McKinseyClimate Change in Utilities.ppt

E,120,Climate change,for Europes utilities,Enrique de Leyva and Per A.Lekander,Power producers should pay close attention to a European,Commission proposal to curb greenhouse gas emissions.It could,have paradoxical effects.,uropes plan to control the greenhouse gases responsible for globalwarming will probably lead to higher energy prices for both con-,sumers and businesses and greatly accelerate the shift from coal(including,1,121JAMES KACZMAN,lignite)to gas as the primary fuel used in power plants.These are the main,conclusions to be drawn from a McKinsey model of mainland Europes1,energy market as it would emerge under a European Commission scheme to,cap the emissions of power and heavy-industrial plants.But the model also,generated a paradoxical nding:unless utility regulators intervene,many,power producersincluding some of the fossil-fuel-burning generators that,emit the largest amounts of carbon dioxide(CO2),the greenhouse gas that,the European Union is trying to controlcould receive unexpected nancial,gains under the scheme.,The proposal as it stands would lead utilities to invest in new gas plants and,to write off obsolete coal plants.But in many cases,the cost would be more,than covered by increased operating prots arising from a forecast 40 per-,cent rise in wholesale electricity prices.Europes power regulators have never,given utilities a free ride,however,and are unlikely to do so now,when the,The modeled region includes Austria,the Benelux countries,France,Germany,Italy,the four Nordic,countries,and Switzerland.,122,0,0,207,45,39,28,20,20,21,16,12,10,3,1,1,T H E M c K I N S E Y Q U A R T E R LY 2 0 0 3 N UM BE R 1,EXHIBIT 1,whole point is to curb,Kyoto calling,emissions.If,as the,model suggests,some,Change in emissions levels,19902001,Change in emissions levels requiredto meet 200812 target1,power plants would,1990 baseline emissions,millions of metric tons of CO2,gain from the currentproposal,modications,50%40%30%20%10%,10%20%30%40%,to the schemesched-,uled to take effect in,Germany,303,January 2005almost,United Kingdom,certainly lie ahead.,Italy,137,Spain,64,Given the far-reaching,NetherlandsFranceGreeceDenmarkBelgiumFinlandPortugalAustriaIreland,strategic implicationsof the plan,Europeanpower generators andheavy energy users haveso far given its detailssurprisingly shortshrift.Yet those detailswill determine which,Sweden,(and how many)coal-,Luxembourg,and oil-burning plants,should be closed in,As agreed upon in the EU burden-sharing agreement of 1998.,favor of new gas-red,Source:European Environment Agency(EEA);McKinsey analysis,ones,how and when,the remaining coal,and oil plants can be run most protably,and the amount of additional gas,Europe will need.What is more,higher electricity prices could force heavy,energy users to consider new conservation methods,alternative energy,sources,or other cost savingsall of which would affect producers.,The McKinsey models projected higher electricity prices might be partly,offset by the increasing efficiency of existing plants and by reductions in,transmission and distribution charges over the seven-year(200512)dura-,tion of the plan.In any event,the model makes the expected cost of CO2,regulation more transparent to all parties.Whatever nal regulations emerge,from Brussels,the European power generation business is likely to change,fundamentally.,Trading CO2 to meet Kyoto targets,The stimulus behind the plan was the 1997 Kyoto Protocol,an international,agreement intended to reduce the greenhouse gas emissions of developed,economies,during the years from 2008 to 2012,by at least 5 percent from,123,1,2,2,3,C L I M AT E C H A N G E F O R E U R O P E S U T I L I T I E S,How does a cap-and-trade scheme work?,The European Commission proposal is an exam-,To date,these schemes have achieved their tar-,ple of a cap-and-trade scheme for meeting,gets more cheaply than expected.The cost of,greenhouse gas emissions targets.If the cap,reducing SO2 emissions under the US scheme,itself is politically acceptable,allowing emissions,for example,was forecast at from$700 to,rights to be traded is perhaps the most cost-,$1,500 a ton,yet the final market price of rights,effective way to meet it even if the ultimate cost,reflected a reduction cost of$350 a ton.2 The,isnt known at the outset.