2. Compensation guidelines and Emission Trading 2013 onwards

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1 OUTOKUMPU OYJ Corporate management Riihitontuntie 7B P.O. Box 140 FI Espoo Finland POSITION RESPONSE TO THE COMMISSION S CONSULTATION OF ETS STATE AID GUIDELINES HT (8) January 30 th 2012 FINANCIAL COMPENSATION OF INDIRECT COSTS OF EMISSION ALLOWANCES 1. Outokumpu in brief Outokumpu is a global Stainless steel company. Our plants in Finland, Sweden, the UK and the US produce a wide range of stainless steel products including hot and cold rolled, precision strip, tubular and long products. Our integrated stainless steel mill at Finland, Tornio Works is one of the largest stainless steel mills in the world, including globally unique fully integrated process chain into the essential raw material, chrome. 1 Outokumpu directly employs some people, of which vast majority in Europe. Our primary product stainless steel is traded on global markets; majority of competition operates outside European Union. 2 Our secondary and most energy intense product Ferrochromium we are one of the two producers in Europe and the only producer operating under ETS 3 Outokumpu s processes are energy intensive and our main energy source is electricity. Outokumpu s main production sites in Finland, Sweden and UK consumes electricity approximately 2,8 TWh/a and electricity is an important cost factor in Stainless steel production. Since 2005 EU s unilateral emission trading scheme, ETS has increased the price of electricity significantly and weakened our competitiveness in a global competition. 2. Compensation guidelines and Emission Trading 2013 onwards Outokumpu welcomes the Commission initiative to support sectors exposed to a risk of carbon leakage due to indirect CO2 costs passed on to electricity prices. Outokumpu acknowledges the Commission s analysis which recognizes the Manufacture of basic iron and steel and of ferro-alloys 4 sector s exposure to carbon leakage due to indirect CO2 costs, concluding the eligibility for State aid. Steel is a globally traded commodity and its processes are not only carbon intensive but also electricity intensive, making it a compelling case. Since the implementation of unilateral ETS in Europe, the system has had severe negative impact clearly distorting competition and leading to contradictory incentive to the purposed optimal emission reductions. Costs related to emissions allowances are directly passed on to market prices of electricity (appendix 1). This has significantly weakened competitive position of European electricity intensive products traded on global markets that have no possibility to pass on these costs to product prices. European Council and Parliament has adopted text for amending directive for greenhouse gas emission allowance trading system after Directive states that Member States may financially 1 Case example 1. Integrated FeCr Production 2 Over 70% of stainless steel is produced outside EU; ISSF International Stainless Steel Forum statistics average of European FeCr productions has under 5% share globally. This is under 30% of European consumption. 4 NACE Code: 2710; Manufacture of basic iron and steel and of ferro-alloys 5 DIRECTIVE 2009/29/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the Community Outokumpu Oyj Corporate Management Riihitontuntie 7A, PO box 140 FI Espoo, Finland tel

2 2 (8) compensate sectors exposed to a significant risk of carbon leakage due to costs relating to greenhouse gas emissions passed on in electricity prices. European Commission is preparing guidelines for state aid rules 6 and draft is open for public consultation. 3. Outokumpu s position Compensation is critical correction factor to the ETS system, providing much needed mechanism towards more level playing field. It is crucially important to electricity intensive European products. The overall ETS aim to cut emissions globally is especially safeguarded with low emission and energy efficient European products. Implementation of a strong compensation framework helps to avoid carbon leakage without jeopardizing investments in Europe. Level of compensation should not be artificially decreased with factors, trigger or floor prices or limits which do not reflect the actual situation in European electricity markets. We strongly object only partial compensation as well as further progressively diminishing aid. We require a proper realization of the compensation mechanism that reflects the actual indirect costs. Introducing EUA trigger or floor price would mean that competition distortion remains unchanged until certain EUA price is reached. For example to Outokumpu 15 trigger price would mean 37 M indirect costs annually through higher electricity prices before compensation comes in to force. Draft guidelines introduce two formulas in order to calculate maximum compensation levels 7. Formula should not include aid intensity factor at all. Some of the proposed emission factors are artificial and don t reflect the real cost past through of EUA price to electricity market price. Emission factor should be the marginal CO2 intensity of the relevant power market area. Based on realized electricity market prices and market design at least Nordic market should be treated as one market area. For example there is no fact based justification (appendix 1) to separate Denmark from the Nordic market area. Nordic area should include Denmark in addition to Sweden, Finland, Norway and the adequate factor is 0,9 tco 2 / MWh instead of currently proposed 0,67. As these indirect costs are based on the impact of ETS system, we see that the natural sources for funding compensation are the auctioning revenues of EUA s during Based on the fact that there is no binding international climate agreement insight before 2020, it s essentially important to secure competitiveness through sufficient compensation. To support our position and views we have attached case example and appendix. Case describes features of our unique integrated Ferrochrome production. Appendix provides in depth analysis of the Nordic electricity market design. Outokumpu respectfully requests determined actions and implementation of compensation guidelines in the spirit of the renewed ETS directive. Kari Parvento EVP Ferrochrome and R&D 6 GUIDELINES ON CERTAIN STATE AID MEASURES IN THE CONTEXT OF THE GREENHOUSE GAS EMISSION ALLOWANCE TRADING SCHEME POST-2012 Communication from commission draft referred 10 th Jan Maximum level when electricity benchmark available: Aid intensity at year t, expressed as a fraction (e.g. 0,8) times CO2 emission factor (tco2/mwh) (at year t) times EUA forward price at year t-1 (EUR/tCO2) times Product-specific electricity consumption efficiency benchmark (MWh/tonne) defined in Annex III times Baseline output. Optionally when electricity benchmark is not available max. level is: Aid intensity at year t times CO2 emission factor (tco2/mwh) (at year t) times EUA forward price at year t-1 (EUR/tCO2) times Fall-back electricity consumption benchmark 0.7 times Baseline electricity consumption.

