Living in a Carbon-based World: CO2 and its impact on the EU Power Sector

1. Living in a Carbon-based World: CO2 and its impact on the EU PowerSector Gavin Bell March 2010

2. First, a little about me... • Ph.D. from Canterbury • EMRG • One of the many from Canty that ended up in Europe... • Worked since 1999 in energy sector as consultant and in industry • UK, Germany, Austria, Netherlands, Spain, Albania, Montinegro, Macedonia, Norway, Denmark, Czech Republic, Cuba • Headed up the continental power market analysis team and the cross commodity analysis team at Statkraft • Europe’s largest renewable generator • Around 55 TWh annual production • Currently CEO of Ably (plant data and analysis firm) and independent consultant • Based in Norway since 2003 ecovest limited

3. Key EU ETS Takeaways • EU ETS market is part of an ”energy complex” involving power, fuels, CO2, and other commodity markets • Each drives the other • Increasingly, money cannot be made in one market only – you need to look at them all simultaneously • CO2 will drive increasing internationalisation of energy markets, as CO2 markets interlink • EU ETS in the forefront • Any CO2 market is a political beast – politics drives the price and direction ecovest limited

4. Outline • EU ETS Overview • A multi-commodity energy complex • Short term interactions • Long term interations and drivers • Summary ecovest limited

5. EU ETS Overview

6. EU ETS – What is it? Technically... Really... • Classiccap and trade system to regulate CO2 emissions in the EU + EEA countries • Absolute limit on CO2 emissions • Allowances distributed to facilities covered by the scheme • >12000 facilities • >4000 companies • Participatingfacilities surrender an allowance per tonne CO2 emitted during annualcomplianceperiods • Commercially crucially important market in the EU energy sector • Driver of investments • Impact on price • CCS • CERs • Credit rating • Hedging • Exposed to CO2 • Need to mitigate to manage risk • Trading • Direct opportunity to make money ecovest limited

7. ETS Summary 2005 2007 2008 2012 2013 2020 Phase 1 Phase 2 Phase 3++ Trial Period Kyoto Period Post-Kyoto Period • Tighter limits basedonphase 1 experience (6.5% below 2005) • 90% freeallowances • 3% Auctioning • 6% New Entrant Reserve • EEA included • Allocation via NAPs • Can import credits from otherflexiblemechanisms • Appx. 12% of total • 43% of EU emissions (incl. Aviation, CCS) • Single EU Cap, reducing 1.74% p.a. • Auctioning – 50% in 2013, 100% by 2027 • 100%(ish) auctioning in powersector from 2013 • Links with 3rd Countryschemes; harmonisationof CDM/JI rules • 95% freeallowances • Allocationofpermitsdonenationally (National Allocation Plans - NAPs) ecovest limited

8. Banking and borrowing • Banking and borrowing allowed within a phase • No banking or borrowing between phases 1 and 2 • A key reason for observed priced development • Banking allowed from phase 2 to phase 3 • Linking prices in these two phases • Especially important now phase 2 seems long • No borrowing ecovest limited

9. Distribution of allowances • Two key ”sectors” • Power • Industry • Behavedifferently in relation to ETS • Industry • Generallylong • Reduceemissions via investment (med-long term) • Oftenannual or ”period” view • Power sector • Generallyshort • CO2 priceimpactsdispatch • Hedgingofpowerproduction ecovest limited

10. EU ETS History Fuel bull run Fuel bull run 2nd phase NAP cut Financial crisis Fuel bear run 2005 Verified emissions Industrial length gradually in market Oil, equities bull run 2005 2006 2007 2008 2009 ecovest limited

11. A multi-commodity energy complex CO2 and Power (and fuels, currencies, interest rates etc etc)

12. Complex interactions driving markets Coal Coal Priceof CO2 Priceof gas Gas Gas Priceof CO2 Priceof gas ecovest limited

13. CO2 and power market interaction Short term Long term • The powerstack • Stack driving emissionlevels • ETS priceimpactingthestack • Non-marketexternaleffects • Weather • Driving power and heat demand and availability (hydro, wind) • Hedging, market psychology • Energy complex • Oil a strongsentiment driver ofpower and CO2 (++) • External economy (e.g. recent demand destruction) • CO2 market is key driver in investmentdecisions • Power market investments (emittingvsnon-emitting) driver offuture CO2 price • CO2 pricefeed-through to powerprice a driver offuturepowerdemand • Future CO2 price driver oftodays CO2 price (banking effect) ecovest limited