(By comparison,if a,option to trade encourages companies to explore,tax were placed on carbon emissions,their cost,innovations that might reduce their emissions.If,would be known but there would be no guarantee,a company can cut its emissions for a cost lower,that the cap would be met.),than the market price for emissions rights,it has,an incentive to do so and to sell its excess rights.,This theory has been tested in a number of,Since other companies can then buy them,their,schemes for managing scarce environmental,market price falls to the cheapest cost of reduc-,resources,notably the schemes for reducing,ing emissions.The broader the scheme,the,sulfur dioxide(SO2)emissions from US coal,greater the incentive to innovate and the lower,plants,1 for managing blue-fin tuna stocks in the,the probable cost.,South Pacific,for reducing CO2 emissions in,Title IV of the US Clean Air Act Amendments of,Danish power plants,for promoting renewable,1990 to control sulfur dioxide and nitrous oxide,energy technologies in the United Kingdom andItaly,and for reducing CO2 emissions in the,emissions creating acid rain.See A.Denny Ellerman,Paul L.Joskow,RichardSchmalensee,Juan-Pablo Montero,and Eliza-,plants of BP and Royal Dutch/Shell,companies in,beth M.Bailey,Markets for Clean Air:The US AcidRain Program,New York:Cambridge University,which business units trade their emissions rights.,Press,2000,pp.25696.,their aggregate 1990 levels.Regardless of the protocols legal status,2 the,European Union is pressing ahead to meet its own Kyoto target:emissions,8 percent below the levels of 1990(Exhibit 1).,To that end,the European Commission has proposed a so-called cap-and-,trade scheme(see sidebar,“How does a cap-and-trade scheme work?”)that,would be mandatory for more than 5,000 energy and industrial plants,3,accounting for about 46 percent of total EU emissions.The scheme sets an,annual limit on the aggregate amount of greenhouse gases those plants may,emit.Every year,the total emissions of each of them would be calculated,For the protocol to come into force,it must be ratified by more than 55 countries,including those,responsible for 55 percent of the emissions of developed countries.The United States,which,accounts for 36 percent of these emissions,hasnt ratified the protocol,though 97 countries have.,Power plants that have a capacity of more than 20 megawatts,as well as aluminum,cement,ceram-,ics,chemicals,coal,glass,petroleum-refining,and steel businesses.However,the other main CO2-,emitting sectorsagriculture,residential heating,and transportare excluded.,124,1,2,T H E M c K I N S E Y Q U A R T E R LY 2 0 0 3 N UM BE R 1,EXHIBIT 2,Modeling Europes energy markets,Key inputs,Model,Key outputs,Generation capacities at plant level,Hourly simulation of prices over,Market prices for region/country,Real transmission capacities Existing-and new-plant costs(capital,fuel,operations andmaintenance,shutdown,start-up),15-year period Assessment of pricing strategies,new builds,plant shutdowns thatwould optimize players,as well as for selected individualplants or companies Transmission utilization andconstraints,Ownership of plants Pricing strategies in case ofconcentrated market Known changes to regulatedcapacity(obligations to use,economic performanceNorway,Utilization and operatingmargins per plant Net financial results for plantand owner,renewable energy sources,phaseouts of nuclear plants),Luxembourg,NetherlandsDenmark,Finland,Included in modelIncluded in model,butresults not presentedin this article1,Belgium,Sweden,Not included in model2,Russia,Ireland,Estonia,United Kingdom,Germany,Poland,Latvia,Major energy sources,percentage of total generation,France,Czech RepublicSlovakia,Width=100%,Hungary,Portugal,Austria,Coal,Lignite,Gas,Oil,Spain,Italy,Switzerland,Nuclear,Hydro,Wind,Mix,No Kyoto target set at time of study.Countries indicated import total of 3 gigawatts of capacity per hour from modeled region.,and each would have to ensure that it had the right(known as an allowance),to emit this amount.,Plants would receive most of the rights at no charge but would have to buy,the remainder on a market regulated by the scheme or pay a penalty.Those,with excess rights could sell them on that market or use them on projects,elsewhere,and some plants might try to reduce emissions to sell the result-,ing excess rights to other power generators or heavy users.The market price,of the rights would become the cost of emitting greenhouse gasesand,would be decided by CO2 emissions,since they make up more than 95 per-,cent of all greenhouse gas emissions covered by the scheme.,CO2 pricing and the switch from coal to gas,Most studies of the expected market price of CO2 emissions rights under,variations of the European Commission scheme forecast a price of 15,125,2003 emissions levels,40,1,4,5,C L I M AT E C H A N G E F O R E U R O P E S U T I L I T I E S,($14.80)to 30 per ton4 of CO2 emitted.Our proprietary simulation model,(Exhibit 2)supports that range for the mainland European market.After,some initial volatility,we expect the price to settle at about 25 a ton by,2008(Exhibit 3).,Price analyses tend to converge because,under the scheme,the demand for,CO2 emissions rights will exceed the capped supply by 14 to 30 percent as of,2008.The cap-and-trade approach seeks to close that gap at the lowest pos-,sible cost.Apart from including Russia in the plan,5 Europes cheapest path,would be to switch from coal-red,to gas-red power generation.Gas-,EXHIBIT 3,red plants need less than half of,Finding the price of pollution,the rights required by their coal-,red counterpartsalso called high-Percentage change over,Market price of CO2 emissions,per metric ton,emissions plantsto produce thesame amount of electricity,since theyemit that much less CO2.