COGEN Europe Position Paper. Phase-III of the EU ETS: How to treat Combined Heat and Power installations in an auction-based scheme

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1 COGEN Europe Position Paper Phase-III of the EU ETS: How to treat Combined Heat and Power installations in an auction-based scheme New version: 7 April 2008 INTRODUCTION: While the EU Emissions Trading Scheme (ETS) offers great potential to encourage energy efficient behaviour in the European industrial and power sectors and spur investments in cleaner generation technologies, experience gathered over the first years of the current scheme indicate that the EU ETS has largely failed to drive investment in high efficiency cogeneration (also known as Combined Heat and Power, or CHP). There is a need for policy makers to integrate the specific allocation issues facing cogeneration into a workable scheme or face the risk of failing to capture the important contribution cogeneration can make to the EU s efforts to curb CO2 emissions and increase energy efficiency. COGEN Europe and its Members have been actively working on innovative allocation methodologies for the European Emissions Trading Scheme and submitted a position paper in May 2007 detailing the double-benchmarking approach to allowance allocation, which remains the soundest methodology to the CHP sector stakeholders. Following publication from the Commission of a proposal revising Directive 2003/87/EC, and as a further contribution to the policy formulation process, this paper highlights 2 fair, specific, and workable options for the treatment of cogeneration installations in the European Union should auctioning emerge as the main allocation methodology to installations. In addition, this paper highlights the issue of small-size CHP installations under the proposed system and offers a solution to avoid severe competitive disadvantages to such installations in both the heat and electricity markets. 1

2 1. EU RECOGNITION AND PROMOTION OF CHP FOR ITS BENEFITS Cogeneration (also referred to as CHP) is the most efficient technology for converting primary fuel into electricity and heat. Fulfilment of the significant potential for CHP in the EU can make a major contribution to achieving the Kyoto and IPCC targets, as well as the EU s 2020 CO2 and energy efficiency targets. This potential lies both in the development of new CHP capacity as well as in the optimisation of the running hours of existing CHP plants. The EU Commission recognises the value of CHP as an element of its energy saving strategy, and has developed the EU CHP Directive 2004/8/EC to assist in promotion of CHP. The EU CHP Directive, by laying down a very robust methodology to calculate primary energy savings for each individual installation offers the possibility to calculate the associated CO2 emissions reductions from high efficiency cogeneration. This contribution to lowering global CO2 emissions must be taken into account in the allocation methodology for cogeneration installations in phase-iii. In the current EU ETS system the special role of CHP is recognised. COGEN Europe draws the Commission s attention to the following clause (20) in the pre-amble to the EU ETS 2003/87/EC This Directive will encourage the use of more energy- efficient technologies, including combined heat and power, producing less emissions per unit of output Unfortunately the EU ETS failed to do so so far. 2. CHP AND AVOIDED GLOBAL CO2 EMISSIONS The International Energy Agency in its report entitled Combined Heat and Power Evaluating the benefits of greater global investment has highlighted the key role CHP has to play in both the developed and developing world when it comes to avoiding CO2 emissions. It is therefore essential that the EU enters the negotiations on a future international agreement on combating climate change with a sound policy framework which will not deter investment in high efficiency cogeneration. The report, focusing on the G8+5 countries, reads (extracts from Executive Summary): Combined heat and power (CHP) represents a series of proven, reliable and cost-effective technologies that are already making an important contribution to meeting global heat and electricity demand. Due to enhanced energy supply efficiency and utilisation of waste heat and low-carbon renewable energy resources, CHP, particularly together with district heating and cooling (DHC), is an important part of national and regional GHG emissions reductions strategies. The report confirms that CHP merits a closer look by policy makers as they investigate paths toward a lower-carbon, more efficient, lower-cost and reliable energy future. Some key results of the analysis include: CHP can reduce CO2 emissions arising from new generation in 2015 by more than 4% (170 Mt / year), while in 2030 this saving increases to more than 10% (950 Mt / year) equivalent to one and a half times India s total annual emissions of CO2 from power generation. CHP can therefore make a meaningful contribution towards the achievement of emissions stabilisation necessary to avoid major climate disruption. Importantly, the near-term reductions from CHP can be realised starting today offering important opportunities for low- and zero-cost GHG emissions reductions. 2

