HOW WILL A CO 2 PRICE AFFECT THE PLAYING FIELD IN THE NORTHWEST EUROPEAN POWER SECTOR?

Transcription

1 HOW WILL A CO 2 PRICE AFFECT THE PLAYING FIELD IN THE NORTHWEST EUROPEAN POWER SECTOR? Adrian Wals 1 and Fieke Rijkers 2 ECN, P.O. Box No , Amsterdam, The Netherlands September 2003 Abstract In October 2001 the European Commission issued a draft Directive on greenhouse gas emission allowance trading within the Community, 3 declaring its intention to introduce an Emissions Trading System (ETS). The system is initially restricted to trading of CO 2 and will come into force starting in the year As the electricity generation sector is included in the scheme by the allocation of emission allowances to the power producers, an additional (CO 2 ) cost on electricity production will be imposed on all large generators 4. By using the COMPETES 5 model, the paper analyses the impact CO 2 emissions trading might have on the Northwest European electricity markets. Principally it studies competitiveness issues between producers in the Dutch and neighbouring power sectors. It focuses on effects of emissions trading on production costs for particular producers and on transmission and electricity prices. The COMPETES model covers the electricity markets of the Netherlands, Belgium, France and Germany. It simulates strategic behaviour (oligopolistic competition) among the larger electricity generation companies while simultaneously representing a transmission pricing system for the electricity network. 1. INTRODUCTION The European Commission officially declared its intention to introduce an EU wide Emissions Trading System (ETS) in October 2001, when a draft Directive on greenhouse gas emission allowance trading within the Community was issued. Later, in July 2003, a political agreement was reached on an amended version of this Directive between the European Parliament, the Commission and the Council of Environmental Ministers. According to the amended version, an EU ETS will be introduced in all Member States - including the newly acceded countries of Eastern Europe - starting from January This scheme is a so-called downstream cap and trade system covering direct emissions Adrian Wals, Policy Studies, ECN: Wals@ecn.nl Fieke Rijkers, Policy Studies, ECN. Since September 2003, Office for Eenrgy Regulation (Dte) COM(2001) 581 of Combustion installations with a rated thermal input exceeding 20 MW (except hazardous or municipal waste installations) are expected to participate in the ETS. COMPETES stands for COmpetition & Market Power in Electric Transmission and Energy Simulator [2], [3]. This model is a game theoretical model based on the theory of Cournot competition and Conjectured Supply Functions. The model covers Northwest Europe and includes a representation of the transmission network by using a Direct Current Linearisation the Alternating Current load flow.

2 Sijm and van Dril [1] outline the major characteristics of such a scheme: A cap is set on the total emissions of all participants in the scheme by allocating a certain amount of emission allowances, which is fixed ex ante for a certain period. These allowances can be freely traded among the participants. Participants are obliged to surrender a quantity of allowances equal to their emissions over a certain period. A surplus of allowances can be sold (or banked), while a deficit has to be covered by purchasing additional allowances (or paying a penalty). The obligation to surrender allowances is imposed on fossil fuel users (in contrast to an upstream system in which this obligation rests on the suppliers of fossil fuel). Emissions of electricity and off-site heat are attributed directly to power and heat producers (in contrast to an indirect system in which such emissions are imputed to consumers of electricity and heat). As the electricity generation sector is included in the scheme, by 2005, an additional (CO 2 ) cost on electricity production will be imposed on all large generators, if the scheme results into a positive price for CO 2. Fuel mix and production technologies vary significantly across Northwest Europe. A CO 2 price will therefore have a significant impact on the playing field of the electricity sector. The purpose of this paper is to illustrate the impact of an ETS in the Northwest European electricity market, with and without the presence of market power. By using the COMPETES model, the particular effects of a CO 2 price on electricity prices, generation patterns, electricity trade, competitiveness of countries and firms, and CO 2 emissions are illustrated. 2. THE COMPETES MODEL The effects of an ETS are investigated with the use of the COMPETES model. The model covers the Northwest European electricity markets (the Netherlands, Belgium, France and Germany). It simulates strategic behaviour (oligopolistic competition) among the larger electricity generation companies. This strategic behaviour is based on the theory of Cournot games and Conjectured Supply Functions (CSF) on electric power networks. These theories and their relation towards other theoretical approaches is discussed by Day et al. [2]. The specific theoretical approach and application within COMPETES is described more in-depth in the papers by Hobbs et al. [3] and [4]. COMPETES can represent the strategic behaviour of the generation companies and also the different systems of transmission pricing, among them fixed transmission tariffs, congestion-based pricing of physical transmission, and auction pricing of interface capacity between countries. In order to illustrate the effect of a ETS, the competitive and Cournot scenarios are considered. Some specific considerations of the application of the model are: The consumers are modelled as being price sensitive (elasticity of -0.2). In reality, in the short-term demand response is probably substantially smaller. On longer time scales however elasticity will be somewhat increased. The output of the model is a static equilibrium situation in which the optimal price, profit and production is calculated. This can be seen as a medium-term situation, which justifies a small price-elasticity. As said, the model is a static model. This implies that it does not integrate new investments endogenously. While for Belgium, Germany and France the situation is for the year 2001, for the Netherlands the inputs are based on the situation in 2004, taking into account new power plants that are expected to be commissioned until The Hague - September 2003 AER/CPB/ECN

