With agreement on an EU emissions trading scheme (ETS) expected to be ratified by the European Parliament and passed into law in July the power industry has to address the impact of emissions compliance on electricity prices. It is noticeable that since the ETS Bill was introduced by Portugal’s centre-right MEP Jorge Moreira da Silva in June forward electricity prices for the period 2004-05 have appreciated significantly. The spread between UK winter-04 and winter-05 baseload has widened to nearly £2.00/MWh with the summer-04/summer-05 spread widening to around £1.50/MWh. The significance of these spreads is placed in context when comparing with the winter-03/winter-04 spread, which is around £0.25/MWh.
The primary justification for the widening of price spreads that straddle the introduction of the EU ETS in 2005 is the impact of emissions compliance. Swedish utility group Vattenfall forecasts that the impact of emissions compliance could inflate electricity prices by as much as 75 per cent. The EU itself concedes that emissions compliance will induce some short-term ‘economic pain’ but believes that the longer-term impact will be beneficial and that emissions compliance will not bankrupt the economy.
The EU view on emissions compliance is largely at odds with the view of the US. It was for the very reason of the perceived impact on the economy of emissions caps under the Kyoto Protocol that the Bush Administration decided to exit the Kyoto mechanism. The EU now believes that it can prove emissions compliance will provide greater environmental benefits without long-term economic damage, and further believes this proof will encourage the US to re-enter the Kyoto mechanism. Such a view may be wishful thinking, particularly if Bush is re-elected president in 2004. While the US may be arguing its stance on economic grounds much of its decision on Kyoto is due to political belief.
What is interesting is the conversion of the EU to trading schemes as an emission reduction mechanism. It was only two years ago that the EU argued that emission trading should not be the singular route to emission reduction, arguing that trading should complement other emission reduction schemes. That it now fully endorses the value of trading to emission reduction is validation of the US philosophy. What is ironic is that it is the EU and not the US which is effectively introducing the first ‘continental’ ETS. The US has not introduced a ‘federal run’ ETS, preferring instead to encourage voluntary ETS schemes.
There are strong arguments in favour of an ETS approach to emission reduction. Emissions are a byproduct of oil, gas and coal and are essentially an extension of the value chains of these energy products. Both oil and gas, and increasingly coal, are commodity markets that are priced in a freely traded market. As emissions are a byproduct of a market based value chain they should be mitigated by market-based solutions. Trading is just such a market-based solution.
If we subscribe to the view that emissions are a function of the energy value chain then emissions will have to be valued as such. This requires the value chain to be deconstructed to its individual components and managed as a portfolio of risks. The challenge for the market ahead of the introduction of the EU ETS is to deconstruct this value chain. This presents some interesting challenges.
Consider the electricity value chain. As electricity is a derived product its value is determined by the generation feedstock used in generation, whether it be gas or coal. Gas and electricity prices will increasingly show convergence as the percentage of gas-fired generation increases. Equally the price of gas is influenced by the oil price with European gas prices largely indexed off oil. Therefore the gas-fired electricity value chain is influenced not just be the price of gas but also by the oil price. Similarly at the end-user end of the value chain the price of electricity is further influenced by supply and demand fundamentals in a competitive market. The emissions element further complicates the electricity value chain.
In the period leading up to the EU ETS the onus on the market is to understand the energy value chain and the contribution of emissions within this value chain. Equally the market has to agree on a consistent set of rules to value and account for emissions as they become traded as commodity in their own right. With the fraudulent accounting of Enron still fresh in the mind of the market the International Accounting Standards Board (IASB) circulated proposed new accounting interpretations for greenhouse gas emissions in May. The intent of the IASB is to eliminate the risk that divergent accounting practices will develop in the new market arena of emissions trading. Emission credits can be considered as financial assets, liabilities or government grants and an obvious concern is to eliminate any ambiguity in valuing emission credits and ensure that they are properly accounted for.
Beyond the process of understanding the emissions value chain and developing a consistent set of market rules to trade, and account for, emissions there will similarly be a requirement to develop the necessary trading and risk management software to enable companies to efficiently manage their emissions compliance within their overall energy portfolio.
If emission reduction is to be driven by a market-based solution, which arguably it should be, the rules and practices that will underpin this new market should be developed by the market itself. With forward electricity prices now clearly being influenced by emission compliance elements the onus on the market is to start developing these market rules now. By July 2004 the EU wholesale gas and electricity markets will be fully competitive and within a further year an ETS will be in place. To delay the process of developing emission market rules and trading and risk management software solutions may serve to introduce an unnecessary risk into the energy value chain.