3 Through reduced need for transmission and distribution network investment, and displacement of higher-cost generation plants, increased use of CHP can reduce power sector investments by USD795 billion over the next 20 years, around 7% of total projected power sector investment over the period CHP IS A SYSTEM INNOVATION, INTEGRATING HEAT AND POWER AND THEIR RESPECTIVE INDUSTRIES. Given that it sits astride sectors (energy intensive industries and power generation), CHP should not be categorised as being part of the power sector as as such it would risk being unfairly treated, but should rather be associated with the heat host s industrial sector. COGEN Europe would like to make clear that it strongly supports the free allocation of allowances for both heat and electricity with double benchmarking on performance against reference standards, as a fair treatment of cogeneration. Any movement to auctioning -as argued hereafter- threatens to undermine cogeneration and may even force efficient plants to reduce their running hours. Our strong recommendation is that for Phase III and indeed in any future period, free allocation and double benchmarking be used, as of all methodologies under consideration, it most fairly treats cogeneration. To illustrate the working and benefits of CHP we hereunder present a short schematic, realistic example of an industrial CHP plant. We will later use this example to illustrate and quantify our proposed improvements of the EU ETS system. Figure 1: Energy and CO2 flows for separate heat and electricity 1 generation compared to a high efficiency cogeneration system (achieving 20.5% primary energy savings) Separate Production of Heat and Electricity (Natural Gas) Combined Heat and Power (Natural Gas) 21 units CO2 39 units CO2 18 units CO2 31 units CO2 55 Electricity Grid Losses 50 Electricity 80 Heat 50 Electricity 80 Heat 115 Fuel 100 Fuel 170 Fuel Central Thermal Power Plant 215 Fuel Industrial Steam Boiler Plant Industrial CHP Plant Source: Delta Energy and Environment 1 In the diagram above the non-chp generating option is assumed to be a Combined Cycle Gas Turbine, with emissions of 21 units CO2 for generation of 55 units electricity. Other variants are possible, including the country s average portfolio emission factor and a range of fossil fuel mixes. 3

4 In this example, the equivalent amounts of 80 units of heat and 50 units of electricity are produced in two different ways. The CHP plant to the right uses 170 units of fuel and has an overall CO2 emission of 31 units. For the separate production of the same amounts of heat and power 215 units of fuel would be needed and 39 units of CO2 emission would result, as is shown to the left. The global emissions decrease by 8 units (39 less 31) thanks to CHP. This CHP scheme saves 20% primary energy. However the heat network or industrial facility that the CHP is associated with, e.g. a paper mill, chemical facility and/or an oil refinery should it invest in high efficiency CHP to produce the required energy for its processes - will need to acquire 13 additional allowances (31 less 18) in order to cover its obligations under the EU ETS. The reason for this is that by installing a high efficiency CHP at the industrial site, thus saving this 20% of primary energy and reducing emissions globally, the industrial site has increased its onsite fuel consumption and hence also the local emissions (on-site) of CO2. 4. POTENTIAL PROBLEMS UNDER THE PROPOSED EU ETS PHASE III AUCTIONING THREATEN CHP The Parliament ad Council are currently considering the possibility of increasing the share of auctioning of CO2 allowances under Phase III of the EU ETS. Under an auctioning system an industrial site would have to buy the additional allowances associated with its CHP operation at auction. However this exposes the CHP operator to additional risk. 1) Drive to overall carbon emissions reduction : the focus on emission reductions dissuades companies from investing in CHP as they will have to show an increase in carbon emissions (13 units in the case above) on their site despite the fact that they will increase the energy efficiency (and decrease emissions) of the system as a whole. The fact that CHP increases on-site emissions has an impact on both existing installations and (potential) new entrants. Incumbents would be tempted to run existing CHP installations for a shorter period and rely more on industrial boilers for their heat needs, thereby losing some of the overall CO2 reductions attributable to operation in CHPmode. As for potential new CHP, or in the case of renewals, the situation could lead to investments in boiler-only solutions and therefore in no CO2 savings at all. 2) Competition with sectors not carrying the cost of CO2: A CHP operator with a plant over the 20MW thermal input threshold and therefore covered by the scheme may have limited or no ability to pass on the cost of carbon to his customers. An industrial CHP can supply heat to a number of customers, many of whom would be taken individually- below the threshold, while CHP plants feeding into district heating schemes are competing directly with individual boilers. As a result, while the CHP unit falls within the scope of EUETS the customer does not and is therefore faced with an additional cost of carbon that he would not have faced if he had installed his own, smaller, less 4

