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 / Winter 2006 / Issue 45(originally published by Booz & Company)


Toward a Flexible Energy Future

In its approach to climate change, the E.U. has adopted a modified market system, at least in principle. The Emissions Trading Scheme (ETS), introduced in 2005, is still (as of late 2006) in the first phase of implementation. Each member country proposes a cap on greenhouse gases emitted by power plants and other major industrial sites; the E.U. approves the caps; and then companies are granted permits to operate within those caps. Carbon-profligate companies can buy more emissions rights from carbon-frugal companies, giving everyone more incentives for lowering emissions and building efficiencies.

But the ETS is an imperfect work in progress, in which political horse-trading overrides the best scientific judgment. The caps were so generous in the first year that no countries were forced to reduce total CO2 emissions — which (as many observers noted) undercut the entire purpose of the initiative. In the end, it is not clear whether the ETS will have the political will to overcome bargaining on the part of special interest groups, but only a tough stand will allow it to deliver a true shadow price for carbon that genuinely leads to the CO2 reductions required to mitigate climate change.

Because the ETS is still embryonic, most countries in the E.U. are retaining a national carbon or energy tax. This represents a significant structural difference: Trading systems, which fix the level of permitted emissions and allow the price to vary, tend to be more effective at capping emissions than tax systems, which fix the price and allow the amount of pollution to vary. Tax systems are also more prone to the arbitrariness of top-down control; the U.K.’s Climate Change Levy, for example, is a confused mixture of energy and carbon tax, levying on nuclear power, even though it is a low source of CO2.

The Price of Volatility
Emissions trading programs represent a valuable first step, but because they don’t take the other uncertainties of the sector into account, they alone are not an adequate means of guiding energy investment. Volatility adds cost to any portfolio. Investors know this well; they diversify across a variety of assets, balancing their requirements for growth and security. A good modified market energy portfolio should do the same, taking into account the volatility of the availability and price of different fuels.

Natural gas, as the world has witnessed, can fluctuate enormously. In the U.K., the spot price of natural gas doubled between 2004 and 2006. Even more damaging were two price spikes, in which U.K. gas prices briefly rose about 400 percent. Importing nations, in particular, have little recourse if suppliers raise prices suddenly (as Russia’s Gazprom has done) or supplies approach a natural peak (as has been predicted for oil). Other fuels are relatively stable; once reactors are built, the price of nuclear power remains relatively constant. Nuclear power can therefore take the role that bonds play in a pension fund: not necessarily the highest-yielding asset, but one that reduces volatility.

Another source of uncertainty that needs to be addressed arises from the protracted and uncertain nature of planning and licensing regulations. These are particularly damaging to highly capital-intensive options, such as the building of new liquid natural gas (LNG) or nuclear power facilities, or the recovery of heat from waste incineration. The U.K. government is proposing to address this uncertainty by allowing licensing of technologies to run in parallel with the planning process. Any resumption of nuclear construction should be preceded by agreement on a strategy for disposal of nuclear wastes (though those energy sources emitting CO2 as a waste are not required to meet an equivalent constraint). We should also insist that enough funds be allocated for waste disposal and decommissioning of plants, lodged outside the producer’s balance sheet.

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