Russia’s ratification of the Kyoto Protocol and Tony Blair’s decision to keep Kyoto on the agenda of his recent Washington visit following the re-election of George Bush have ensured the environment remains at the head of global politics. But while the political capital to be made out of environmental issues is set to continue through into the new year with the introduction of the EU Emission Trading Scheme (ETS) the almost blinkered focus on the environment could yet have dangerous consequences for supply security.

Given the contribution of energy usage to environmental emissions any prudent energy policy has to ensure a degree of equilibrium between environmental sustainability and supply security and, as a consequence, market economics. In this respect it was interesting to read the latest report from the influential left-leaning Institute for Public Policy Research (IPPR) – The Burning Question – which argues that in “setting out a clear framework for energy policy which makes clear the environmental issues, climate change should take precedence over economic objectives when the two areas come into direct conflict.”

Arguably within any energy policy that promotes environmental issues climate change and economic objectives will nearly always come into direct conflict. It is universally accepted, for example, that development of renewable energy technologies and the corresponding targets of emission reductions will, at least in the short to medium term, lead to an increase in energy costs. If environmental issues have a macroeconomic impact on the energy market then it is fair to deduce they will also have microeconomic impacts.

One of the arguments proffered by Bush in rejecting Kyoto in his first term, and expected to be continued throughout his second term even though his ‘special friend’ Blair may try and convince him otherwise, is that Kyoto’s negative economic impacts outweigh any environmental benefits. It is difficult to ague against this broad rationale. UK industry, for example, is concerned that the onus placed on emission reduction through the EU ETS with respect to other EU member states will have a negative impact on its competitiveness and as a consequence its economic objectives. This competitiveness imbalance will be even more pronounced with the US where there are currently no mandatory emission reductions in place.

But where the greatest challenge lies with respect to environmental issues is the generation sector as this sector bears the burden of emissions reduction under the EU ETS. At this month’s EMART Energy conference in Barcelona the issue of generation assets and the challenge to develop an environmentally competitive European electricity sector was actively debated both within the conference sessions and on the fringe. While Europe can claim to have completed the ‘big picture’ policy with its second directive on European competition and the creation of an internal energy market, albeit without the success envisioned, it has yet to integrate the environmental issues into the big picture. Instead Europe is faced with a competition directive and an emissions reduction directive and the challenge is to integrate these two directives to achieve the goal of an environmentally competitive European electricity market. If successful, the integration of environmental sustainability and a competitive electricity market could provide a valuable market model for other global economies, but only if the macro economic objectives are similarly realised.

If we subscribe to the views of the IPPR report then the driving force of this vision has to be the environment but this in turn may risk marginalising the macroeconomic view of the electricity sector as the two are inextricably entwined. From a macroeconomic perspective the key challenge is to reduce risks and improve market efficiencies, and as environmental ‘products’ are introduced into this mix the scale of this challenge is magnified. Indeed the recent sharp increase in UK wholesale electricity (and gas) prices is testament to the challenges faced as prices were driven higher on the fear factor of insufficient supply to meet peak winter demand. As proven generation supply – coal and nuclear – is progressively replaced by largely unproven and inflexible renewable energy sources this fear factor will only be enhanced and with it the economic consequences of higher prices.

At a conservative estimate, between 200 and 300 GW of generation capacity is expected to be modernised by 2020. If the driving force of modernisation is environmental sustainability then the staple generation sources will be replaced by new renewable energy sources such as wind power. Already, the mass scale development of wind farms is having an economic impact. In Germany, for example, which is at the forefront of wind capacity, grid operators have sought to increase grid access fees arguing that due to the inflexibility of wind farms connected to the grids the grid operators have to buy in large capacities of balancing generation, the cost of which has to be passed on to customers.

The alternative to replacing this generation capacity with renewable energy sources is to modernise, or upgrade, the existing capacity. For coal plants, which have traditionally provided the bedrock of baseload capacity, this means investing in clean coal technology by fitting flue gas desulphurisation (FGD) equipment. In Europe this has been effectively made mandatory through the large combustion plant directive (LCPD), which comes into force in 2008. For coal plant operators this becomes an economic decision; can the cost of FGD be recovered through electricity margins? A review of European generators suggests the market is roughly divided on this issue based on the number of coal plants that have been opted into the LCPD.

A similar dilemma is proffered with respect to nuclear, with the issue here directed at nuclear waste management. Again this is an economic issue; while nuclear is emission free its environmental consequences relate to efficient and effective waste management and whether governments are prepared to make the investment required to meet these requirements. In both cases governments are tending towards replacement as opposed to modernisation, apparently basing their rationale more on the environment than economic objectives. But in both cases governments may be making the wrong decisions for the wrong reasons.

If energy policy is to integrate environmental sustainability with supply security then the lead surely has to come from security not the environment, and as such greater precedence has to be afforded to economic objectives while ensuring environmental issues are not denigrated. As is currently evident this is a major challenge, but it is not insurmountable. Modernisation, as opposed to replacement, of existing coal and nuclear plant should be the foundation on which such a policy is based to secure the security on which the values of environmental sustainability are built.