5 efficient boilers. This can be identified as the internal leakage problem facing high efficiency CHP installations under the current design of the ETS. 3) Impact on growth of CHP around the 20MW threshold: Cogeneration installations in the MW thermal input range compete with separate heat and electricity installations that fall outside the EU ETS, putting CHP installations at a severe competitive disadvantage. New entrants would be discouraged from replacing their boilers with CHP units if this could imply that they fall under the EU ETS and therefore see an increase in their costs due to the obligation to purchase allowances. This is especially important given that no free allocation for heat will be the rule by 2020, whereas the non-ets boilers will not face any penalty. Under the current scheme, remedying this problem would require creating a high efficiency CHP-specific threshold. This can easily be done within the current ETS framework and does not risk distorting the electricity market as small-scale installations generating only limited amounts of electricity do not compete with in the electricity market with large-scale generation but rather rely on feed-in tariffs or purchase obligations. In addition, an electricity generation installation producing such limited quantities of electricity would fall outside the scope of the EU ETS. 5

6 4) Identifiable market imperfections: while electricity markets are expected incorporate the price of CO2 into the price of electricity, based on the CO2 emissions of the marginal generator, there is a risk of large players exerting their market power by basing the pass-through on their average portfolio emissions, thereby putting independently-owned cogeneration installations at a disadvantage. Overall, current imperfections increase considerably the financial risks associated with investment in CHP. 5. TWO APPROACHES RECOGNISING THE BENEFITS OF CHP UNDER THE PROPOSED AUCTION ALLOCATION SCHEME Allocation to cogeneration installations under an auction scheme requires that specific safeguard mechanisms are put in place. Cogen Europe proposes 2 alternative ways to give CHP plants credit(s) for the environmental benefits they realise beyond their installation boundaries. These alternatives assume auctioning to be the main allocation method for CO2 allowances. All options are based on the principle that CHP plants must be treated fairly, taking into consideration their contribution to lower global CO2 emissions. The following options are variations in the way CO2 allowances are allocated to high efficiency cogeneration installations. The underlying working assumption is that CHP heat fed to a final user cannot face more stringent allocation than an industrial boiler installation in the same host sector and that the CHP installation must capture the benefits of the CO2 reductions it achieves in the emissions trading system. All the numbers used refer to the example in figure 1. While many different alternatives can be conceived, the following aim to be workable within the basic framework laid out in the Commission s proposal COM(2008)16 and should be viewed as a specific element of any high level approach focusing on the EU s industrial sectors. This implies that in keeping with the spirit of the proposal- the main allocation methodology for electricity is auctioning, while heat production is only partially auctioned. The following section details: 1/ The base case as found in the Directive proposal and which has negative impacts for High Efficiency CHP. 2/ Alternative 1 which offers long-term allocation certainty based on favourable comparison with heat boilers. 3/ Alternative 2 which takes the CHP installation s global carbon savings contribution into consideration. 6

7 Base case (Directive proposal): CHP is treated as an electricity generator CHP buys allowances on its entire electricity production and receives only a decreasing fraction of the required allowances needed to cover the emissions associated with its heat production. As a result, the CHP operator has to buy a total of 17 credits in 2013 and all 31 credits in 2020 while free allocation decreases from 14 credits in 2013 to 0 in In the base case the CHP unit -regardless of its size and the risk of internal leakage- will only get as many allowances for free on a fraction of the heat generated as if it was a standard industrial boiler. This allocation will decrease and reach 0 by This allocation procedure is unhelpful and will cause operators and investors to disregard CHP as the installations will be penalised because of their larger size compared to boilers. IMPORTANT: the current draft envisages that only 80% maximum of the allowances for heat will be distributed for free in 2013, decreasing in a linear way to 0% by Alternative 1: CHP is incentivised over heat boilers for its increased energy efficiency CHP gets its entire heat allocation for free and buys allowances for electricity production only (13). The facility thus buys13, with free allocation of 18. There is no decreasing linear correction for High Efficiency CHP installations over the period. Here the CHP facility buys at auction what it would have been required to buy had it been an electricity-only power plant (13 units) while receiving allowances free of charge on the heat side, taking into consideration the need to incentivised investment in sustainable technology. This option incentivises both the operation of high efficiency CHP incumbents and new entrants while avoiding the creation of any distortions on the electricity market. In effect, the CHP operator would have to enter the auction to buy allowances for his electricity production only. This solution is the most suitable in order to avoid the risks of internal leakage that face small-scale installations as well as CHP installations feeding heat into District heating schemes. Note: The baseline free allocation for the heat is based on Community-wide heat benchmarks. Alternative 2: CHP is rewarded for its global carbon savings 7

