The accepted
wisdom in energy markets now is that constraints on
greenhouse
gas emissions (GHG)—referred to as
"carbon constraints"— being
imposed on the European power sector will have significant
commercial implications for utilities and fuel suppliers
alike. With the European Union Emissions Trading Scheme
(EU ETS) now moving forward and clearer carbon dioxide
(CO2)
price signals emerging for the period 2005-2007, coupled
with the Kyoto Protocol coming into force on February
16, 2005, one of the key risk management challenges
utility analysts now face is understanding likely drivers
of the price of CO2 in the first Kyoto budget
period of 2008-2012.
The price of CO2 will
drive revenue forecasts in 2008-2012, a period during
which expected cash flow will be material to planned,
new power plant investment decisions. Some analysts
suggest planning for a price of €25/tonne
of CO2. ICF International’s recent analysis suggests, however,
that fundamentals analysis of the market, policy, and technology drivers can
help provide significantly more robust estimates for the price of CO2 and
considerably reduce uncertainties. Our perspective is that a price of €25/tonne
of CO2 represents a crisis scenario rather than one grounded in any
realistic analysis of the market drivers that will affect price.
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This article was published
in the Spring/Summer 2005 issue
of Perspectives.
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Undertaking a fundamentals analysis of the demand and supply
for carbon during 2008-2012 is made more difficult by the
plethora of variables involved, many of which hinge upon
key policy decisions yet to be taken including:
- the tightness
of the overall cap for the EU ETS to be set during 2008-2012
- the
linkage between the market for EU allowances (the currency
of the EU ETS), other domestic trading schemes (e.g.,
Canada and Japan), and other carbon commodities created
by the Kyoto Protocol’s market mechanisms, such as
the Clean Development Mechanism (CDM), which allows
companies to obtain carbon credits from undertaking projects
that reduce carbon emissions in countries like India, Brazil,
and China
- the potential
addition of other gases and sectors into the EU ETS
ICF International’s
integrated analysis incorporates these uncertainties by using
a scenario-based approach and considers the following:
- the
quantity of cost-effective abatement options available
to participants in the carbon market (represented by detailed
bottom-up, sector-specific, marginal abatement cost curves)
- the
likely shortfall of emissions within the carbon market(s)
due to the tightness of the caps and the availability
of credits from the project-based mechanisms of CDM and
Joint Implementation (JI)
- the impact of surplus allowances (e.g.,
hot air), particularly from Russia and Ukraine entering
the market
- the range of possible fuel prices given current market
trends
Any approach for analyzing the price of carbon during 2008-2012
must consider the dynamic response of the power sector. ICF International has undertaken power market modeling using our
proprietary Integrated
Planning Model (IPM®), a dynamic,
linear programming model that minimizes the cost of meeting
future electricity demand while complying with a multitude
of constraints. These include cross-border power transmission
limits, environmental constraints, reserve margin constraints,
and forced investments such as renewables.
ICF International
forecasts a total unmet demand in the range of 300-800 million
tonnes of CO2/year during 2008-2012. The
scenarios we have explored for the price of carbon in the
EU during 2008-2012 identify a series of key insights. In
general, this trading period is characterized by significant
growth in the size of the market compared to 2005-2007, with
further cuts being made to European trading sectors and additional
cuts from other parties as the Kyoto Protocol commences trading.
Consequently, the price of carbon dioxide equivalent (CO2e)
will rise compared to that in 2005-2007.
Our analysis demonstrates
that under all likely policy and market scenarios within
2008-2012, two key variables set the price of CO2e
in this period:
- the introduction into the carbon market of,
and the response to, assigned amount units (AAU), or so
called “hot
air” allowances, from Russia and Ukraine
- the implementation
of cost-effective, large-scale power sector abatement
options within Europe, as load shifting from coal to gas
accelerates and new combined cycle gas turbine (CCGT) power
plants come on line in specific markets where high value
opportunities emerge
Another key insight from our analysis is that there
is adequate availability of large-scale, power sector fuel
switching opportunities to reduce emissions. These opportunities
dominate the overall marginal abatement cost curve relative
to the abatement potential from other sectors included in
the scheme. Long-run fuel prices and the spread between coal
and gas prices are key factors in determining the level of
abatement available in the power sector at specific cost
levels.
Generally, however, the available abatement options
have the potential to meet all demand requirements when Russia
and Ukraine hot air allowances are used in combination. Without
the use of hot air allowances, the price of carbon would
increase considerably (although still less than the €25/tonne
forecast by some commentators). Moreover, it is probable
the price will be constrained in such scenarios by the increased
use of CDM credits, which put downward pressure on the level
of abatement required and ensure a lower price of carbon.
The figure (indicative scales for price and
level of abatement) highlights the dynamic relationship
of these dominant drivers on the price of CO2e
during 2008-2012. Compared with the 2005-2007 market, in
which we expect to see higher price volatility given the
pivotal role of weather and fuel prices, we anticipate
low upside and downside price volatility during 2008-2012
as a result of the shift in balance between power sector
abatement and excess hot air allowances entering the market.
Given
the relevance of the price of carbon to power plant valuation,
companies that are active in the EU energy sector need
to develop explicit estimates for the future price of
carbon over the expected life of existing and proposed assets
and incorporate them into investment protocols. ICF International
coined a term that would now be an appropriate descriptor
in the energy risk management lexicon: BAPEC, or Best
Available Price Estimate for Carbon.
Learn more about ICF International’s energy forecasting
services.
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