3 In their bidding strategy generators only take into account their marginal cost consisting of fuel and variable operation and maintenance costs. They do not take into account the startup costs of their power plants. Strategic behaviour of the generators is modelled by using the Cournot assumption: All oligopolistic power producers maximise their profits by choosing a certain level of production under the assumption that their competitors do not change the output level. 3. MODELLING THE EFFECT OF CO 2 PRICES IN THE ELECTRICITY MARKET The approved amended version of the Directive on greenhouse gas emission allowance trading within the Community will introduce a European wide ETS market that includes a large number of economic activities in all MS. Future CO 2 prices will depend in general on the supply and demand for CO 2 allowances and in addition, among other things, on the additional directive on Flexible Instruments, the possible participation of (some of the) accession countries and the penalty level (40 /tonne CO 2 in the first phase and 100 /tonne CO 2 in the second phase). Fixed (exogenous) CO 2 prices are considered when modelling the electricity market in this paper, instead of modelling emissions trading explicitly. As a result of considering the price of emission allowances as exogenous, it is assumed that electricity producers are price takers, i.e. they are not able to influence the price of CO 2 credits. Although this is not an unrealistic assumption, as individual electricity producers have a relatively small concentration of allowances relative to the entire EU market, possible price manipulation of the credits cannot be ruled out. According to economic theory, the cost of an emission allowance should be considered as a marginal cost of producing electricity, no matter which allowance allocation system is implemented. Basically two different allocation methods exists, gandfathering and auctioning. For grandfathering, emission allowances are allocated free of charge and therefore power producers will consider them as opportunity costs of not selling them on the market. When the allowances are auctioned, power producers have to incur costs they consider directly as marginal costs. In other words, no matter the allowances allocation system among the producers or plants, as long as it results into the same CO 2 price the impact on the decisions regarding energy efficiency and fuel mix is the same. In this study different possible CO 2 prices are considered as marginal costs of production in the COMPETES model. Investment decisions are not modelled endogenous within COMPETES. The effects of ETS on the electricity market is therefore considered for the short term (i.e. effects on the fuel mix and the dispatch of power plants) and not in the long term (investment decisions, type of technology). In the longer term, considering desired market shares, CO 2 emission rates can be varied further by acquiring production plants, postponing closure of existing plants and using new entrants facilities in existing and future trading schemes. Therefore, although the model is accurate for marginal quantities on the short term, it may not reflect actual electricity prices for larger customers and longer-term contracts. While the ETS has a starting date of 2005, the COMPETES model is based on inputs for 2004 in the Netherlands and 2001 for Belgium, France and Germany 6. 6 This should create no inconsistencies, as no major differences in the total capacity compared to total demand and no large differences in the relative production portfolios are expected in the countries in 2004 compared to 2001.

4 4. MODEL RESULTS 4.1 Electricity prices at different CO 2 prices Under perfect competition, the electricity price equals the marginal cost of the most expensive power plant that is needed to fulfill electricity demand 7. The impact of an increase in the marginal cost of power production on the electricity price, due to the implementation of a price for CO 2 emissions, is based on two effects; (1) the shift of the supply curve due to the increase in the marginal costs of production, and (2) the reduction in consumption if the demand is at all responsive to price. In a Cournot market, where each power producer maximises its profits subject to an assumption that rival sales are fixed, prices can, in general, be higher than the marginal costs of the most expensive plant dispatched. Figure 1 and 2, illustrate the effect of different emission prices levels (5, 10, 15, 20 and 40 /tonne) for the Competitive and Cournot market scenarios calculated using COMPETES. 60 /MWh NL B F G /tonne CO2 Figure 1: Average electricity price for different CO 2 prices in the Competitive scenario Figure 1 shows the yearly average price of electricity for the competitive variant with different CO 2 prices. Prices among countries vary because of congestion in the interconnectors that link them. It can be seen that the price of electricity in each country rises as the price of the emission allowance increases. The German electricity price is the most responsive to the CO 2 price. In the most extreme case, German prices reach the same levels as prices in Belgium and the Netherlands. In contrast, the French electricity price is affected the least among the four countries. 7 In the short run, the price of electricity equals either the short-run marginal cost of the marginal unit or the marginal willingness to pay of consumers (demand curve/demand bidding) if plants are at capacity. In a transmission constrained system, where redispatch is necessary to satisfy transmission limits, there are generally more than one marginal plant, and competitive prices will then vary from place to place. The Hague - September 2003 AER/CPB/ECN

