Performance based emissions trading post 2012 Performance based emissions trading post 2012

IIR Conference “CO2 in the Industry”Carlton Oasis Hotel Spijkenisse, Netherlands,

19-20 September 2007

Vianney SchynsManager Climate & Energy Efficiency

Utility Support GroupUtility provider for a.o. DSM and SABIC

Vianney.Schyns@usgbv.com

Jan BerendsManager Environment & Product SafetyRoyal DSMJan.Berends@DSM.com

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Contents

1. Present political situation

2. Failures present EU ETS rules – examples at DSM & SABIC

3. Key aspects of benchmarks

4. Benchmarks ex-ante or ex-post

5. Setting the total cap 2013-2020 – effectiveness

6. Conclusion

7. Annexes

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Present political situation (1)Present political situation (1)

• Historical grandfathering was a historical mistake= Recognised by EU Commission

• 3rd Trading period: perhaps auctioning for electricity & (partial?) auctioning and/or benchmarking for industry

• EU Commission will come with a proposal December 2007 – then co-decision EU Parliament & Council – Takes 1.5 – 2 years, is no decision for single Member State

• Benchmarking for allocation to operators= Ex-ante: based on historical production

= Ex-post: based on actual production

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Present political situation (2)Present political situation (2)

• Industry is against auctioning

– Auctioning electricity= Electricity prices remain high bad for competitiveness / leakage

= Windfall profits nuclear, hydro (EU 45%) what about France (90%)?

= Revenue recycling poses problems with effectiveness of EU ETS

– Auctioning industry= Bad for competitiveness, “leakage” by production relocation

– Auctioning with Border Tax Adjustments at EU borders is neither practical (huge bureaucracy) nor politically desired

Failures present Failures present rules of the rules of the

EU Emissions Trading SchemeEU Emissions Trading Scheme

Examples DSM & SABIC

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Chemelot examples of ineffective allocation

• Incumbent plants– Efficiency factor ß (total energy worldtop / total energy

actual) of all plants and all energy use/CO2-emissions is related only to local emission of few plants

Incentive CO2 reduction largely taken away SEE ANNEX for example Chemelot

• New entrants (new plants or extensions existing plants)– Dutch rule = “never more allowances than needed”, zero incentive

for investments in cleaner technologyNew DSM melamine plant: 70% better than Best PracticePrevious design work new SABIC large scale plant

Key aspects of benchmarksKey aspects of benchmarks

Few benchmarks – high coverage

Suitable benchmark formula

Benchmarks take account of all energy carriers

Benchmarks in a direct emission scheme

Same effectiveness as auctioning

Examples chemical industry

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Few benchmarks – major coverage, ParetoFew benchmarks – major coverage, ParetoBenchmarking Netherlands: about 90

100%

Coverageofemissionsunder theEU ETS

Electricity (1) and for CHP (Combined Heat& Power) (1 for heat)

Steel (6-7)

Cement (2)

Refineries (1)

Major chemicals (20-30)

Policy recommendation:include (co-)firing biomass

Allocation:• Vital few: about 40 benchmarks• Trivial many: basis is own efficiency, “be generous”, give incentive to reduce emissions

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Suitable benchmark formulaSuitable benchmark formula

Benchmark = WAE – CF x {WAE – BP}Benchmark = WAE – CF x {WAE – BP}

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Benchmark takes account of all energy carriersBenchmark takes account of all energy carriers

Productionplant

Feeds

Steam

Natural gas ?Other fuel ?

Electricity

CO2 ?

Product(s)

Many energy functions can be done either with:• Steam, or• Electricity, or• Natural gas or other fuel

Benchmark takes this into account:Normalised calculation to (total)primary energy – or total CO2

Benchmark for only fuel – direct emissions – is meaningless

Examples: chemical plants, refineries, cement, paper plants, etc.

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Benchmarks in a direct emissions schemeBenchmarks in a direct emissions scheme

Allocation = direct emission – emission {total plant – total BM}

Productionplant

Feeds

Steam

Natural gasOther fuels

Electricity

CO2

Product(s)

Site utilities have also benchmarks

Example 1:

• Net-import of secondary energy carriers:

70 – {120 – 100} = 50Plant worse than benchmark

Example 2:

70 – {90 – 100} = 80Plant better than benchmark

See formula in ANNEX

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Benchmarking same effectiveness as auctioning (1)Benchmarking same effectiveness as auctioning (1)

Incentive to reduce emissions is independent of the exact value of benchmark in a certain year

Incentive = avoided purchases + sales of allowances

Example:Investment to reduce emissions from 900 to 600 kg CO2 per unit of product (in old plant or new plant)