8 CHP receives free allocation of allowances equivalent to the global carbon savings arising from the investment in CHP, on top of any free allocation granted towards heat production. The facility thus buys 9 allowances in 2013, with a free allocation of 22 allowances (8 allowances for carbon savings in the system and 80% of 18 allowances for heat production, i.e. 14 allowances). By 2020, the facility has to buy 23 allowances, with a free allocation of 8 allowances only (representing the avoided CO2 emissions realised at system level) Here the industrial facility is allocated free permits equivalent to the overall carbon savings of the CHP plant relative to separate heat and power generation but also receives the decreasing free allocation for heat production. This option provides investors with a small incentive to operate and invest in High Efficiency CHP over boilers as the global carbon savings extra allocation will remain constant until 2020, providing medium-term predictability. We believe both approaches above with decreasing effects will create a more fair and even market and level potential unfair treatment of CHP under auctioning. Only via a clear financial recognition of CHP benefits can investors and operators be expected to realise the EU s CHP potential. 8

9 6. Conclusions and recommendations CHP is the most efficient form of energy conversion and should be fairly rewarded for this. The best available solution to support this is double benchmarking. If CHP were to be subject to full auctioning without the protection of any of the methods outlined above then no heat producer or utility would want to build a cogeneration facility; The design of the EU ETS Phase III should reward the building and utilisation of lower carbon emitting forms of generation such as CHP consistent with its low carbon emissions and global CO2 savings. If it fails to do this, then the scheme is fundamentally flawed; CHP developers should not have to purchase more CO2 allowances following the installation of a carbon-saving CHP than they would have had to if CHP had not been installed; Small-scale High Efficiency CHP installations must have a CHP-specific threshold or face unfair competition from heat and electricity producers not covered by the EU ETS. Cogen Europe also calls on the European Parliament and Council to earmark auctioning revenue towards the promotion of High Efficiency CHP, in line with the spirit of Directive 2004/8/EC. Cogen Europe recommends the EU to adopt one of the approaches above to recognize CHP for its environmental benefits under auctioning of CO2 allowances and to release the great potential CHP has for helping to meet EU, Kyoto and IPCC targets. COGEN Europe is supportive of the Commission s drive to strengthen the environmental integrity of the EU ETS and supports the idea of further harmonisation of the scheme along the lines of EU-wide sector allocation methodologies. The revisions of the EU ETS Directive present the opportunity to further improve the Emissions Trading Scheme to ensure that This Directive will encourage the use of more energy- efficient technologies, including combined heat and power, producing fewer emissions per unit of output COGEN Europe will gladly assist the Parliament and the Council in building sectoral consensus around the detailed issues raised by our proposals such as special considerations for avoided system emissions through primary energy savings, operational load factors and specific emission references moving forward with the adoption of the revised Directive. 9

10 This Paper has been prepared by the COGEN Europe Working Group on Emissions Trading WG Chairman: Dr Simon MINETT (Delta Energy & Environment) WG Coordinator: Mr Thomas ESDAILE-BOUQUET (COGEN Europe) WG Members: Den Blanken, Kees Gardiner, Paul de Sarandy, Nick Corregidor Sanz, D. Starcher, Loren King, Barry Calvert, Ian Davidse, Hans Cornelis, Erwin Hees, Gert Reijalt, Marieke Cogen Nederlands British Sugar / UK CHPA ExxonMobil Iberdrola ExxonMobil ConocoPhillips RWE Npower Akzo Nobel COGEN Vlaanderen Smurfit Kappa Fast COGEN For more information, please contact: Dr Fiona RIDDOCH, Managing Director or Mr Thomas ESDAILE-BOUQUET, EU ETS Coordinator info@cogeneurope.eu Tel: +32 (0) Fax: +32 (0)