5 These results are consistent with the production portfolio of each country. In Germany a significant percentage of the installed capacity comprises CO 2 intensive plants, such as coal generators. In France the price is rather insensitive to the CO 2 price because nuclear power plants no direct CO 2 emissions set the electricity price during most of the time periods. In Belgium as in the Netherlands, the market price is set by coal plants during off-peak periods, and by gas fuelled plants during the peak periods [5]. 70 /MWh NL B F G /tonne CO2 Figure 2: Average electricity price for different CO 2 prices in the Cournot scenario In Figure 2 the yearly average electricity price for the Cournot scenario is presented. Comparing them with the competitive case, it shows that significant price increases are possible due to market power. In the Cournot scenario the Belgium price remains higher than the Dutch and German prices due to the market concentration in the country (Electrabel), under the assumption that regulation or other public sector measures do not restrain oligopoly pricing in that country. The French price remains under 20 /MWh, because Edf is considered to price at marginal cost in that country 8. 8 It is assumed that due to institutional and political issues, although Edf is a monopolist in the country, the firm does not exercise the market power it is capable of. However, the model allows Edf to set prices strategically in other countries.

6 Table 1: Electricity prices compared to the base case (%) 9 Competitive 0 /Tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne NL B F G Cournot 0 /Tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne NL B F G Table 1 shows the electricity price changes as the CO 2 price increases compared to the Competitive and Cournot base cases. It reveals that the electricity price in the Competitive scenario increases more on a percentage basis than in the Cournot variant. It also increases more in the Competitive scenario on an absolute basis; for example, comparing the 0 and 40 scenarios for Germany, Figures 1 and 2 reveal that German prices increase by approximately 35 /MWh in the Competitive case but only 25 /MWh in the Cournot solution. Mannaerts and Mulder [6] argue that electricity producers, operating on a market with imperfect competition and hence having set the prices above the marginal cost level, will take into account demand responses to price increases. They expect that an increase in marginal costs will not be fully passed on to electricity prices for end users as producers, facing a linear demand curve, will partly reduce their mark ups Changes in generation patterns and cross-border flows In a competitive electricity market, the order of dispatch of power plants is based on their marginal costs. Considering that the implementation of a CO 2 price increases the marginal costs of CO 2 intensive power plants, a change in the dispatch order inside the country and between countries can be generated. The latter would be manifested as a change in the electricity trade patterns. 9 The base cases represent a Competitive and Cournot market, respectively without a CO 2 price. 10 Part of the reason for this is that the linear demand curve is more elastic at higher prices; consequently, it is more difficult for Cournot producers to pass on cost increases to the more elastic demand they face compared to Competitive producers. It is possible that under alternative assumptions, such as a constant elasticity demand curve, that Cournot prices will increase just as much as Competitive prices under CO 2 pricing. However, the reduced consumption under the Cournot scenario would actually reduce the demand for emissions allowances, which should reduce the price of those allowances. As a result, given a certain number of allowances allocated to the market as a whole, Cournot competition is likely to yield lower allowance prices, which will lessen the impact of the CO 2 allowance system on power prices. To model this interaction of energy and allowance markets, it would be necessary to have an explicit model of CO 2 trading for the entire EU market (analogous to [7]). As shown in Section 4.4, below, the Cournot solutions under a given CO 2 price have somewhat lower emissions (e.g., 1% lower under no CO 2 price). The Hague - September 2003 AER/CPB/ECN

