The international economics of climate change, emissions trading and innovation

1
The international economics of climate change,
emissions trading and innovation Joint Institute
of Policy Studies / EFNZ presentation
Wellington, 18 Oct 2006
Michael Grubb, Chief Economist, The Carbon
Trust Visiting Professor of Climate Change and
Energy Policy, Imperial College, London, Senior
Research Associate, Faculty of Economics,
Cambridge University
2
Outline

• The nature of the problem
• Stabilisation strategies and economics
• Mitigation scale of challenge and costs
• Economic instruments and insights from the EU
  Emissions Trading Scheme
• Low carbon innovation
• The international stage

3
The nature of the problem - Is not that climate
change may hurt us at some time in the future,
but that it is
4
.. Already evident, probably implicated in some
extreme events , but unevenly distributed and
(usually) difficult to isolate from other factors
(a) c. 1900
(b) Recent
Photos Courtesy of Munich Society for
Environmental Research
5
inherently unpredictable concerning some of the
most important potential impacts, which arise
from instabilities rather than incremental change

6
and cumulative over huge time horizons with a
lot of inertia and irreversibility
7
Climate Uncertainty has only been going one way
since 2001 IPCC report

• Significant uncertainties still exist over the
  scale, timing and distribution of climate impacts
• However, almost all the new research over the
  last 5 years has shown impacts to be happening
  quicker than previously expected e.g. ice sheet
  melting glacier retreat ecological boundaries,
  etc
• Last main element of contrarian evidence
  apparent discrepancy in satellite temperature
  data now resolved
• Previous focal point of 550ppm now seen as too
  high ..

8
Scale of the challenge where are we trying to
get to?
9
Temperatures projections and stabilized
temperatures at different CO2 concentrations
Source IPCC Synthesis Report, 2001

• 1000 to 1861, N. Hemisphere, proxy data
• 1861 to 2000 Global, Instrumental
• 2000 to 2100, SRES projections

Range temperature for stabilization of CO2
concentration at equilibrium after 2100
650
550
450
10
Climate change impacts are best expressed in
terms of risk categories
450
550
650
Source IPCC Synthesis Report, 2001
11
Linking impacts to temperature
Temperature range at equilibrium
450 1.5 - 4C 550 2 - 5C 650 2.5 - 6C
Source Jan Corfee-Morlot, Niklas Höhne "Climate
change long-term targets and short-term
commitments", Global Environmental Change, Volume
13, Issue 4 , December 2003, Pages 277-293
12
Quantifying impacts in global economic terms is
fraught with difficulty

• Discounting the weight accorded to future
  impacts is critical and is subject to basic
  ethical principles
• Discounting for public policy is not the same as
  deriving from market returns, but expresses
  fundamental principles about responsibilities for
  and expectations about the welfare of future
  generations
• Discount rate should be endogenous in case of
  impacts that could have substantial impact on
  global welfare
• Aggregation the weight accorded to impacts on
  different peoples countries similarly has to
  reflect fundamental ethical principles cannot be
  dismissed eg. by comparison with foreign aid
• no practical substitution between foreign aid and
  mitigation expenditure
• a highly imperfect expression of willingness to
  help others
• confuses willingness to help others with
  responsibilities not to inflict damage
  (fundamental distinction between acts of omission
  and acts of commission)
• Done properly, the costs of climate change left
  unchecked probably equate to 10-30 of current
  consumption-equivalent

