Implications and Opportunities for European Business in a

Carbon constrained Economy

Vincent Dessain,

Executive Director,

Europe Research Center,

Harvard Business School

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Summary

A. Introduction

B. GHG Emissions – The overall picture

B.1 GHG’s major emittersB.2 Potential Buyers-Potential Sellers ?B.3 Emissions Trading: Lowest-Cost Method of Reducing GHGsB.4 The implications of a Carbon-Constrained Economy on Market Dynamics

C. EU Emissions Trading Scope

C.1 EU 15: Targeted Sectors in EU Emissions Trading DirectiveC.2 EU Emissions Trading SchemeC.3 EU Emissions Trading PrinciplesC.4 National Allocation Plans PrinciplesC.5 Will the allocations be generous enough

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Summary (continued)

D. The electricity producers – an example

D.1 Electricity ProductionD.2 Power Production DistributionD.3 Cumulative Production

D.4 5 biggest CO2 emitters in EuropeD.5 Price of ElectricityD.6 Impact of EU ETS on Power Companies Valuations

E. Trading experiences and expectations

E.1 A U.S. Example: SO2 under clean air act of 1990E.2 UK ETS experiment

E.3 How will CO2 allowances trade?

E.4 CO2 expected price 2008 - 2012E.5 Strategies adopted by market players

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Introduction

• Observations in this presentation are based on initial discussions with EU commission officials, government representatives and market participants

• This presentation only expresses the author’s personal views and not the school’s

• Following further analysis of EU emissions trading market, we may develop a research project that looks at the criteria of success to effective design of a new market

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GHG’s major emitters(Year 2000) (MTON CO2 Equiv)

USA40%

EU (15)23%

Russia12%

Central and

Eastern Europe

9%

Japan8%

Other4%

Canada4%

Source: Adapted from UNFCCC

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Potential Buyers-Potential Sellers ?EU-Member State GHG emissions

1990

(M Tons)

GHG emissions 2000

(M Tons)

Target Deviation from target

Belgium 143.1 151.9 132.4 - 19.5

Denmark 69.4 68.5 54.8 - 13.7

Germany 1222.8 991.4 966.0 - 25.4

Finland 77.1 74.0 77.1 + 3.1

France 551.8 542.3 551.8 + 9.5

Greece 104.8 129.7 131.0 + 1.3

Ireland 53.4 66.3 60.4 - 5.9

Italy 522.1 543.5 488.2 - 55.3

Luxemburg 10.8 5.9 7.8 + 1.9

Austria 77.4 79.8 67.3 - 12.5

Portugal 65.1 84.7 82.7 - 2.0

Sweden 70.6 69.4 73.4 + 4.0

Spain 286.4 386.0 329.4 - 56.6

United Kingdom 742.5 649.1 649.7 + 0.6

Netherlands 210.3 216.9 197.7 -19.2

Source: Adapted from UE DG Environment

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Potential Buyers – Potential Sellers (continued)

EU Accession State Emissions in 2000(M Tons)

Target vs 2000

Poland 386 + 37%

Romania 185 + 30%

Czech Republic 147 + 20%

Bulgaria 109 + 29%

Baltic States 88 + 32%

Hungary 84 + 13%

Slovakia 49 + 36%

Slovenia 13 + 31%

Source: Adapted from UE DG Environment

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Emissions Trading: Lowest-Cost Method of Reducing GHGs

Source: Viewpoint/The Marsh & McLennan Companies Journal/Volume XXXII No. 1 2003

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The implications of a Carbon-Constrained Economy on Market Dynamics

Source: Viewpoint/The Marsh & McLennan Companies Journal/Volume XXXII No. 1 2003

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EU 15: Targeted Sectors in EU Emissions Trading Directive

Trading Sectors Emissions in 2000 MTON CO2 %

Public electricity & heat production 894 65.9%

Petroleum refining 148 10.9%

Iron & steal fuel combustion 115 8.5%

Cement 88 6.5%

Manufacture of solid fuels 51 3.8%

Pulp & paper 35 2.6%

Iron & steal production 24 1.8%

Glass 2 0.1%

1357

Source: Adapted from environmental-finance magazine

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EU Emissions Trading SchemeEU-15 Number of installations affected

Austria 250

Belgium 260

Denmark 300

Finland 300

France 1500

Germany 7000

Greece 100

Ireland 66

Italy 2000

Luxemburg 15

Netherlands 350

Portugal 125

Spain 600

Sweden 300

UK 1750

TOTAL 14916

Source: Adapted from environmental-finance magazine

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EU Emissions Trading Principles

• To become largest CAP and Trade Program worldwide

• NAP’s ready for review by EU commission by March 1-31, 2004

• Warm-up phase 2005-2007: Learning by doing

• Five year mandatory Kyoto phase from 2008-2012

• Start with CO2 expanding to other GHG

• Sector pooling with trustee appointment possible

• Informal multinational pooling also possible

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National Allocation Plans Principles

• Emissions (historical base) seem to be the only viable metric rather than input, output or capacity

• Two stage process reconciling top down, bottom-up

• In warm-up phase: free of charge 95%, 5% by auction

• For 2008 – 2012: 90% free of charge, 10% that can be auctioned

• New entrants will need to buy from the market

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Will the allocations be generous enough?