• Year 1, BM = 750: incentive = 150 + 150 = 300• Year n, BM = 700: incentive = 200 + 100 = 300

Predictability of investment climate

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Benchmarking same effectiveness as auctioning (2)Benchmarking same effectiveness as auctioning (2)

Same benchmarks for incumbents and new plants Recognised by EU Commission

Avoids= Distorting transfer rules

= Barriers to entry

= Enhanced market concentration

Ensures= Equal incentive for plant improvement & plant replacement

No “maximisation” or “minimisation” rules, see e.g. Matthes (NL 110% and 85% now)

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Examples chemical industry prove it worksExamples chemical industry prove it worksEU bechmark data major chemicals

Product Consultant Weighted EU Best Efficiencies PSR = WAE - CF x (WAE - BP)EU average Practice Electricity Heat CF = Compliance Factor =

WAE BP 15% 20%

GJ/ton GJ/ton1 Steamcrackers (1) Solomon Associates 144,8 107,8 37,5% 90% 139,3 137,42 Pyrolosis gasoline (pygas) Process Design Centre 1,3 0,6 42% 90% 1,2 1,23 Benzene extraction Process Design Centre 3,8 2,2 42% 90% 3,6 3,54 Butadiene Solomon Associates 9,72 7,3 37,5% 90% 9,4 9,25 MTBE Process Design Centre 1,9 1,06 42% 90% 1,8 1,76 ldPE (low density polyethylene) Phillip Townsend Associates 8,53 5,96 42% 90% 8,1 8,07 hdPE (high density polyethylene) Phillip Townsend Associates 5,43 3,14 42% 90% 5,1 5,08 PP (polypropylene) Phillip Townsend Associates 3,56 2,27 42% 90% 3,4 3,39 EPDM (ethylene propylene rubber) (2) Phillip Townsend Associates 32,22 28,0 42% 90% 31,6 31,4

10 PVC (polyvinyl chloride) Process Design Centre 3,8 3,4 42% 90% 3,7 3,711 Nylon-6 Process Design Centre 10,0 5,71 42% 90% 9,4 9,112 Ammonia (3) Plant Services International 13,13 7,23 40% 90% 12,2 11,913 Nitric acid Process Design Centre -0,12 -1,8 42% 90% -0,4 -0,514 Fertiliser (Calcium Ammonium Nitrate)Process Design Centre 0,99 0,35 42% 90% 0,9 0,915 Urea Plant Services International 5,06 3,06 42% 90% 4,8 4,716 Melamine (4) Nexant 79,46 60,55 42% 90% 76,6 75,717 Caprolactam excl. cyclohexanon Process Design Centre 8,7 -0,9 42% 90% 7,3 6,818 Acrylonitril (2) Phillip Townsend Associates -6,2 -8,3 42% 90% -6,5 -6,619 Yeast Process Design Centre 5,9 5,62 42% 90% 5,9 5,8

1) Solomon energy efficiency index (EEI) adjusted for supplemental feeds2) WAE and BP are not EU but worldwide data (for confidentialilty reasons)3) 20.67 GJ/ton feedstock energy (these process emissions fall outside the EU ETS)4) These data include feedstock use which must be subtracted: 29.5 GJ/ton ammonia and 21.99 GJ/ton urea incl. ammonia use. Typicals are: 3.2 ton urea and -0.9 ton ammonia, both per ton melamine. This gives WAE = 35.6 GJ/ton melamine and BP = 16.7 GJ/ton melamine.

Once defined, benchmarks are quite straightforward

Benchmarks ex-ante or ex-postBenchmarks ex-ante or ex-post

Quality of historic production data & forecastsGuarantee of total cap

Solution of “production subsidy”

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Quality of historic data for operatorsQuality of historic data for operators

Variations in annual load factors over five years, found in

UK by consultant NERAfor UK government

… with climate change instruments based on history?

Historic production tells nothing about the futureHistoric production tells nothing about the future

Link to actual production: Avoids distortions Avoids windfall profits Solves problems new entrants and closures, SEE ANNEX

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Quality of historic data & forecasts for states

• What means a historic cap: many new plants enter the market?– Many new power plants in Italy around 2009 .. Germany .. NL

• What means a historic cap: import or export of product?– More electricity import NL from Germany – Is NL then doing well?– New CHP in Luxembourg – Is Luxembourg doing bad?