(Gas con-tains a lower level of carbon,andmodern gas plants are more efficient.),2010010,010202530,20,Once the price of emissions rights,30,50,approaches 25 a ton,it becomes,more protable to build and run,2003,2005,2007,2009,2011,2013,2015,high-efficiency gas-red plants than,Probable Kyoto target,to continue operating high-emissions 1ones,which will be closed and their,13%targeted reduction(relative to 1990 emissions)for modeled region.,rights released to the market,thereby,driving the price back down.At lower prices,however,it will be worthwhile,for high-emissions plants to continue in operation so as to meet the gradu-,ally rising demand for energydemand that will push the price back to the,25-a-ton switching point.,Many high-emissions plants that remain in operation may be required only,for regular peaks in demand,such as weekdays and winter.We estimate that,from 2005 to 2012,about a third of these plants will switch to that role,(which might require investments to change their operating patterns),while,a third will remain at base-load capacity and a third will be shut down in,Metric ton:2,205 pounds.,Including Russia in the scheme,along with the European Unions proposed new members from the,old Eastern bloc,would create an oversupply of rights for at least five years and keep the market price,much lower.But Europes actual emissions wouldnt fall.The surplus rights would result from the huge,fall in Eastern bloc emissions of CO2 from the 1990 baselinethe effect of a slump in energy de-,mand during the industrial,military,and economic revolution that followed the political transformation,of 198990.,126,6,6,7,T H E M c K I N S E Y Q U A R T E R LY 2 0 0 3 N UM BE R 1,favor of gas.Thanks to better gas technologies and to the availability of gas,supplies,which now seem sufficient,coal might by then be giving way to gas,in power generation.One effect of CO2 regulation would be that gas will,take over coals role as the backboneof Europes nonnuclear electricity,Switching from coal to gas is the,supply much more quickly.,only way to reduce emissions,by the amount the targets require,In fact,switching from coal to gas,is the only realistic way to reduceemissions by the amount the targets,require.Technological improvements in high-emissions generation produce,only minor reductions of CO2 emissions,since they,unlike particulate,emissions such as nitrogen oxides and sulfur dioxide,cant be ltered out.,Renewable energy technologies and carbon sequestration(reinjecting CO2,into the sea or the Earths crust or planting trees to counter emissions),would at best each deliver only 10 percent of the reductions needed.For,wind generation to be competitive with gas,for example,the price of emis-,sions rights would have to be 50 a ton,and solar energy would require a,price of 100 a ton;moreover,it would be necessary to guarantee that both,could generate a reliable supply of energy.While such technologies will be,essential to keep emissions in check as energy use rises,they wont con-,tribute greatly to the schemes targets up to 2012.,Rising energy prices,Under the current proposal,the cost of regulating emissions would be,borne by consumers,by the industry,and by utilities whose operating mar-,gins didnt improve sufficiently to cover the cost of coal plant write-offs,forced by the plans economics.,In a competitive commodity market such as the one for wholesale electricity,the spot market price is determined by the cost of producing the last unit,needed to cover demand.7 Exhibit 4 shows how,in most European electricity,markets,the generator of that last unit of energy will often be a fossil fuel,plantone of those liable to pay the additional 25-a-ton cost of emitting,CO2.If so,theory suggests that the wholesale price of electricity should rise,by this additional cost,and the model conrms that the average wholesale,spot price would indeed rise about 30 percent above the level that would pre-,vail without CO2 regulation.This increase would be incorporated in longer-,term supply contracts as they rolled over.,Our model assumes that environmental and other policy constraints will make it impossible to build,any significant hydro or nuclear generators from now to 2015.,In the short run,this marginal cost will be the variable fuel and operating costs.In the longer run,it,will include plant maintenance and capital costs.Price levels might also depend on the markets bal-,ance of supply and demand and on concentration,particularly in periods of high demand.,Operatingcosttoproduceenergy,(existingplants),1permWh,67,92,127,Wind,3,1,2,3,C L I M AT E C H A N G E F O R E U R O P E S U T I L I T I E S,EXHIBIT 4,As costs rise,so do prices,Market price of CO2 emissions=25 per metric tonDemand fluctuates hourly,through this range,Full cost2 of new,120100,Operating cost of,Gas steam,Gas turbineOil104,capacity is maindeterminant ofprice in long run,806