Load-based versus sourced-based systems 19 April 2007 Greenhouse Gas Cap and Trade Systems: Symposium on Linking Californian Public Utilities Commission

Load-based versus sourced-based systems19 April 2007

Greenhouse Gas Cap and Trade Systems: Symposium on Linking

Californian Public Utilities Commission19 April 2007

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Table of ContentsMorgan Stanley Commodities

Section 1 The Morgan Stanley Team

Section 2 Load-based versus source-based systems

Section 3 Other design features of an ETS

Section 4 Conclusions

Morgan Stanley Commodities

Section 1

The Morgan Stanley Team


Geographic Coverage

One of the top global commodity traders with an experienced team of professionals

• Trading as a principal since 1982• Over 290 professionals world-wide• Offices throughout the world providing 24 hour, global coverage of all markets


With offices throughout the world, global coverage of the commodities markets is possible with Morgan Stanley.

Morgan Stanley Commodities is an international group, with employees from a diverse range of nationalities (~40)

London (91)

Tokyo (6)

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Calgary (2)

Shanghai (2)Atlanta (1)

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Moscow (1)

Toronto (1)


The Morgan Stanley TeamMorgan Stanley Commodities

Expertise and Investments

•Morgan Stanley has allocated USD 3Bn for investments in the carbon market•Experienced carbon team with detailed understanding of regulatory issues•Substantial commodities experience in structuring complex trades

Commodities Trading and Origination

Charles Rankin (Managing Director) [email protected] John Woodley (Managing Director) [email protected] King (Managing Director) [email protected]

Carbon Trading

Imtiaz Ahmad [email protected] Hartridge [email protected] Corden [email protected]


mailto:[email protected]












The Morgan Stanley TeamMorgan Stanley Commodities

Personal experience

•Co-wrote the rules for the UK ETS - the first traded market for GHGs•Ran auction allocating emission reduction targets•UK ETS gave responsibility for electricity away from the emissions source (load-based)

•Joined the European Commission to implement the EU ETS•Managed finalisation of legal framework, monitoring and reporting guidelines, registries regulation and registries system•Worked on approving national allocation plans and extension of EU ETS to aviation •EU ETS always gives responsibility to the emissions source (source-based)

•So first-hand experience of problems caused by moving away from source-based systems



Section 2

Load-based versus source-based systems


What types of participation are possible in an ETS?


Three levels of participation and the answer can, in theory, be different for each question:

• Who monitors the emissions?

• Who receives the allowances?

• Who is responsible for complying (allowances equal to emissions)?

• Question 2: Under either a source-based or a load-based system, allowances can be freely allocated to any set of individuals or organisations as a form of compensation.

• However, if those receiving the allowances are not active in the market this can raise market problems e.g. artificial supply shortage leading to upwards price bias.





• Source based: the emissions source is always the answer to question 1 (monitoring) and question 3 (compliance). This keeps the design simple and makes the entity most able to reduce emissions responsible for doing so

• Load based:

– The emissions source often isn’t the answer to question 1 (monitoring). If it isn't, the basic integrity of capping emissions, calculating reductions accurately and providing an automatic incentive to the market to choose the least-cost option is lost

– Instead the proxy monitoring calculations (e.g. default emission factors) will drive the emission reduction technologies chosen





• Load based (continued):

– The answer to question 3 (compliance) is the load serving entity (LSE). This moves responsibility away from the emissions source, thereby introducing two types of problems:

– identification: an LSE has to rely on another party to reduce emissions (generators) but often cannot identify the source of purchased electricity. This is a major barrier to being pro-active and investing to reduce emissions at a generation plant

– Even if identification possible, the electricity market is not designed to enable an LSE to claim ownership over emission reductions it has paid for at a generation plant

– Again, if identification possible, LSEs have to work through contracts with generators in order to make emission reductions happen, which raises transaction costs. This undermines the least-cost principle of emissions trading



What are the consequences of a load-based system?



• CONSEQUENCE 1: instead of electricity markets automatically working in sync with an ETS, the electricity markets will need to be adapted. Otherwise no chance of carbon price signals being received by generators. This raises ETS implementation and transaction costs

• CONSEQUENCE 2: since LSEs are reliant upon generators receiving carbon price signals and taking action, the policy is less effective and so the emissions cap will be less stringent than it could otherwise have been

• CONSENQUENCE 3: LSEs will object to paying compliance penalties if they miss their cap due to generators not having taken action to reduce their emissions

• LESSON LEARNED IN UK AND EU ETS: if an organisation does not have to take action to comply (either not the responsible entity or just over-allocated), do not assume they will respond swiftly to market signals which make it cost-effective to reduce emissions. This is highly relevant to the LSE-generator relationship in a load-based system


If load-based is less effective, why choose this model?


• Historically, load based systems have been introduced for two reasons:

–Legislative powers do not exist to tackle the emissions of sources directly

–Legislative powers exist, but no political appetite to reduce emissions from emissions sources (i.e. other political problems raised by fuel switching to lower-carbon options)

• In its most extreme (and default) form: all electricity sold is given the same average emissions factor, so only focus is on reducing total demand for electricity

• In other words: it is widely recognised that taking compliance away from the emissions point is less effective in reducing emissions



How do you improve a load-based system?