• What means a historic cap: economy is strongly recovering?– Forecast of growth in central Europe, seven legal cases European Court

of Justice against EU Commission: Czech Republic, Estonia, Hungary, Latvia, Poland, Slovakia, Lithuania

– Influence Burden Sharing on allocation is perverse

• Solution: benchmarks linked to actual production

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Benchmark with ex-post + guarantee total capBenchmark with ex-post + guarantee total cap

Benchmark with ex-post electricity Scenario with a higher production growth than forecasted

(without contingency reserve) Second trading period Third period2008 2009 2010 2011 2012 Total 2013 2014

FORECASTS Production fossil, TWh 2000 2034 2069 2104 2140 10346Start Benchmark, ton CO2/MWh 0,600 0,590 0,580 0,570 0,561

Total cap, Mton CO2 1200 1200 1200 1200 1200 6000Fixed Fixed

Ex-post Update production fossil, TWh 2030 2034 2090 2125 2155 10434 Update forecastover 2008 Ex-post, TWh 30

done in 2009 Ex-post, Mton 18to 2010 Allocation, Mton CO2 1200 1200 1194 1194 1194

Benchmark, ton CO2/MWh 0,600 0,590 0,571 0,562 0,554Total cap, Mton CO2 1200 1200 1212 1194 1194 6000

Fixed Fixed Fixed

Ex-post Update production fossil, TWh 2030 2045 2130 2140 2175 10520 2190 2230over 2012 Ex-post, TWh 30 11 40 25 5

done in 2013 Ex-post, Mton 18 6 23 14 3to 2014 Allocation, Mton CO2 1200 1200 1194 1191 1168 986 997

Benchmark, ton CO2/MWh 0,600 0,590 0,571 0,563 0,538 0,450 0,447Total cap, Mton CO2 1200 1200 1212 1197 1191 6000 1011 1002

Fixed Fixed Fixed Fixed Fixed Fixed Fixed

• Automatic adjustments within an ex-ante agreed total capAutomatic adjustments within an ex-ante agreed total cap• More stringent benchmarks work exactly like auctioning (& cap & trade)• System is self-adjusting; virtually no interest costs

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Benchmarking in the product chainBenchmarking in the product chain

Benchmarking with ex-post adjustment to actual production providesincentives in the product chain … avoids “production subsidy” effect (= higher electricity demand by lower electricity prices)

Electricity andheat

generation

Industrialmanufacturing plant

with use of electricity and heat

Fuel

Electricity

Product

Heat, fromCHP or fromboilers

Fuel

… the efficiency ofthe production ofelectricity & heat

… the efficiency of the use of (fuel), electricity & heat

Feed

Setting the total cap 2013-2020 Setting the total cap 2013-2020 while maintaining an effective COwhile maintaining an effective CO22-price-price

Ex-post cap maybe too stringent: exploding CO2-price

Ex-post cap maybe too soft: collapse CO2-price

What is the solution?

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Setting total cap 2013-2020 – effectivenessSetting total cap 2013-2020 – effectiveness

• Total cap may appear to be too stringent– Renewables behind target, delay phase-out German nuclear, higher

economic growth than expected, etc. very high CO2-price

• Total cap may appear to be too soft– Reverse of possible causes above very low CO2-price

Ex-ante frozen allocation not effective

• Solution– Contingency reserve if cap too stringent for example 100 Mton– No loser benchmarks if cap too softTarget is to maintain a realistic CO2-price to ensure a robust and

predictable EU ETS for companies to reduce emissions

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ConclusionConclusion

Performance-based allocation- Can be realized with guarantee of the total cap- Creates same incentives for emission reduction as auctioning

- Can be the basis for a stable & gradually increasing CO2-price

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Transition for a global trading scheme

Benchmark:Specificenergy useor CO2

emission

2012 2017 2022 2027

Benchmark EU-Japan

Transition period (with 3 or more BMs for same product) avoids high cost in case of auctioning for regions with higher emissions per unit of product (vital: BMs without differentiation new/old plants)

2032

Incentive low carbon technologies the same in global trading scheme

2008

Benchmark USA-Canada

Benchmark China-India

Global benchmark

AnnexesAnnexesWhat’s wrong with present EU ETS rulesWhat’s wrong with present EU ETS rules

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Benchmarking 2008-2012 to Chemelot incumbent plants

B. Combined heat & power

Swentibold in ETS

C. Utility productionsite Chemelot

“EdeA” in ETS

A. External powerPlants in ETS D. Plants outside ETS 2008-2012:

ammonia, nitric acid, fertilisers, melamine, polymers, etc.

