15 January 2009

Carbon impact on energy prices: Who's passing on costs and who's profiting?

By Stephen Gardner, ClimateChangeCorp, 18 Dec 2008

Costs from EU ETS participation are pushing up electricity prices, but who really benefits?

The British government claimed a first last month. On 19 November, it sold its first permits to emit CO2 to UK participants in the European Union's emissions trading system (ETS). The sale raised £54 million for Alistair Darling's beleaguered Treasury – or four million allowances at £13.60 each.

Currently, the ETS is in phase two (2008-2012), at the end of which companies must show they have enough allowances to cover their emissions. If participants pollute more than expected, further allowances must be bought on the carbon markets.

Auctioning is one way of distributing carbon allowances up front to ETS participants. The other method, employed in the first phase of carbon trading, is handing out of free allowances at the start of the trading phase.

The government cites commercial confidentiality when asked the identity of bidders in the auction, but the main buyers are likely to have been electricity generators. This is because not all ETS participants are treated equally when the free allowances are handed out. There is an assumption integral to the ETS that power companies can pass the carbon price on to their customers. Other industries – such as steelmakers or chemical firms – are different. They are exposed to international competition, or they have strategic value, so the cost of carbon added to their bottom line could do them damage. Consequently governments look to protect them, by giving them more free permits than they need.

The UK's biggest oil refinery for example, at Fawley near Southampton, was given an annual free allocation of 3.6 million allowances in the ETS first trading phase (2005-2007), compared to its annual CO2 emissions of around 3.1 million tonnes, according to figures from analysts Carbon Market Data. For the second phase, the UK government has tightened the cap on Fawley, but it is still more than generous, with an annual allocation of 3.3 million allowances.

By contrast, the UK's largest power station, Drax in Yorkshire, was between 2005-2007 given 14.5 million free allowances, but emitted around one third more CO2 than that (20-22 million tonnes annually). For 2008, Drax's free allocation was slashed further, to 9.5 million allowances.

Controversial pass through

Controversy has arisen because power companies started to pass through to their customers the cost of carbon allowances long before the 19 November auction. Or at least they started to pass through the theoretical cost of carbon permits that in the main they received for free.

An analysis for the government by energy consultants IPA found that (during the first phase of carbon trading when allowances were being handed out for free) in 2005 alone electricity producers used the pass through to net £1.2-£1.3 billion in windfall profits – money for nothing. The pass through, which has continued, will push up the wholesale electricity price by up to £10.50 per megawatt hour in the period to 2020, according to IPA. This represents a significant chunk of the total wholesale price, which is currently around £70.

The power sector's regulator, Ofgem, says that household electricity bills have increased by £31 in 2008 because of the windfall. The annual average domestic bill is now £465.70. Ofgem's Chris Lock claims the total ETS phase two windfall to electricity generators will be £9 billion.

While some players in the carbon markets are incensed by the windfall – Patrick Birley, CEO of the European Carbon Exchange says it is tantamount to “fraud” - Cedric Bleuez of analysts Carbon Market Data believes the windfall arose simply because the first years of the ETS have been experimental. Governments allowed it to happen as they wanted power firms to accept the ETS and so did not want to put “too many constraints on companies.” Bleuez adds that tightening up will come later, in the form of auctioning of all allowances to power companies.

Under EU plans 100% auctioning to energy companies is proposed to start from 2013, when phase three of the ETS begins, and should ensure that rather than leading to windfall profits for energy companies, the ETS pass through results in revenue for government. Brooke Flanagan, a research fellow at the Institute for Public Policy Research (IPPR), which conducts research on climate change policy, says her organisation “support[s] the auctioning of permits,” as a means of raising funds for climate change mitigation measures.

Pushing up prices

Karsten Neuhoff of the Cambridge University Electricity Policy Research Group, who has studied cost pass through in different European countries, says that pass through will push up the price of electricity from carbon-belching power stations, making renewable power a more attractive option for households and businesses. Auction revenues, meanwhile, could mean a fund for investment in renewable electricity generation, which governments “must ambitiously go for,” according to Neuhoff.

Specifically allocating auction revenues to such causes would help focus the effort to green the economy. Some countries, such as Austria, Hungary and the Netherlands, have promised to do this. But, says Jonathan Farr of the Department of Energy and Climate Change, there is no UK plan to directly link auction revenues and climate change mitigation, though there are non-linked schemes, such as Warm Front, a programme that gives energy efficiency grants to poor households. The government announced on 24 November £100 million in extra funding for this.

This is relatively little when one considers that, even in the current ETS phase, serious revenues will be raised from auctions of emission allowances. The UK will auction 7% of its total allowances up to 2012, raising £1.2 billion assuming the current price holds up. Carbon Market Data's Cedric Bleuez says he is “surprised” there is no ringfencing plan. “It makes sense to use the money for funding research and development in the green economy, or to fund renewable energy schemes,” he says.

David Porter, Chief Executive of the Association of Electricity Producers, says that if UK electricity is going to meet its target of zero emissions by 2050, in line with the government's climate change plan, the auction money needs to be channelled into the research and development of energy technologies - especially carbon capture and storage.

The danger is that, in the current economic crisis, there may be many other calls on auction revenues that go into the general budget. The IPPR's Brooke Flanagan says this should not be the case. In fact, the looming recession provides a stronger incentive for “investing in new technology that can create employment and helping people with rising fuel bills,” she says.

Because of the EU ETS – and ultimately because of the need to tackle climate change – consumers and businesses can expect higher energy bills in the future.

Essentially, we are all buying the right to expect a move away from fossil fuel-burning energy production in favour of low carbon energy. In order to meet our expectations, the government needs to spend carbon allowance auction revenues wisely.

ClimateChangeCorp.com © Ethical Corporation 2009

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