10% surplus over b-a-u

In between Kyoto & National targets

Source: Adapted from DKW

Carbon constraint (Mton CO2)

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Electricity Production

C02 emission per type of production

In grams Hydro Nuclear Wind Combined Natural Coal Lignite

per KW/h cycle gas

CO2 emissionper par kWh 4 6 3 à 22 427 883 978 1 120

Source :Adapted from ACV Study– CDC Report

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Power Production Distribution

In % E.ON

EDP Electrabel

Endesa

Enel Iberdrola

RWE

Verbund

Produced volumes: TWh

96 26 68 59 179 41 178 24

Nuclear 51 - 39 22 - 57 18 -

Fuel 11 - 39 - 80 1 - -

Coal 35 69 - 66 - 14 70 6

Gas - - - - - - 7 -

Combined - - 9 - - - - -

Hydro 3 31 11 12 20 27 4 94

Other Renew - - - - - - - -

Other - - 2 - - - 1 -

Source: Annual Reports

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Cumulative ProductionFuel, Coal, Gas (TWh)

Enel

RWE

E.ON

Endesa

EDP

Iberdrola

Electrabel

Verbund

Source: CDC Reports

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5 biggest CO2 emitters in Europe

Companies MTon % or Euro total

RWE 126 3.08

Enel 99 2.41

E.ON 76 1.86

Endesa 73 1.77

Vattenfall 71 1.73

Source: CDC Reports

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Price of Electricity

Type of Unit Power Gen cost w/o emissions allow (cents/MWh)

Power Gen cost w/ emissions allow (cents/MWh

Var (%)

Combined 2.9 3.6 24.1

Coal 2.6 4.0 53.8

Lignite 2.3 3.9 69.6

Coal (CHP) 1.9 2.9 52.6

Gas (CHP) 2.7 3.2 18.5

Wind 5.2 5.2 0.0

Source: Vattenfall

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Impact of EU ETS on Power Companies Valuations

Source: CDC Reports

Verbund

EDP

EDF

Endesa

Vattenfall

EVN

Suez

E.ON

Electrabel

Iberdrola

RWE

Enel

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A U.S. Example: SO2 under clean air act of 1990

• Principle of Allowances under CAP and Trade system

• Allocated "free" to incumbents, "bankable" and "fully tradable"  

• Market started to become reasonably efficient by 1994

• Market prices much lower than expected

• Relatively efficient private market developed in four years– 1993: Third party brokers start to disclose prices– Transactions cost from $ 3.50 per allowance per trade to $ 1.50 per

allowance per trade (1994 – 1996)– Bid-ask spreads go from $ 20 in 1994 to $ 1.50 in 1997– Active SWAPS markets developed

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UK ETS experiment

• 34 participants, voluntary and capped, 400 trading accounts, 300,000 – 1000,000 allowances traded, through 150-200 trades

• Few bidding strategies where company decides on amount of emission reductions achievable through a project, the average cost of each ton of emission reduction and the price at which they would drop out of auction

• Several participants had not yet developed a precise analysis of their abatement cost through a marginal abatement cost curve

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0 5 10 15 20 25 30 0 5 10 15 20 25

How will CO2 allowances trade?

Germany

UK

Accession MS

CO2 price (€/tonne)

Allowance Allocation Economic Conditions

hot cold year

growth

fuel costs

CO2 price (€/tonne)

Source: Adapted from DRK

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CO2 expected price 2008 - 2012

Source: Adapted from BA Power - Strategic Planning

Market Source Expected price (€ton CO2)

Ecofys 20 - 42EU CO2 Mc Kinsey 18 - 25Emission EU 20 – 83Certificate Penalty* 100

CDM Ecofys 5-7JI Ecofys 5-10

* The penalty does not release the operator from the obligation to surrender its allowances

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Strategies adopted by market players

Case 1: Market price higher than abatement marginal costStrategy: Reduce emissions more than your target and sell extra allowances

Case 2: Market price lower than abatement marginal costStrategy: Buy allowances to reduce total cost to meet reduction target

Case 3: Market price equal to abatement marginal costStrategy: Reduce emissions at break-even point

Case 4: Two main choices to meet your emissions targetTarget: Either purchase allowances on the market or reduce emissions

(production reduction, fuel switch or technology investment)