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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 Imperial College OF SCIENCE, TECHNOLOGY AND MEDICINE 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 The nature of the problem - Is not that climate change may hurt ‘us’ at some time in the future, but that it is … .. 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 … inherently unpredictable concerning some of the most important potential impacts, which arise from instabilities rather than incremental change … … and cumulative over huge time horizons with a lot of inertia and irreversibility “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 .. Scale of the challenge – where are we trying to get to? 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 Climate change impacts are best expressed in terms of risk categories Very low Positive or negative monetary; majority of people adversely affected 0 Past Negative for Distribution most regions of impacts Increase Large increase Risks to some Risks to many 1 2 450 3 4 Future 550 Increase in global mean temperature after 1990 (°C) Source: IPCC Synthesis Report, 2001 Aggregate impacts Net negative in all metrics Negative for some regions -0.7 Risks of large scale singularities Higher 650 Risk of extreme weather events Risks to unique & threatened systems 5 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 Mitigation: the challenge and the costs Historic emissions show developed country responsibility for fossil CO2…. 7 Emissions in Tg CO2eq. 3 Annex I x 10 N2O CH4 Forestry CO2 Fossil CO2 2.5 2 1.5 1 0.5 0 1900 1910 1920 1930 1940 7 Emissions in Tg CO2eq. 3 1950 Year 1960 1970 1980 1990 2000 1960 1970 1980 1990 2000 Non-Annex I x 10 N2O CH4 Forestry CO2 Fossil CO2 2.5 2 1.5 1 0.5 0 1900 1910 1920 1930 1940 1950 Year Source: Marland et al. / Houghton et al. / EDGAR 3.2 .. Rich countries still dominate in per-capita terms, in a unequal patterns of emissions that underlie both political complexities and huge pressures for growth Emissions (Tonnes of Carbon Per Capita) 6.00 United States 5.00 per-capita emissions vs population, 2000 Can-Aus-NZ 4.00 Russia Japan Developing country (non-Annex I) countries W. Europe 3.00 EITs 2.00 South Africa Middle East Latin America 1.00 China Other Asia India Other Africa 0 1000 2000 3000 4000 Population (Million) 5000 6000 7000 .. Whilst most growth is expected to be in developing countries Emissions in Tg CO2eq. 3 x 10 7 N2O CH4 Forestry CO2 Fossil CO2 2.5 2 1.5 How can developed country emissions be reduced… 1 0.5 0 1900 3 Emissions in Tg CO2eq. Annex I x 10 1910 1920 1930 1940 7 1950 Year 1960 1970 1980 1990 2000 Non-Annex I … and developing country emission growth be limited? N2O CH4 Forestry CO2 Fossil CO2 2.5 2 1.5 1 0.5 0 1900 1910 1920 1930 1940 1950 Year 1960 1970 1980 1990 2000 2010 2020 2030 2040 IPCC SRES A1B scenario Abatement scenarios involve a wide range of technologies and systems across all big countries .. - Emissions and technologies in Indian long-term Scenarios Conventional Technology Paths Synfuels, Gas hydrates, Nuclear fission Fuel cell vehicle: Carbon-free hydrogen Energy efficient appliances/ infrastrucutre 6750 6000 IA2 Frozen Technology CO2 Emissions (Million Ton) 5250 4500 3750 IB2 Nuclear Fusion, Backstops IA1 Information highways, High speed trains IA1T Advanced materials, Nanotechnology 3000 IB1 2250 High share of renewable Energy Renewable Lifestyle changes, EnergyEco-friendly Technologies choices 1500 750 2000 CO2 Capture/ Storage, pipeline networks Substitution of transport by IT 2020 2040 2060 2080 2100 Dematerialization, material substitutions Source: P.R.Shukla Sustainable habitats, Public amenities 450ppm requires radical action in next 10 years – even 550ppm will be difficult Global anthropogenic CO2 emissions (GtC) 14 Global CO2 emissions: 8.5 to 10.5 GtC Change from 1990 to 2020: +23% to +50% 13 12 550 ppmv 11 10 9 8 7 450 ppmv 6 5 1970 1980 1990 2000 2010 2020 2030 2040 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 @5% from 10 different models Mitigation policies A low carbon economy will need both much cleaner energy and big reductions in energy demand “Clean” energy supply Levers to reduce UK carbon emissions Carbon intensity (MtCe/MToe) 0.8 1990 (0.219) 2000 (0.161) 0.7 IAG Global Sustainability 0.6 0.5 %Reduction RCEP 2 0.4 0.3 20% (0.103) Carbon Trust 0.2 30% (0.072) 40% (0.050) 50% (0.033) 60% (0.021) RCEP 1 0.1 0 0 0.05 0.1 0.15 0.2 Energy intensity (MToe/£Bn GDP) Reduced energy demand 0.25 0.3 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” 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 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 Behaviour Buildings, Appliances & other Industry Substitution (Manufacturing and Construction) Transport Technical innovation Economic instruments Innovation instruments Economic Competitiveness Voluntary, regulatory and systemic instruments Economic instruments and the EU Emissions Trading Scheme EU Emissions Trading Scheme – Overview Participants Allocation Timing Key issues • All EU 25 countries • All electricity, ferrous metals, pulp & paper, cement and all facilities > 20MW, total 46% of EU emissions • International links through Kyoto project crediting • Member states develop National Allocation Plans (NAPs) by sector and installation • To be consistent with Kyoto target