E. Plants in ETS 2008-2012:two steam crackers

CO2

CO2

CO2

CO2

CO2

Electricity

Steam

Permit site Chemelot = C + D + E

Allocation permit site Chemelot = ßD + E x emission E + ßC x emission Cwhile for example: emission C could be too high, although ßC = 1.0Ineffective allocation – lack of incentive – no true benchmarking

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Benchmarking 2008-2012 to Chemelot incumbent plantsBenchmarking 2008-2012 to Chemelot incumbent plants

• Assume for Chemelot– Units A, B, C, D, E all 20 PJ and all 1.2 Mton– Total = 100 PJ and 6 Mton (Chemelot footprint)– Benchmark worldtop = 80 PJ = 4.8 Mton

• Present allocation Chemelot– ßD + E (= 80/100 = 0.8) x 1.2 + ßC (=1.0) x 1.2 = 2.16 Mton

• Assume projects to reduce emissions– Units A, B, C, D, E all 15 PJ and all 0.9 Mton– Total = 75 PJ and 4.5 Mton (Chemelot footprint)– Saving: 1.5 Mton

• Future allocation Chemelot– ßD + E (= 80/75 = 1.07) x 0.9 + ßC (=1.0) x 0.9 = 1.86 Mton

– Allocation incentive: 0.3 Mton versus 1.5 Mton realised

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Present ETS rules: new entrants & closuresPresent ETS rules: new entrants & closures

Unsolvable dilemmas new entrants (NE) & closures (C) (see e.g. also Grubb and Neuhoff, Stern, Egenhofer, Weishaar, Matthes, Schyns, Ecofys report for the EU Commission)

Theory: freeze allocation [all allowances after C & zero for NE]

Zero for NE actually hinders low carbon investments/competitiveness Retaining allowances after C – how long? – is worse than transfer

rules as it enhances market concentration Withdrawal allowances after C: perverse incentive keeping inefficient

plants in operation

Most authors elaborate these problems, but fail to conclude that within individual ex-ante frozen caps solutions are simply impossible search for squared circle

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Basics of shortcomings present allocationBasics of shortcomings present allocation

• Existing plants: allowances ex-ante frozen cap based on historical emissions – rewarding pollution – frozen quantity, whether production in- or decreases (“static, frozen economy”)

• New plants and debottleneckings: theory says buying (inhibits efficient industry renewal); repair = allowances from a new entrants’ reserve, also an ex-ante frozen cap (“plan-economy”)

• This principle = root cause of shortcomings, PLUS, as result:– Insecurity investments in new plants (finite reserves)– The allocation habit of few allowances for new plants versus many

allowances for existing plants : LACK OF EFFECTIVENESS to invest to reduce emissions

– Repair: “transfer rules” (allowances closed plant to new efficient plant), but new problem: high distortions, reinforcing market concentration

– Lowering production & selling freed allowances is declared equally legitimate as investing to reduce emissions

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Ex-ante rules prevent electricity liberalisationEx-ante rules prevent electricity liberalisation

• State interference prevents competitive market– At gross margin of opportunity-cost, winning and losing market

share: zero sum game; at higher gross margin: distortions– New entrants, vital for more competition, but ex-ante state

decision of operating hours determines profitability – plan economy

– Transfer rules protect incumbents: barrier to entry can be € 0.25 billion for a 1000 MWe power plant (4 years, or trading period)

– Even worse: incumbent does not apply for transfer rule and keeps old plant stand-by (1000 MWe coal-fired plant of € 1.1 billion, distortion ~ € 0.2 billion/year)

• Fight for allowances overrides fight for market share• Price of system: economic rents – windfall profits

– Cause is the opportunity to sell allowances when not agreeing a contract (opportunity-costs)

– Transfer of wealth to € 40-50 billion/year or double (EU-27)

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Cap & trade: market price > opportunity-costCap & trade: market price > opportunity-cost

Eurosfor anequal totalproductionvolume

Companies A & B

A winsmarketsharefrom B

Companies A & B: same production, efficiency and same quantity of allowances

Grossmargincashflow

Opportunitycost

Mark-up

Cost of buyingallowances:= distortion

Profit ofsales ofAllowances= distortion

Net profit

A

BNet loss

AnnexesAnnexesBenchmarkingBenchmarking

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Key principle of benchmarkingKey principle of benchmarking What a CEO wants to know?

He wants to know – e.g. with cost-price: Where his plants stand?; then Why? + What can be done about it?

He refuses notions like “We are the best in the peer group of our [obsolete] technology, or in our [small] scale, or in our plant vintage” (many corrections make everyone equal)

Key principle: benchmarks relate The product … with the objective function – CO2 in the EU ETS Deviations shall be possible, but temporary and aimed to avoid

leakage outside EU (… objective function) Example: energy efficiency as objective function can avoid leakage by

switch to gas and shipping of carbon-rich fuels outside EU

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Benchmark data of plants under the scheme (now EU)Benchmark between average & best performance, e.g.