14. Question... ? What is correlation and what is causality? ecovest limited

15. Short term interaction

16. The classic – fuel switching • Relationship between gas, coal, and CO2 drives stack and emissions • Other aspects reduce fuel switch flexibility • Fuel contracts • Inflexibilities in fuel access • Don’t always get the fuel switching you expect... Coal – gas fuel switching SRMC CO2 cost nuke, wind coal gas, oil GT lignite CCGT ecovest limited

17. Impact of fundamentals Acc. Changes: fuel prices & weather EUA Dec-08 Source: Point Carbon ecovest limited 05.06.2014 17

18. But it’s not a ”tick the boxes” world... • Relationships are not straightforward, nor consistent • Sometimes, CO2 can explain power price movements, sometimes its, say, coal and gas prices, or something entirely different • Often possible to know in hindsight... • But forecasting is not easy • Q: What sort of analysis is useful...? ecovest limited

19. Hedging activities • Hedging of production begins already 3 years ahead • CO2 part of that hedge • Thus, begin to hedge production in phase 3 of ETS from 2010 onwards • BUT – phase 3 allowances not yet available • Via purchase of phase 2 (2012) allowances for banking • Hedging demand can drive prices Could turn a long phase 2 market into a short one... ecovest limited

20. Crude oil – key sentiment driver ecovest limited 20

21. Economy driving demand in power and CO2 • Significant demand destruction as a result of financial crisis – from 2008 to 2009: • Germany: 6% decline • France: 3% decline • Less demand for EUAs • Lower price • Pressure on power prices • Market is expected long in phase 2... Source: Point Carbon ecovest limited

22. Phase 2 market balance • Market is long in phase 2 • Including credits: 970 Mt • In theory... • Price in phase 2 should equal discounted price in 2013 (first year, phase 3) • Prices today are lower than this... • Anticipate at least that phase 3 will increasingly impact phase 2 prices • What is driving phase 3 price expectation? short long Source: Point Carbon ecovest limited

23. Long term interaction

24. CO2 price in 2020 and beyond • How can we assess the long term price? • And thus today’s ”equilibrium” price level? • Equilibrium model • What price balances supply and demand • That is, long term relationships between • Power and CO2 • Industry and CO2 • CERs, other ETS schemes and the EU ETS • Or... an educated guess – it is a political process after all • What price needed to drive CCS? • EU effectively target long term caps to achieve this price level... ecovest limited

25. Phase 3 supply: political and commercial process • Steadily declining allowance cap • 21% below 2005 emissions in 2020 • Power sector (more-or-less) 100% short • Industry reducing from 80% free allowances in 2013 to 30% in 2020 • CERs/ERUs • Supply depends on a ”post Kyoto” agreement • No agreement, only Kyoto + ”bilaterals” CERs • Credit limit of at least 11% of the phase 2 allocation • Can choose when to use the credits (phase 2 or phase 3) • But, max 1400 Mt in phase 2 ecovest limited

26. Phase 3 demand: interation between markets • Power and heat • Change in stack, through investments and retirements • Expected future prices (fuels, capital costs, exhange rates, cost of money) • Portfolio considerations • Other mechanisms – e.g. Renewables directive • Demand for power and heat • Industry • Economic growth • Change in energy intensive industry in EU • Change in carbon intensity ecovest limited

27. And the results... Bottom up forecast ”Political” forecast... • Typical price forecast ranges for CO2 for 2020 • Point Carbon 37 €/t • Barclays – 40 €/t long term • Deutsche Bank 30 €t • UBS – 20 €/t • UK EAC – 22 €/t • The CCS approach (or renewables or whatever...) for, say, 2025 • Additional capital cost • Reduction in efficiency • CO2 emissions saved • + fuel cost assumptions etc... • Around 50 €/t (2025) • Discounts to 35 €/t (2020) ecovest limited

28. Summary

29. Summary • CO2 (via ETS) integral part of EU energy markets • Investment • Hedging • Trading • Complex interactions between these markets • Drive prices • Significant and dynamic relationship between long and short term dynamics • And don’t forget it is a political process • Once there is an ETS, there’s a strong pressure for consistency and predictability ecovest limited

30. Gavin Bellecovest limitedArmauer Hansens gate 6a0455 Oslo, Norwaytel: +47 950 27979bellgj@hotmail.com