and anti-subsidy provisions • 2005-7: phase 1, no national target, opt-out provisions • 2008-12: governed by Kyoto target, opt-in possibilities • 2013+ ? Likely to strengthen • 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. The market works but carbon price has had a bumpy ride since inception EUA price 25 October 2004-24 May 2006 35 30 Euro/t CO2 25 20 Futures Dec 2007 Futures Dec 2006 OTC Index 15 10 5 0 1-Oct-04 31-Dec-04 1-Apr-05 1-Jul-05 30-Sep-05 30-Dec-05 31-Mar-06 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 EU ETS can substantially increase marginal operating costs, but (eg. cement) can maintain profits with only modest pass-through & price impact (current allocns) Increase in marginal production cost, % Cost pass-through required to maintain sector operating profits Proportion of increase in marginal cost passed through to prices, % Increase in wholesale cement price, % Scenario 1 €5/tCO2 27.3% 7.0% 0.6% Scenario 2 €15/tCO2 70.5% 7.5% 2.0% Scenario 3 €25/tCO2 w/cutback 136.3% 39.7% 16.8% 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% Profit/loss depends upon pricing policies and incentives, allocation, and trade situation net value-at-stake insufficient for major problems in Kyoto period Potential value at stake (NVAS / MVAS) under 0 to 100% free allocation 20% 18% 16% MVAS: Max. value at stake (no free allocation) Electricity Refining & Fuels Cement NVAS: Net value at stake (100% free allocation; exposure to electricity price only) 14% 12% Food & Tobacco 10% Glass & Ceramics 8% Iron & Steel Pulp & Paper 6% Non-ferrous metals inc. aluminium Chemicals & Plastics Metal Manufactures 4% Textiles 2% 0% 0% 5% 10% 15% 20% 25% 30% 35% UK trade intensity from outside the EU • 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 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 Policy coverage Value at stake in 2020, %* (% change in EBITDA predicted by Cournot model in brackets) • EU ETS low scenario (15Euro/tCO2) • EU ETS high scenario (30Euro/tCO2) • EU ETS high scenario with allowance cut back increased to 30% 11 (16) 23 (13) 27 (26) Source: 0.5 (0.4) 52 (25) 43 (11) • Steel imports impact profit taking at higher prices, still profit from ETS under 30% cutback but only a little Note: Petroleum Cement Steel 75 (6) • Cement imports constrain cost pass through, 30% cutback neutralises gains 1.3 (0.7) 2.0 (-0.1) 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 • Marginal effect as energy is small fraction costs and profits *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 emissions Oxera 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 The power sector and low-carbon innovation 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 price In theory, rising carbon prices / strengthened emission caps can provide the incentive for strategic investment in innovation… Volume = learning investment (10s of $bns across technologies) Volume = benefits compared to reference system generating costs with existing technology ($trillions) 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 Iceland Demand 390TWh Wind 45-50% PV 3-5% Biomass 25% Marine 5-10% CO2 capture Only for hydrogen Nuclear - MicroGen 20% Norway Northern Ireland Figure 1.5 : “Green plus” Scenario: UK Electricity Network in 2050 France Source: Ch.2 in Future Electricity Technologies and Systems, CUP, 2006 Netherlands 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 R&D Applied R&D Cost per unit Pure research Demonstration Pre Niche Market Fully Commercial Supported Commercial Commercial Market expansion Technology “Valley of Death” Consumers Market engagement programmes Strategic deployment Internalisation policies & Barrier removal Market Pull Investments Business and finance community Rents in the EU ETS – enough to pay the bill ? EUA price 25 October 2004-24 May 2006 •Power sector profits from EU ETS c. €5bn during 2005 Euro/t CO2 35 30 •E.On announce €100m R&D Centre 25 •UK Environmental Transformation Fund announced ‘co-incident’ with Auctioning decision 20 Futures Dec 2007 Futures Dec 2006 OTC Index 15 •UK £1bn National Institute for Energy Technologies (NIET) announced to be 50:50 cofunded with private sector, initial sponsors E.On, EdF, Shell, BP. 10 5 0 1-Oct-04 31-Dec-04 1-Apr-05 1-Jul-05 30-Sep-05 30-Dec-05 31-Mar-06 •International and sectoral investment linkages emerging through the CDM The international stage … Carbon Emissions (MTCpa) Impact of any Kyoto-like agreement will accumulate over time and depend upon scope & strength of future action 14,000 Developing country scenarios of technology & policy spillover First Commitment Period Zero Adoption 12,000 developing country emission scenarios 10,000 8,000 Intermediate Adoption 6,000 4,000 2,000 1990 Industrialised Country Emissions (Kyoto -1% pa) 2010 2050 Source: Grubb, Hope and Fouquet, in Climatic Change, 2003 Maximum Adoption (Intensity Convergence) 2100 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 (G8+5+?) Dialogue that culminates in Japan in 2008 including the world’s Big Emitters The Asia-Pacific Partnership on clean technologies including the A-P Big Emitters 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. 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 Conclusions and prospects 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 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