13
Mitigation the challenge and the costs
14
Historic emissions show developed country
responsibility for fossil CO2.
Source Marland et al. / Houghton et al. / EDGAR
3.2
15
.. Rich countries still dominate in per-capita
terms, in a unequal patterns of emissions that
underlie both political complexities and huge
pressures for growth
6.00
per-capita emissions vs population, 2000
United States
5.00
Can-Aus-NZ
4.00
Russia
Japan
Developing country (non-Annex I) countries
W. Europe
Emissions (Tonnes of Carbon Per Capita)
3.00
EITs
South Africa
2.00
Middle East
Latin America
1.00
China
Other Asia
Other
India
Africa
-
0
1000
2000
3000
4000
5000
6000
7000
Population (Million)
16
.. Whilst most growth is expected to be in
developing countries
7
Annex I
x 10
3
N2O
2.5
CH4
Forestry CO2
2
Fossil CO2
1.5
Emissions in Tg CO2eq.
How can developed country emissions be reduced
1
0.5
0
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
1900
Year
7
Non-Annex I
x 10
and developing country emission growth be
limited?
3
N2O
2.5
CH4
Forestry CO2
2
Fossil CO2
1.5
Emissions in Tg CO2eq.
1
0.5
0
1910
1920
1930
1940
1950
1960
1970
1980
1990
1900
2000
2010
2020
2030
2040
Year
IPCC SRES A1B scenario
17
Abatement scenarios involve a wide range of
technologies and systems across all big countries
.. - Emissions and technologies in Indian
long-term Scenarios
Source P.R.Shukla
18
450ppm requires radical action in next 10 years
even 550ppm will be difficult
Global CO2 emissions 8.5 to 10.5 GtC Change from
1990 to 2020 23 to 50
14
13
12
550 ppmv
11
10
Global anthropogenic CO2 emissions (GtC)
9
8
7
450 ppmv
6
5
1970
1980
1990
2000
2010
2020
2030
2040
19
Mitigation costs with endogenous technical change
suggest that efficient stabilisation at 450ppmCO2
may cost c. 1 GDP by 2050, and similar total
discounted
- But outliers indicate both risk of higher costs
and opportunities for gain
Present value total costs discounted _at_5 from 10
different models
20
Mitigation policies
21
A low carbon economy will need both much cleaner
energy and big reductions in energy demand
The UK 2003 Energy White Paper set the UK on a
path to reduce carbon emissions by 60 by 2050
through a combination of energy efficiency in the
short term and renewables in the long term To
achieve the required savings from energy
efficiency would need roughly a doubling of the
rate of energy efficiency improvement seen in the
past thirty years Technology innovation will
have a key part to play in underpinning all our
goals and delivering a low carbon economy To
deliver these outcomes our aim will be to provide
industry and investors with a clear and stable
policy framework
Levers to reduce UK carbon emissions
Carbon intensity (MtCe/MToe)
Clean energy supply
Reduction
Reduced energy demand
Note Figures in brackets show UK carbon
intensity (MtC/Bn), Scenarios show 2050
projections Source RCEP 1998, DTI EP68 GDP
growth forecasts, IAG Long-term Reductions in
GHG in the UK, Feb 2002
22

• Different drivers and concerns imply different
  instruments
• mitigation not delivered by one policy any more
  than one technology
• costs and competitiveness reflect the range of
  ve -ve impacts

Economic Competitiveness
23
Economic instruments and the EU Emissions Trading
Scheme
24
EU Emissions Trading Scheme Overview

• All EU 25 countries
• All electricity, ferrous metals, pulp paper,
  cement and all facilities gt 20MW, total 46 of EU
  emissions
• International links through Kyoto project
  crediting

Participants

• Member states develop National Allocation Plans
  (NAPs) by sector and installation
• To be consistent with Kyoto target and
  anti-subsidy provisions

Allocation

• 2005-7 phase 1, no national target, opt-out
  provisions
• 2008-12 governed by Kyoto target, opt-in
  possibilities
• 2013 ? Likely to strengthen

Timing

• Market price uncertainty driven by NAPs,
  relative coal-gas pricing, and emerging nature of
  market with mixed / late participation
• Specific allocation issues including new
  plant, plant closure, etc
• Various legal issues surrounding legal nature,
  tax rules etc.

Key issues
25
The market works but carbon price has had a bumpy
ride since inception
26
BIG Money though not quite in the way that some
expected

• At 20/tCO2, the asset value of 2.2bnCO2
  allowance is around 40bn/yr 100ms have been
  won or lost in trades against erroneous price
  expectations
• Disputes continue over the reasons for the
  surplus in 2005 - but it is some combination of
  overallocation and greater than predicted
  abatement (eg. in cement sector)
• Where competitive electricity markets, pricing
  effects as expected lead to profits probably
  totalling around 5bn across the EU, swamping the
  modest net purchases in the sector

27
EU ETS can substantially increase marginal
operating costs, but (eg. cement) can maintain
profits with only modest pass-through price
impact (current allocns)
Cost pass-through required to maintain sector
operating profits
Increase in marginal production cost,
Increase in wholesale cement price,
Proportion of increase in marginal cost passed
through to prices,
Scenario 1 5/tCO2
27.3
0.6
7.0
70.5
2.0
Scenario 2 15/tCO2
7.5
Scenario 3 25/tCO2 w/cutback
136.3
16.8
39.7
Phase 1 2, direct allocation helps offsets
electricity price rise (c.90 cost pass-through
in electricity) Long term scenario, required
cement cost pass through increases as its direct
allocation is cut back 30
Profit-maximising pass through predicted by
market modeling c.80
28
Profit/loss depends upon pricing policies and
incentives, allocation, and trade situationnet
value-at-stake insufficient for major problems in
Kyoto period
MVAS Max. value at stake (no free allocation)
NVAS Net value at stake (100 free allocation
exposure to electricity price only)