3 3 (8) Integrated Ferrochromium production extreme case example in ETS framework Outokumpu has globally unique stainless steel production site Tornio Works (TW) located at Europe in Finland. Integrated production chain covers all production phases beginning from ferrochrome (FeCr) through steel melting until finished cold rolled stainless steel. This production chain is the most integrated set up in the world. Therefore Tornio Works is not directly comparable to other installations. Energy and CO 2 efficiency is remarkable; emissions from benchmark route are more than double compared to TW. 8 The FeCr is produced with some 50% lower energy consumption and CO2 emissions. Tornio Works integrate s energy and CO2 performance aggregate from several sources. Recycled steel used as main raw material, differences in FeCr -technology, efficient energy use and recovery, heat recovery, waste gas and by-product utilization, are main contributors of efficiency also the avoided transportation plays a role in calculations. Tornio Works has been included as a one integrated production site under Emission Trading Scheme (ETS) since This means that it is the only FeCr installation under ETS system. Ferrochrome and European stainless steel production Stainless steel production needs chromium, by definition stainless steel has minimum of 10,5% of Chromium. There is no substitution for Cr in stainless steels. European stainless steel production (app. 7-8 Mt annually) uses 1.4 Mt of ferrochrome being equal to 170 kg FeCr/t steel on an average. Of this Outokumpu produces some 240 kt annually, under 20% of EU consumption. All other FeCr originates outside EU 9. All other stainless steel producers use imported chromium. ETS and especially indirect cost have damaged competitiveness of both the FeCr and our Stainless steel production. Indirect costs The whole stainless steel production process is very energy-intensive. The ferrochrome production is a stage in which the energy consumption is the highest, requiring both electricity and reductant. Energy costs are significant, some 30% of all production costs. These indirect costs from pass through have affected Ferrochromium production from the implementation of emission trading system since During the period share of indirect ETS 10 costs of gross value added (GVA) has been some 20% on an average, topping nearly 40% during These affects are larger than the profit margins. The affect is significant. European presence, Finnish exports Over 90 % of Stainless steel produced in Tornio is exported, over 50% to Europe. During recent years stainless steel has been among the top 5 most important exporting items for Finland. Conclusion It is hard to find other European product as vulnerable to carbon leakage, being completely unable to pass indirect ETS costs on to product price. Also the production cost structure is very dependent on electricity prices. Integrated FeCr production is also Globally unique process. This combined to the fact that it is the energy efficiency and low emission benchmark globally that makes current situation even more unjustified cleanest installation is the only one burdened with ETS costs, both direct and indirect. Compensation is crucially important for FeCr production, after all European FeCr production should be considered as serious positive climate act. 8 Virtual Benchmark study compared TW production route to similar average production chain. See also picture 1. 9 There is one other FeCr smelter installation in Sweden, which is not included to ETS and has no Chrome mine, all chrome ore is imported outside EU 10 Calculation where EUA indirect cost fixed to 15 /MWh over

4 Picture 1. Summary of avoided emissions with annual production of 1.5 Mt. Scope 2 indicates emissions from electricity use. Scope 2 is affected both electricity consumption of processes and specific emissions of the electricity production. 4 (8)

