opp.

ton CO2 Installed 8000 Load Real CO2 Cost CCGT CO2 Cost Cost Cost Cost Boiler CO2 Cost Cost Cost Cost

per MWh GW TWh Factor TWh Mton € mln TWh Mton € mln € mln € mln € mln TWh Mton € mln € mln € mln € mln

Hydro 0 120 960 0,5 480 0 480 0 0 0 1.314 2.915 480 0 0 0 5.396 9.774Wind 0 15 120 0,2 24 0 24 0 0 0 66 146 24 0 0 0 270 489Nuclear 0 120 960 0,8 768 0 pm 768 0 pm 0 2.102 4.664 768 0 pm 0 8.634 15.639Coal 37% 0,91 150 1200 0,7 840 768 18.798 700 640 15.665 -850 1.916 4.251 610 557,9 13.651 -4684 6.858 12.422CCGT average 49% 0,41 40 320 0,4 128 53 3.291 268 110 6.891 383 733 1.627 268 110,5 6.891 1285 3.013 5.457Gas boiler 40% 0,50 30 240 0,2 48 24 1.512 48 24 1.512 0 131 291 138 69,68 4.347 1012 1.551 2.810

OCGT 35% 0,97 18 144 0,1 14,4 14 518 14,4 14 518 0 39 87 14 13,92 518 0 162 293Oil 40% 0,75 60 480 0,62 297 223 9.359 297 223 9.359 0 813 1.804 297 222,8 9.359 0 3.340 6.050

4424 2600 1082 33.479 2600 1012 33.946 -467 7.114 15.786 2600 975 34.767 -2387 29.223 52.935

CO2-reduction, sales to other sectors -70 -107

Real cost of fuel switch (additional fuel costs) 467 467 -37 additional 1.288 1.288

Windfall profit (€ mln) (assumption: 100% grandfathering of allowances) 6.647 15.319 27.935 51.647

Revenues of CO2-sales 467 467 CCGT extra CO2-profit 2.387 2.387

Total cash flow (€ mln) 7.114 15.786 30.322 54.034

• Windfall profit at € 20/ton CO2: € 20-30 billion/year• Optimisation profit of the scheme at € 20/ton CO2: € 2.5 billion/year Source: EU Commission• Price below fuel + opportunity-cost: cut production & sell allowances

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Emerging recognition of purpose problem

• Fitness for purpose– Reduction investments should never be regretted, but …

= Cap & trade: reduction becomes historical emission in future

• Problems with cap & trade– Quotes of advocates of cap & trade (!)

= “No sensible company undertakes reduction investments on the basis of current allocation methods”

– Peter Vis, EU Commission DG Environment= “Reference 2005 for allowances 2008-2012 would be perverse”= “Old reference should be taken, but this cannot go on for ever

… next step must be bold”

Alternative:Performance Standard Rate

Policy objective: effective trading scheme

How it works

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Policy objective: decoupling emission & growth

Emission

Production growth

Business as usual

Energy efficiency

Biomass,carbon sequestration,technology breakthroughs

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PSR: weather & growth secondary factors

Specificenergy useor CO2

emission

Decreasing efficiency order of plants

Weightedaverage

Sellers ofallowances

Buyers ofallowances

PSR

High abatementcost

Low abatementcost

Much better market liquidity: many buyers & sellers

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PSR: incentive suited for purpose

Emission

Emission at same production level

PSR year 1Allowances coupled toproduction level

PSR year nAllowances coupled toproduction level

Key feature:project reward,independent of future PSR

Certainty of reward for reduction investments

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PSR: incentive suited for purpose

Emission

Emission at same production level

PSR year 1Allowances coupled toproduction level

PSR year nAllowances coupled toproduction level

Key feature:project reward,independent of future PSR

Successful reward of carbon sequestration

Example: clean coal plant

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Cornerstones of PSR

1. Start with major emitters: limited number of products2. PSR not timely available: each operator starts with own

efficiency; establish PSR after first year• Predictable business environment, operator knows efficiency will be

rewarded, PSR will emerge soon

3. PSR just below average: otherwise market unable to supply shortage of allowances

4. PSRs will gradually tighten: environmental purpose5. Banking & lending: market stability (5% - 7%)6. Recommendation independent “Climate Board”

similar as for monetary policy, making annual reviews, giving policy advice and adjusting when needed

• PSR • Banking & lending rate

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Few PSRs: already major coverage

100%

Coverageofemissionsunder thescheme

Electricity (1 PSR) incl. for CHP (Combined Heat& Power)

Steel (4-5 PSRs)

Cement (1 or few PSRs)

Refineries (1 PSR)

Major chemicals (10-20 PSRs)

Benchmarking inthe Netherlands:100 PSRs

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Benchmark formula for PSR

• Benchmark data: population under the scheme– EU-25, future with Norway, Japan, South Korea, Canada, etc.

• PSR = WAE – CF x (WAE – BAT)– WAE = Weighted Average Efficiency– BAT = Best Available Technique (proven Best Practice)– CF = Compliance Factor, equal for all PSRs, reflecting equal efforts

between different types of installations

• Compliance Factor– 2008: CF = 3% (to create CO2 market price)

– 2012: possibly 15%-20%

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PSR = WAE – CF x (WAE – BAT)

Specificenergy useor CO2

emission

Decreasing efficiency order of plants

Weightedaverage 1

PSR 1

BAT

Product 1steep curve

Product 2flat curve

Normalised curves

Weighted average 2

PSR 2

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Practical recommendations to start in 2008

• Consultants for data collection 2003 or 2004 – Electricity: emission & production incl. heat for CHP (6 months job)– Steel: similar

– Probably already available: cement, refineries, steamcrackers,

ammonia, sugar, etc. • Producers must accept: keep it simple

– No correction for secondary effects

• Major countries: not waiting but taking initiative – Germany, UK, Italy, France, Spain, Scandinavia, etc.+ Benelux with

benchmark experience (not wait for completeness, expand gradually)– Appoint high level “champions” with industry experience for main

products (fresh & independent views) – Hire consultants for concrete jobs, no theoretical studies

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Conclusion

• Major transform of EU scheme required to avoid loss of real progress for 8 years, to ensure compliance with:

– Worldwide environmental integrity– Polluter-pays principle and competition rules, two

acid tests for a sustainable scheme when attracting new participants such as Norway, Canada, South Korea, Japan & later USA, China, India, etc.;

– A predictable business environment, leading to clear stimulation of innovation, essential for environmental results and in full support for the Lisbon strategy in Europe as well as global welfare