7 Table 2: National electricity generation (in % of total generation in the four countries) at different CO 2 prices. Competitive 0 /tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne Netherlands Belgium Germany France Total Cournot 0 /Tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne Netherlands Belgium Germany France Total Table 2 shows the percentage of the national generation capacity in the total generation in the four countries. With an increase in the CO 2 price, it can be seen how the bulk of production gradually moves from a CO 2 intensive power production country as Germany, to less CO 2 intensive countries as France and the Netherlands. In Belgium, relative production levels remain constant at 6 percent. It should be note that the increase in France is associated with a rise in exports until 5 /Tonne, but also with a lower reduction in consumption as wholesale prices do not increase as much in that country as in the Netherlands, Belgium and Germany (a standardised elasticity is assumed for all countries). Table 3: Net average interconnector usage (MW) at different CO 2 prices Competitive 0 /Tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne NL B G F Cournot 0 /Tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne NL B G F Table 3 shows the net average interconnector usage between the four countries. The Netherlands remains a net importing country except for CO 2 allowances at 40 /Tonne, where due to lower production costs, it becomes a net exporting country for electricity. On the other hand, Germany gradually reduces its net exports, as the price of CO 2 increases. At an high CO 2 price of 40 /Tonne, it becomes a net importing country. The positions of Belgium and France remain relatively the same. 4.3 Effects on power producers Short-run profits for power producers are determined by the difference between the short-run marginal costs of production and the market price. Marginal costs of power production highly depend on technologies and fuel costs. In general, nuclear and hydro power plants have lowest marginal costs of production. Coal power plants have low but varying marginal costs (albeit higher than the former) depending on the coal price. Gas and oil power plants have relatively high marginal costs. With the introduction of a CO 2 price the shape of the marginal cost curve changes together with the profits of power producers.

8 Table 4: Annual company profits at different CO 2 prices relative to the Competitive base case Company 0 /Tonne 5 /Tonne 20 /Tonne (%) 11 Comp Cournot Comp Cournot Comp Cournot COMP NATIONALE DU RHONE Competitive Fringe_BELGIUM Competitive Fringe_FRANCE Competitive Fringe_GERMANY Competitive Fringe_NETHERLANDS E.ON ENERGIE AG ELECTRABEL SA ELECTRICITE DE FRANCE ENBW ENERGIE-VERSOR SCHWABEN ESSENT ENERGIE PRODUCTIE BV HAMBURGISCHE ELEC-WERKE AG NECKARWERKE STUTTGART AG (NWS) RELIANT RWE ENERGIE AG VATTENFALL EUROPE AG In Table 4, the profit differentials of most of the oligopolistic firms and the group of competitive firms are presented. In all countries, competitive firms see their profits increase at a higher rate than the oligopolistic firms when CO 2 prices increase. This is because Cournot firms withhold their capacity in order to raise the market price. Although they see their profits increase, they withdraw production and therefore sales. It could be argued that competitive firms act as free riders, as they profit from higher electricity prices and an increase in sales. When a CO 2 price is implemented, in general, company profits increase. This is caused by the shift of the upper part of the marginal cost curve (where gas and arguably coal power plants are represented), which results in an increase in the producers surplus. Only firms that own CO 2 intensive plant see their profits reduced. It should be noted that these are only operational profits, and do not account for fixed costs of production. It should also be stressed that the actual profits of firms are also influenced by the way allowances are allocated. If allowances are allocated via a grandfathering system, a transfer of wealth to the emitters exists that can be seen as a fixed subsidy, independent of future production [6]. Profits of firms would increase as a result of this. Due to the uncertainties in the allocation of allowances, its impact on profits is not accounted for in this study. 4.4 Reduction of CO 2 emissions A price on CO 2 causes a reduction in emissions via two mechanisms, (1) the reduction in consumption and therefore production levels because of the increase in the electricity price, and (2) the reduction in emissions because of the effect of the fuel mix and dispatch order of power plants. The latter occurs, for example, when a gas power plant becomes cheaper than a coal power plant as a result of the CO 2 price. These two effects are illustrated in Tables 5 and In the Cournot case, all capacity not owned by one of the larger companies is assumed to bid competitive and is allocated to the competitive fringe. The Hague - September 2003 AER/CPB/ECN