• Upper end of range zero free allocation
• Lower end of range 100 free allowances (effect
  of 10/MWh electricity price increase to sectors)
• Assumes allowance price of 15/tCO2 and no CO2
  price pass through in sector

29
As a result, most participating sectors profit on
domestic markets (but exports hit if no
reimbursement) Non-participants carry the cost,
Al. may exit if buys from grid
Value at stake in 2020, ( change in EBITDA
predicted by Cournot model in brackets)
Policy coverage
Petroleum
Cement
Steel
General Insights

• All ETS sectors profit under our standard
  allocations, as product pricing effects outweigh
  net input cost increase
• ETS enables these sectors to capture bulk of the
  scarcity rent
• At 30/tCO2 both cement and steel approaching
  turning point from imports
• Sectors outside ETS face the higher prices, Al.
  exits if on grid

• EU ETS low scenario (15Euro/tCO2)

0.5 (0.4)
23 (13)
11 (16)

• EU ETS high scenario (30Euro/tCO2)

1.3 (0.7)
52 (25)
27 (26)

• EU ETS high scenario with allowance cut back
  increased to 30

2.0 (-0.1)
75 (6)
43 (11)

• Steel imports impact profit taking at higher
  prices, still profit from ETS under 30 cutback
  but only a little

• Cement imports constrain cost pass through, 30
  cutback neutralises gains

• Marginal effect as energy is small fraction
  costs and profits

Note Value at stake (increase in total costs
after allowance allocation)/(starting EBITDA)
high variant scenarios with CCL doubled carbon
price of 30Euro/tCO2 and cut back of 1 pa versus
business as usual projected emissionsSource Oxer
a
30
Some initial high-level conclusions from EU
experience with economic instruments

• No practical economic instrument is pure
  because it aims to change relative prices in ways
  that favour lower carbon technologies over high
  carbon incumbents, fierce struggles are
  inevitable
• It has proved possible to implement a harmonised
  market in emissions cap-and-trade for industrial
  emissions across 25 diverse countries
• Industry attitudes change once the instrument is
  adopted lobbying then focuses upon getting the
  best, and the best has been large aggregate
  profits for some sectors,
• The EU ETS will continue post 2012 irrespective
  of progress elsewhere

31
Some specific conclusions around the EU ETS

• The major problems are not with market design,
  but with the allocation process
• Allocation and efficiency do interact
  particularly with repeated-rounds
• The logical solution to most problems with the EU
  ETS is to work towards greater auctioning over
  time
• Free allocation can only work if there is a
  central authority empowered to accept or reject
  allocation plans according to agreed criteria
• For the longer term, continuing free allocation
  will require greater institutional independence
  of allocation authorities, tasked with
  neutralising PL impacts rather than a host of
  other pressures
• Competitiveness is not an issue for operational
  costs in the present phase, but it is an issue
  for new investment in specific sectors may imply
  structural changes post 2012

32
The power sector and low-carbon innovation
33
The need for carbon pricing implies ..

• An internationalist strategy that links abroad
• To provide a sizeable, liquid carbon market that
  maximises opportunities for efficient mitigation
• To assist developing country mitigation through
  the CDM
• To help converge carbon prices
• To strengthen influence in future ETS
  developments and provide a stronger international
  basis for next steps
• Decarbonising the power sector
• is the basis for minimising economic impact on
  other sectors
• may ultimately provide a platform for low carbon
  transport solutions
• An integrated strategy covering energy
  efficiency, electricity regulation, emission
  allowances and innovation

34
In theory, rising carbon prices / strengthened
emission caps can provide the incentive for
strategic investment in innovation
Volume benefits compared to reference system
generating costs with existing technology
(trillions)
Volume learning investment (10s of bns across
technologies)
price
additional benefits with CO2 price
existing tech. plus CO2 price
cost savings with no CO2 price
existing technology
new technology
market size
time and cumulative installation
35
Figure 1.5 Green plus Scenario UK
Electricity Network in 2050Source Ch.2 in
Future Electricity Technologies and Systems, CUP,
2006
Diverse scenarios are possible to get low carbon
electricity radical scenarios with high
percentage of renewables require changes to
system structure and more use of advanced
transmission and power control
36
Accelerating innovation requires combining push
and pull to drive investment in technologies
and systems that traverse the entire innovation
chain
Government
Policy Programme Actions
Product/ Technology Push
Basic RD
Applied RD
Demonstration
Pre Commercial
Niche Market Supported Commercial
Fully Commercial
Market expansion
Cost per unit
Technology Valley of Death
Pure research
Consumers
Market engagement Strategic deployment Internalis
ation programmes policies Barrier removal
Market Pull
Investments
Business and finance community
37
Even market engagement requires a mix of
instruments .Carbon Trust support for
innovation commercialisation
Commercialise intellectual property
Generation of low carbon IP and Concepts
Identify Capture Relevant IP
Example innovation awards AIM launch of fuel
cell companies
Technology Accelerators
Venture capital
Support for RDD
75m investment fund offering launched this month
Incubators
Potential for carbon saving
Actual carbon abated
38
Rents in the EU ETS enough to pay the bill ?