5 5 (8) Appendix 1: Nordic Electricity Wholesale markets and EU ETS The Nordic wholesale market for the electricity is operated by Nord Pool Spot ASA power exchange, located in Oslo Norway. In Nord Pool Spot the market actors trade electricity in the spot market. The Spot market is so called day a head market operated once a day by closed trading round -principle, where actors place their bid- and ask- offers for each individual 24 hour for next day. The Spot -market operates with marginal cost principle, where the crossing of bid- and ask curves determinate the price ( /MWh) and the volume (MWh/h) for each hour. In a short term, taking in to account the electricity s specific character as non storable commodity, the large portion of hydropower production and the lack of demand response (un-elastic consumption), there is high volatility in the Nordic wholesale prices. In addition to Spot market Nord Pool ASA / Nasdaq OMX Commodities provides market place for financial products from days to years, five years forward. The financial products are settled against the spot price (underlying asset is spot), so market actors can hedge their future market price risk through financial market products. 1.1 The cost of coal condensing power determinates the Nordic electricity market price In Nordic electricity market the power production (and the consumption) is approximately TWh/a. Roughly half of the production is based on hydro power production, mainly located in Norway and Sweden. All together, approximately 65 % (2008) of power generation in Nordic is based on the renewable energy like hydro, wind and biomass/wood based fuels. Nuclear power represents approximately 20 % share of the production. So, in total 85 % of Nordic power production is CO2 free. The coal condensing power has been the marginal production capacity in Nordics - last decade. The marginal cost of coal condensing power has set the price for Nordic power market in a normal hydrological situation. At times, mainly due the variation in hydrological situation, but also variations in other market conditions, like changes in consumption, temperature, etc., the price for Nordic electricity market has been defined by other production plants marginal costs than coal condensing power. When choosing a long enough observation period, which consist different market and weather conditions, the impact of these conditions will dampen. In the competitive and well functioning market, the price of electricity will approach the marginal production plant s marginal costs (includes fuel, O&M and CO2 cost) in several years observation period. It is essential to note, that due to the large portion of hydro power production in the Nordic power system and the possibility to storage the water in reservoirs, the price of electricity can be determined by the marginal costs of coal condensing power even though coal condensing plant is not operating as the marginal power plant at the given moment, because of the strategic bidding of producers. EU s Emission Trading Scheme, EU ETS, started in It has had a significant impact in the electricity market price, because Emission allowances (EUA) price effect s the marginal cost of the coal condensing power plants. As an average coal condensing power plant in the Nordic countries has efficiency somewhere around 39 % and 1 ton coal as a fuel has CO2 emission factor 0,35 ton/mwh, we shall have CO2 emission factor for produced electricity by coal condensing power ~ 0,9 ton/mwhe. The price of EUA will pass through to the electricity market price by factor 0,9 in theory. (An example: With EUA price 15 /ton have price impact to electricity price of 0,9 ton/mwh*15 /ton = 13,5 /MWh ). This is illustrated in Picture 1 and described later in this document.

6 6 (8) Picture 1, Picture of principle, the price formation in the Nordic electricity market 1.2 Pricing of the electricity futures As illustrated in chapter 1.1, in theory the electricity prices are set by the marginal costs of marginal production capacity. How this theoretical pricing actually is realized in the power market, can be determined by calculating the production cost of marginal production and comparing this to the realized market price. In a functioning market, this is the case for electricity future markets as well (because the underlying asset for futures is spot price). This can be verified (similar method that in the spot market) by calculating the marginal cost of coal condensing power from the future market price of coal (API2) and the future market price of emission allowances (EUA) and comparing result to the actual market price of future electricity market. A strong correlation can clearly be seen in pictures 2 and 3, which also shows that in Nordic the CO2 cost actually pass through (with factor 0,9 ton/mwh) to the future electricity price by 100 % almost all the time. It s also important to note that electricity consumers procure electricity for the future in advance and the price for the supply is based on the future power market price.

7 7 (8) Grey: variable cost of marginal production Green: CO2-emission costs (opportunity cost) Red: market price for electricity nearest year 2010 forward YR-10 Picture 2, The electricity market price and marginal production costs of coal condensing power including CO2 cost s, year Grey: variable cost of marginal production Green: CO2-emission costs (opportunity cost) Red: market price for electricity nearest year 2011 forward YR-11 Picture 3, The electricity market price and marginal production costs of coal condensing power including CO2 cost s, year 2011.

8 8 (8) 1.3 Spot market price outcome 2011 In a hourly level Nordic market Spot prices are fragmented because of insufficient transmission capacity. As explained in chapter 1.1, in short observation period different market condition shifts the electricity spot market price off from the marginal production costs, coal condensing power. However, when the observation period is long enough, which includes different market conditions, the impact of individual market condition fades out and the pricing in the market will approach the marginal production costs. Yearly observation period the prices convert well (+/-5%) in different market areas, as can be seen for example year 2011 in table below. Finnish market price was the highest (4,8% higher than system price), Norwegian prices the lowest. When comparing realized spot prices in Nordic 2011, they don t confirm the compensation factors proposed by EU. Nordic Power prices 2011 Price area Area Price, average Price difference*), average System price 47,05 /MWh /MWh (%) HEL (Finland) 49,31 2,25 (4,8%) STO 47,85 0,8 (-1,3%) NO1 46,42-0,63 (-1,3%) NO2 46,09-0,96 (-2,0%) DK average (Denmark) 48,69 1,64 (3,5%) DK1 (Denmark) 47,96 0,91 DK2 (Denmark) 49,41 2,36 *) Area price minus System price in /MWh (%) European Union has set an target (3 rd energy package) to establish European internal energy markets by In integrated market s the power prices will convert, when cross-border power interconnectors will be in place as planned. This is important to take in account when design of EU level financial compensation indirect CO2 costs is done. In the long run in a presence of one market (EU internal energy markets), there can t be different compensation factors without significant market disturbance between EU countries and regions.