9 Table 5: Annual CO 2 emissions (Cournot base case in percentages compared to the Competitive base case. The rest percentage changes compared to their respective base cases) Competitive 0 /Tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne Netherlands Belgium Germany France Total Cournot 0 /Tonne 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne Netherlands Belgium Germany France Total Table 5 shows the annual CO 2 emission in the Competitive and Cournot scenarios, when the two aforementioned effects are considered. In both scenarios, Competitive and Cournot, an increase of 5 /Tonne CO 2 represents around a 10 percent decrease in total CO 2 emissions. When the CO 2 price is 40 /Tonne, the Netherlands increases its emissions compared to the base case in the Competitive case, while other countries reduce their emissions. This is consistent with the result in section 4.2, where the Netherlands becomes a net electricity exporter. In other words, as the countries gain in competitiveness, the production levels increase together with absolute emission levels. In the Cournot scenario a greater reduction of emissions takes place because of higher electricity prices. Table 6: Annual CO 2 emissions (percentage changes compared to the base case) assuming constant electricity demand Competitve 5 /Tonne 10 /Tonne 15 /Tonne 20 /Tonne 40 /Tonne Netherlands Belgium Germany France Total Table 6 shows the reduction in CO 2 emissions at increasing CO 2 prices, when the demand for electricity remain constant at all CO 2 price levels. Thus, while the total reduction of CO 2 emissions is the sole result of the modification of the power plants dispatch order, in the particular countries the changes in generation patterns also influences the results. By comparing Tables 5 and 6, we can concluded that most of the reduction in emissions would come from the reduction in consumption. Three issues should be stressed here. First that these results are sensitive to the elasticities assumed and the fuel prices considered. Second that these results only consider the short-term effects of the introduction of a CO 2 price. Third, that these results point towards the potential importance for CO 2 policy of price signals that incent efficient consumption of electricity. 5. CONCLUSIONS This paper illustrates the impact of a CO 2 emissions trading system in the electricity markets of the Netherlands, Belgium, Germany and France, with and without the presence of market power. By using the COMPETES model the particular effects of a CO 2 price is studied on the following aspects:

10 Electricity prices: A CO 2 price increases electricity prices in all countries. While the German electricity price in the most elastic to the CO 2 price, the French electricity price is the most inelastic of the four countries considered. Furthermore it has been demonstrated that in an oligopolistic (Cournot) market, an increase in marginal costs will not be fully passed on to electricity prices as producers will partly reduce their mark ups. This may be a result of the linear demand function we adopted. Competitiveness of countries: With an increase in the CO 2 price the bulk of production gradually moves from a CO 2 intensive power production country as Germany, to less CO 2 intensive countries as France and the Netherlands. Electricity trade: The Netherlands becomes a net electricity exporting country under high CO 2 prices (40 /Tonne) due to relatively lower production costs. On the other hand, Germany becomes a net electricity importing country at high CO 2 prices. Belgium and France, see practically no alteration in their situation. Company profit: When a CO 2 price is implemented, in general, company profits increase. This is caused by the shift of the upper part of the marginal cost curve (where gas and arguably coal power plants are represented), which results in an increase in the producers surplus. The profits including the allocation of emissions credits is not considered in the paper. CO 2 emissions: An increase in the price of CO 2 by 5 /Tonne represents a 10 percentage decrease in total CO 2 emissions in the four countries considered. Most of the reduction in emissions come from the reduction in electricity consumption. Only a small part is due to the changing dispatch order of power plants. In the long run, changes in fuel mix and improvements in generation efficiency will play a larger role in CO 2 reductions. The Hague - September 2003 AER/CPB/ECN

11 REFERENCES [1] Sijm J.P.M., van Dril A.W.N.: The Interaction between the EU Emissions Trading Scheme and Energy Policy Instruments in the Netherlands. Interaction in EU Climate Policy (INTERACT). ECN-I [2] Day, C.J., Hobbs, B.F., Pang, J.-J: Oligopolistic Competition in Power Networks: A Conjectured Supply Function Approach. IEEE Trans. Power Sys., 27(3), 2002, [3] Hobbs B.F. and Rijkers F.A.M. (2002): Strategic Generation with Conjectured Transmission Price Responses in a Mixed Transmission System I: Formulation, IEEE Trans. Power Sys., in press. [4] Hobbs B.F., Rijkers F.A.M., and Wals A.F. (2002): Strategic Generation with Conjectured Transmission Price Responses in a Mixed Transmission System II: Application, IEEE Trans. Power Sys., in press. [5] Scheepers, M., Wals, A. and Rijkers, F. (2003): Position of Large Power Producers in Electricity Markets of North Western Europe, Report for the Dutch Energy Council on the Electricity Markets in Belgium, France, Germany and The Netherlands. [6] Mannaerts, H., and Mulder M. (2003): Emissions Trading and the European Electricity Market. CPB Memorandum, CPB (downloadable at [7] Chen, Y.-H., and Hobbs, B.F., An Oligopolistic Power Market with Tradable NO x Permits, IEEE Trans. Power Sys., forthcoming. Acknowledgments. Comments by Ben Hobbs, Maroeska Boots, Jos Sijm and Martin Scheepers are gratefully acknowledged.