• Power sector profits from EU ETS c. 5bn during
  2005
• E.On announce 100m RD Centre
• UK Environmental Transformation Fund announced
  co-incident with Auctioning decision
• UK 1bn National Institute for Energy
  Technologies (NIET) announced to be 5050
  co-funded with private sector, initial sponsors
  E.On, EdF, Shell, BP.
• International and sectoral investment linkages
  emerging through the CDM

39
The international stage
40
Impact of any Kyoto-like agreement will
accumulate over time and depend upon scope
strength of future action
Developing country scenarios of technology
policy spillover
FirstCommitment Period
14,000
Zero Adoption
12,000
developing country emission scenarios
10,000
Intermediate Adoption
8,000
Carbon Emissions (MTCpa)
6,000
4,000
Maximum Adoption (Intensity Convergence)
2,000
Industrialised Country Emissions (Kyoto -1 pa)
1990
2010
2100
2050
Source Grubb, Hope and Fouquet, in Climatic
Change, 2003
41
2005 saw the launch of four international
negotiation processes about the future ..

• The Kyoto Second Period negotiations launched at
  the Montreal Meeting of Parties to the Protocol
  (153 countries of which 32 are currently Annex B
  with a couple seeking to join)
• The UN global dialogue on future action launched
  at the Montreal Conference of Parties to the
  UNFCCC (c. 180 countries)
• The Gleneagles (G85?) Dialogue that culminates
  in Japan in 2008 including the worlds Big
  Emitters
• The Asia-Pacific Partnership on clean
  technologies including the A-P Big Emitters

42
Future development of the cap-and-trade structure
could be usefully complemented by strengthening
other legs of the UNFCCC/Kyoto package

• A core structure of sequential commitment
  periods capping national emissions (assigned
  amounts)
• First period defined for industrialised countries
  2008-2012 with differentiated allowances total
  5 reduction below 1990
• Basket of six greenhouse gases, plus some
  allowance for sinks / land-use change and
  forestry
• Extensive international adjustment / transfer
  provisions (Kyoto flexible mechanisms)
• Joint Implementation
• Clean Development Mechanism
• International Emissions Trading
• Range of other provisions concerning activities
  in developing countries, technology transfer,
  policies and measures, etc.

43
After long hiatus, the international process is
slowly gearing up .

• There is not yet any feasible zone of
  agreement, but ..
• Conditions are changing and 2007-8 will see a
  number of forces combining for breakthroughs
• IPCC Fourth Assessment, and Stern Review, will
  force open the international debate on the basis
  of the seriousness of problem and the feasibility
  of solutions
• Established carbon markets and investment flows
  through Kyoto mechanisms will embed these as a
  reality
• Growing business concern about risks of inaction,
  and costs of an unstable and fragmented
  international regime, will help convergence
• Growing appreciation that energy efficiency,
  carbon markets and technology innovation are not
  alternates, but complements appropriate to
  different parts of the problem

44
Conclusions and prospects
45
Conclusions

• Science
• provides a clear and compelling case for action
• Suggests aiming to stabilise in range
  c.450ppm-500CO2e ?
• Economic analysis
• confirms that not nearly enough is being done as
  yet
• Suggests costs of stabilisation broadly around
  500ppmCO2e manageable, if action is swift and
  broad-based
• Economic instruments
• EU ETS demonstrates feasibility of cap and trade
  but also complexity of the allocation process
• Generate revenues that can usefully be used to
  support eg.
• Innovation
• requires additional instruments and integration
  with regulatory and infrastructure decisions
• International
• Gearing up for the next round, built upon the
  emerging experience

46
Further information EU ETS Kyoto mechanisms
www.climate-strategies.org Allocation and
competitiveness in the EU ETS Climate Policy
Special Issue, 2006 Energy efficiency,
innovation the Carbon Trust www.carbontrust.co.
uk UK Climate Change Programme potential
evolution for business and public
sector Global economics Endogenous
technical change the economics of atmospheric
stabilisation, Energy Journal Special Issue,
2006