Assumption

• The overall obligation is an absolute emissions cap, not an emissions target related to output. Otherwise, a whole different set of issues are introduced

Conditions

• The emissions source is responsible for monitoring, reporting and verifying the emissions in order to preserve the integrity of the emissions cap

• The allowance (carbon) price is a factor (alongside other factors such as gas prices) affecting the dispatch of electricity on a real-time basis i.e. the electricity market is adapted so as to generators a better signal to reduce emissions



How do you improve a load-based system?


Acceptances

• Windfall profits will accrue in either a source-based system or a load-based system. They go hand-in-hand with a high percentage of an asset (allowances) being freely allocated

• Some leakage is equally inevitable in either a source-based system or a load-based system. The extent depends on wider economic circumstances. Changing the design of a system radically, or wrapping it up in red tape, to try to remove leakage will start to undermine the original purpose of the ETS



Sidestep: note on leakage



• Source-based:

–In-state LSEs import electricity from out-of-state generators

–In-state generators reduce production of electricity

• Load-based:

–In-state LSEs import lower-carbon electricity from out-of-state generators

–Out-of-state LSEs sell higher-carbon electricity to everyone else

–In-state generators export production of higher-carbon electricity to out-of-state LSEs

• So both systems equally prone to leakage

• Very difficult to address cost differential introduced through ETS since import taxes/import restrictions not permitted

• But natural limitations to importing (e.g. transmission losses)

• So focus should remain on designing ETS for the long-term


Adapting electricity markets is the hardest part


• In a source-based system, generators will automatically price carbon into the price of electricity as it is placed with the market operator (MO) selling the power to the LSE

• In a load-based system, ideally the LSE needs to know the carbon content of the electricity in order to know how to bid for the electricity

• Otherwise impossible to indirectly incentivise emission reductions

Three options for providing this information to the LSE:

1. Simply make it part of the MO information flow: price of electricity offered alongside tonnes CO2/kilowatt hour information (potentially converted into quantity of required allowances). So only electricity delivered

• Requires generators to provide verified emissions data on a constant basis (instead of at the end of each compliance period as for a source-based system) which increases costs; but the simplest option



Adapting electricity markets is the hardest part


2. The MO uses the tonnes CO2/kilowatt hour information to offer a more standardised product: price of electricity includes carbon; electricity is delivered alongside the necessary quantity of allowances

• Again, requires generators to provide verified emissions data on a constant basis; requires the MO to auction the allowances on a constant basis (which incidentally addresses windfall profits)

3. The tonnes CO2/kilowatt hour information is used by generators to qualify for the creation of a standardised secondary currency, so that the price of electricity includes carbon

• Again, requires generators to provide verified emissions data on a constant basis; raises a whole set of new issues e.g. the necessity of allowances not being fungible with the secondary currency in order to avoid double counting

• Its high level of complexity is not warranted by the relatively simple need to provide CO2 information: if a policy is too difficult to understand, the market will not be traded



Wider issues: linking schemes


With all the assumptions, acceptances and conditions in mind:

1. Within the load-based ETS:

• The LSEs are responsible for all electricity being sold to the grid, so all power producers selling to the grid must be treated in the same way (monitoring only), even if e.g. a paper producer sells excess power to the grid

• Otherwise accounting problems (emission reductions double-counted) will be created

• Therefore, entities emitting due to both power production and e.g. paper production will be operating on the basis of a hybrid load/source system

• Entities producing power which is not sold to the grid would have to be treated as if in a source-based system. So a load-based system needs to be a hybrid load/source system even if only covering power, otherwise it will incentivise power production outside of the grid (since it would be outside of the ETS)



Wider issues: linking schemes


2. A load-based ETS linked to a source-based ETS whilst sharing the same grid (including any inter-connectors to other grids): again, this will cause the same types of accounting problems

3. A load-based ETS linked to a source-based ETS not sharing the same grid: no accounting problems

• NOTE: Cases 1 and 2 are relevant to a West Coast initiative or California being covered by a federal programme. Case 3 is relevant to an international linkage

• However, if power grid inter-connections increase over time, then linking options decrease in parallel since such linkages would end up moving from case 3 to case 2

• So if developing a load-based system when most systems are source-based, politically options are much more limited



Section 3

Other design features of an ETS

Other design features of an ETS

Successful design features of the EU ETS


• Source-based system

• Monitoring and reporting standards are high and represent years of improvement and consultation

• Electronic registries system for holding allowances is modern, fast and secure; uses international communication protocol developed under Kyoto Protocol

• Solid and effective compliance regime; ensures that the emissions cap is upheld through time through fixed high penalties and a make-good provision

• After a gentler than expected start for 2005-2007 (repeating the history of other trading schemes) the 2008-2012 emissions cap will require substantial emission reduction action

• Free-market approach: no market intervention/price controls

• Access to emission reductions generated outside of the EU ETS:

–Quick link to the international carbon market (project credits)

–Creates a safety valve which simultaneously encourages investment



Section 4

Conclusions

ConclusionsMorgan Stanley Commodities

• Load-based systems are not as effective in reducing emissions

• Nor are they better at addressing leakage or windfall profits

• In any case, load-based systems will need to incorporate an element of source-based coverage if coverage extends outside of the power grid

• And they limit linkage options

• It is complex trying to make a load-based system mimic the efficiency of a source-based system

• With complexity comes costs. Consequently, a load-based system cannot claim to minimise costs - the core appeal of an ETS

• Better to keep it simple, and stick to successful models such as the EU ETS

• If it isn’t kept simple, there may not be much of a market


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