Benchmark = WAE – CF x (WAE – BP)

= WAE = Weighted Average Efficiency= CF = Compliance Factor, to comply with total cap= BP = proven Best Practice, proven means actual measured operational

data (or rather BP Group, for extra stimulation of innovation)

Formula coincides with EU ETS Directive Annex III (3), average emissions and achievable progress for each activity

Industry opposes following alternative Related only to BP (BP + X%) – too short allocation, contra-incentive

to improve BP, effectiveness & innovation

Suitable benchmark formulaSuitable benchmark formula

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Auctioning: clear incentive low carbon technologies, length trading period irrelevant, but leakage & detrimental for competitiveness

Specificenergy useor CO2 emission

Decreasing efficiency order of plants

Buying allowances

BestPractice

IncentiveWeighted average

Incentive

High market liquidity

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Performance-based trading: same incentive as auctioning, length trading irrelevant, (hardly or) no leakage, good for competitiveness

Specificenergy useor CO2 emission

Decreasing efficiency order of plants

Buying allowances

Free allocation

BestPractice

IncentiveWeighted average

Incentive

Selling allowances

benchmark=totalcap

High market liquidity

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Benchmark takes account of all energy carriersBenchmark takes account of all energy carriers

Furnaces withheat recovery

to steam

Feeds

Methane from feedstock

CO2

Separations withhigh power

compressors

Example steamcracker, simplified scheme

2/3 of the investment

Separation train can be:• Efficient, with net-export of steam of whole cracker• Inefficient, steam import• Both can be with the same direct emission of the cracker itself

(ethane,LPG,naphta,gas oil,etc.)

Power train can be:• Steam turbine driven• Electric motor driven• CombinationsHigh influence onelectricity & steam balance, direct emissions elsewhere

(ethylene, propylene, etc.)Products

Steam recovery

Electricity Steam

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Benchmarks in a direct emissions schemeBenchmarks in a direct emissions scheme

Easy inclusion in an ETS No conceptual problem in a direct scheme and no legal problem with

Directive, on the contrary

Allowances according to deviation with benchmark In formula:

A = RDE + RSE – Σ production x (REE/RCE – benchmark) x CCF= RDE = Realised Direct Emission (ton CO2)

= RSE = Realised Sequestered Emissions (ton CO2)

= REE/RCE = Realised Energy Efficiency (GJ/ton product) or Realised CO2

Efficiency (ton CO2/ton product)

= Benchmark = benchmark energy (or CO2) efficiency

= CCF = CO2 Conversion Factor (= 1.0 in case of CO2-benchmark)

Note: Process emission is in this view included in the Best Practice

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Misunderstandings power market clearedMisunderstandings power market cleared

• Fuel specific benchmarks: against objective function= With ex-post: high fuel-switch prices, e.g. € 300-500/ton CO2

= Fuel switch limited with at least 50% (in case of 2 benchmarks)= Coal plants without CCS encouraged (Carbon Capture & Storage)

• One electricity benchmark no deathblow coal-fired power= Coal & lignite very important, climate policy means CCS != Cap & trade: opportunity-cost in power price (soft cost)

= With ex-post: CO2-cost in power price (real cost)

• Dash to gas with one benchmark?= Does not depend on one benchmark, but on total cap

= Fuel switch at same CO2-price as cap & trade & auctioning

= In fact more gas if more new coal and less CHP (given a total cap)= We need a controlled transition (CCS needs time)

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References• References: • < http://www.dsm.com/en_US/html/sustainability/emission_trading.htm >

• “Climate change challenges and the search for a sustainable policy”, 21 June 2005, 8th International Conference on Carbon Dioxide Utilisation (ICCDU-VIII) 20-23 June 2005, Oslo, Norway.

• “Options and consequences for the allocation of allowances to electricity producers”, 21 December 2005, European Chemical Region Network (ECRN) presidium meeting 21-22 December 2005, Maastricht, the Netherlands.

• “Towards a simple, robust and predictable EU Emissions Trading Scheme – Benchmarks from concept to practice”, 21 March 2006, presented to the Dutch Ministry of Economic Affairs.

• “The EU ETS is urgently in need of: effectiveness, level playing field, competitiveness, fair & free competition”, 4th Congress of the ECRN, 10 November 2006, Tarragona, Spain, including:– “One single benchmark for fossil-fuelled electricity in an Emissions

Trading Scheme: does it work, does it hurt and what about alternatives?”.– “How to fit benchmarks with ex-post adjustments in the present EU

Emissions Trading Directive”.