ETS and cogeneration units: the outrage

I must have been 18 years old when I first heard about an exciting concept for improving energy efficiency: combined heat and power (CHP) or cogeneration. For those that never heard about it, a short explanation. In a traditional setting, a consumer is buying gas that he uses to produce steam and/or hot water. Electricity is produced in a power station (with gas, for example), and then transported over the grid to the consumer, a process in which a large portion of the primary energy is lost. When that consumer builds a cogeneration unit, he will produce both the steam and/or heat and the electricity on site. He could, for example, build an engine and use the exhaust heat from the engine to produce steam. By doing that, the energy losses of the centralized power production are avoided.

Let’s throw some figures at it. Let’s say that a company needs 40 GWh of power and 50 GWh of steam. If it produces the steam on-site with a 90% efficient boiler, some 56 GWh of natural gas will be consumed on site. For the 40 GWh of power consumed from the grid, 100 GWh of natural gas will be burned in the power station. The overall consumption of gas is 156 GWh and some 31.200 tons of CO2 are emitted. If that consumer builds a CHP with a 40% electric and 50% thermal efficiency, just 100 GWh of gas are consumed and 20.000 tons of CO2 are emitted. So overall, there is a reduction of 56 GWh in gas consumption and of 11.200 tons of CO2 emissions. It is therefore not surprising that implementation of cogenerations has been supported as an important measure for improving overall energy efficiency and reducing greenhouse gas emissions. In many countries (Germany, Spain, France or Belgium, for example), investments in cogeneration are or have been heavily subsidized in the framework of climate change policies.

It is therefore that I am so appaled that the emission trading system (ETS), the key climate change policy instrument of the EU is currently penalizing cogeneration. This week, I was discussing the economics of a cogen project with a client of mine. One of the costs that we had to take into account was the extra cost for emission rights due to the cogen project. On the one hand, this client will receive subsidies to build a cogen unit, because it is good for greenhouse gas emission reductions. On the other hand, he will be penalized and be obliged to pay for extra emission rights. Even worse is the case of a Dutch client of mine that has to replace his cogeneration unit. He is seriously considering to return to a traditional supply situation, because of the penalizing effect of ETS. So in this very realistic case, ETS is causing global emissions to go up. This is outrageous and absurd. Is anybody in Brussels aware of this?

Let me explain why ETS is penalizing cogeneration units. Companies that have to comply with ETS have to annually hand in an amount of emission rights equal to the CO2 emissions they have caused, which is in most cases linked to their consumption of gas. Until now, companies got free allocations of emission rights, meaning that they received an amount of rights for free. As of the next phase, the EU wants a large portion of the rights to be auctioned rather than handed out for free. Now, if we return to my example, I can explain in very simple maths what happens. Without the cogeneration, the consumer in the example, consumed 56 GWh of gas on-site. The other 100 GWh of gas for the production of the power were consumed by the central power plant, off-site. When he built the cogeneration unit, his gas consumption increased to 100 GWh, all of them on-site. So, by building the cogeneration unit, he increases his on-site gas consumption by 44 GWh and he is emitting 8.800 tons of CO2 more on-site. Overall, the gas consumption and greenhouse gas emissions go down, but he is replacing part of the emissions from the power plant production site to his own site, as he no longer consumes power from the grid. Therefore, if he has to buy these in the auction, he will have to buy an extra 8.800 tons of emissions per year. Currently, the price of emission rights is quite low, at around 6 euro per tonne, meaning that this is causing just 52.800 EUR of extra cost per year, which is not lethal to the overall profitability of the project. The savings on energy cost plus the subsidies are much more important than this 52.800 EUR. However, in projects with a marginal profitability and/or stingy investors, the 52.800 can be enough to kill the project. Moreover, emission rights prices are currently low because of over-allocation. We cannot suppose that this situation will go on forever. If there would ever be a shortage of allocations (e.g. by rolling out auctioning on a broad scale), ETS prices should rise sharply. We have seen prices as high as 30 EUR per tonne in the past. This corresponds with a 264.000 EUR per year extra cost for ETS, because you reduced global emissions of CO2 by building a cogeneration unit. At such prices, shortage of carbon rights will be a serious downturn for cogens’ profitability.

Even if emission rights are not auctioned but continue to be allocated for free, the regime of the new allocation phase seems to be penalizing. Clients tell me that it has become all but impossible to get sufficient emission rights for existing and certainly for new cogeneration units. As the EU struggles to create a shortage of emission rights, allocations are cut back, often in a blunt manner. In the past, new cogeneration units could often draw extra allocations from new entrant reserves. With the stricter allocation policies, these reserves have been emptied. If this continues, we will see a significant reduction in new cogeneration plants, existing plants will not be replaced at end-of-life (which is often within 8 or 10 years after construction) and in case of high emission rights prices existing plants might even be shut down. As we are not living in a context of 100% renewable power production, this will lead to an overall increase in gas and coal consumption by centralized power units and an overall increase of CO2 emissions. Moreover, public money used for climate policy in the form of cogeneration subsidies is being wasted when these units are shut down because of ETS costs. In Germany, it is proposed to give extra subsidies to CHP’s to undo the negative effects of emission trading. I thought that ETS was supposed to be more cost-efficient? This means Germany is increasing subsidies in the framework of one legislation to compensate the extra costs caused by another legislation, with both legislations having the same end goal, namely reducing carbon emissions. What a waste of money.

Readers of this blog know that I am not an ETS fan. Trading of emission rights was introduced because it was considered to be the most cost-efficient way of reducing greenhouse gas emissions. I still believe this is a fact. However, the cost-efficiency of emissions trading is completely undone by its uneffectiveness. It has proven to be impossible to create a system that really works, a system that is a strong incentive to reduce carbon emissions. The main reason for this is that it has proven to be impossible to create a good allocation system. I can understand that policymakers try to fix that. However, in their eagerness to fix the allocation system, they are creating new sources of uneffectiveness. The penalizing effet on cogeneration units is a good example. When I hear a client considering retirement from cogeneration because of carbon policy, I revolt. This level of absurdity cannot be the purpose. I understand that some people at the European Commission have made it a lifetime mission of setting up a functioning emission trading system. I don’t think it will ever work, but if they want to continue to try to fix it, OK. Only, please consider this outrageous penalizing of cogeneration units and undo it.

(Because I don’t want to be just criticizing, my alternative for ETS. Replace it with a carbon tax from which you exempt gas consumption by cogeneration units. Simple, effective, maybe a bit less cost-efficient.)

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