Low-carbon future

With climate change continuing to grab the media headlines it is vital that utility companies have a low-carbon strategy.

Global warming is a huge phenomenon, a claim backed by a rising amount of scientific evidence. There is very little argument that fossil fuels used in power generation contribute substantially to global carbon dioxide emissions. This impact is compounded by rapidly growing global demand for electricity in the face of economic development in emerging countries. As a consequence, international public and political pressure for the energy sector and energy-intensive industries to address climate change is mounting, forcing them to look at all available options for reducing CO2 emissions. These issues are not simply to be addressed within national boundaries. Regional and international initiatives will need to work alongside national measures to tackle climate change. There are two main options for reducing CO2 emissions from power generation: reduce end-use demand and lower carbon intensity through methods like fuel switching, or use renewable energy sources and carbon capture and storage. Both options pose challenges to traditional electricity utilities. They will need to decide how to cope with major changes in a number of areas. Customers of the future could be consuming less electricity and demanding that the energy they do consume be low carbon yet still cheap and reliable. Similarly, companies' carbon exposure could affect their strategic attractiveness to potential suitors for mergers and acquisitions. The value of carbon could also have a large impact on the valuation of individual companies in electricity, such as through the market price of emission allowances they own. The separation of generation and retail activities from transmission and distribution activities, or ownership unbundling, will change decision-making criteria if companies no longer face the integrated consequences of their decisions. While wind power is a critical low-carbon technology, its deployment is dependent on having suitable transmission and distribution networks that may no longer be under the control of the generation company. What's more, the ability to roll out smart meter technologies will depend on where responsibility for metering lies - with suppliers in the UK and integrated distribution companies in much of continental Europe.

Technologies

As far as emerging technology goes, global shifts in the relative fortunes of different technologies, like carbon capture and storage, renewable generation options and smart metering, could radically impact the competitiveness of individual utilities. Technology choices and investments they made in the past may have been either decided too soon or ill-informed. Three forces are driving carbon emissions reduction by generators and retailers of electricity: regulation, competitive pressure and consumer demand. Regulations to reduce carbon emissions span the entire value chain, impacting on consumers, retailers and electricity generators. At the consumer level, governments are tackling climate change through regulations such as improving building standards or stimulating the use of energy-efficient products like lightbulbs. At the electricity retail level, European Union requirements to label the sources of electricity on customer bills are meant to help raise consumer awareness. Smart meters, which show consumption in more detail, and in monetary terms rather than in kilowatt hours, have been installed extensively in some countries, such as Italy, and will be commonplace in many others within a few years. At the electricity generation level, there are many examples of regulation stimulating demand for low-carbon technologies. Many jurisdictions have introduced compulsory targets for green energy within the electricity mix. The EU intends to require all new coal-fired power stations to be carbon-capture fitted by 2020. As the traditional electricity utility business model moves away from vertically integrated monopolies and towards a deregulated marketplace, competitive pressure between firms is increasing. One way to secure market position is through 'green' branding. Utilities that have a greener portfolio, and therefore reduced carbon exposure, could have a competitive advantage over firms that rely more on a base of fossil fuel generation. Sweden's Vattenfall has proposed a burden-sharing model for reducing CO2 in order to manage emissions of greenhouse gases on a global scale. The UK-based Centrica is using its comparatively low-carbon footprint as a differentiator. Consumers are demanding lower-carbon energy for lower energy bills, the option to generate their own electricity and a healthier environment. Recent high and sustained international prices for coal, oil and gas have led to higher electricity prices for many end-users. Combined with increased awareness, this has encouraged consumers to revisit options for reducing their consumption through methods like improved insulation, higher-efficiency appliances and low-energy lighting. It has also shown the need for improved information about consumption that can be provided by smart meters. New technology developments are making consumer-owned electricity generation possible. International demand for small-scale wind, photovoltaic and combined heat and power units is growing. As a result, the need for centrally delivered electricity not only will drop, but will also require more investment and development within distribution networks in order to manage swings from consumption to injection of excess power generation back into the grid. Demand for distributed energy is also creating new markets for small-scale heat technologies such as heat pumps.

Consumer demand

More and more consumers are looking to purchase low-carbon electricity and fuelling demand for energy from renewable sources. For many large non-domestic consumers, this concern is driven by their own branding requirements. There is a growing awareness of the benefits of being seen as environmentally responsible. As a result consumers are starting to have a strong interest in purchasing 'green electricity'. In the EU and the USA, players such as Tetra Pak, Timberland, Ikea and Nutreco purchase large amounts of green electricity. Even as consumers are demanding cheap, reliable and low-carbon energy, they recognise that it comes at a price higher than that of dirtier fossil fuels. Research has shown that there is a willingness to pay for greener energy. This willingness varies from country to country and within consumer groups in a specific country. These differences reflect cultural and economic differences and overall awareness of environmental issues and the role of green energy. Utilities that engage with their customers, raising their awareness and helping them understand the issues, will be in a better position to capitalise on the enthusiasm, creating an opportunity to offset some of the higher investment costs they will face moving towards a low-carbon future.

Carbon trading

If the drivers for reducing carbon emissions are fairly well understood and globally applicable, market mechanisms to achieve these reductions have developed through two routes: government and private initiatives. The EU's Emissions Trading Scheme (ETS) is the most visible example of a government-established market mechanism for the trading of greenhouse gases. It's a cap-and-trade mechanism that leaves it up to participants to decide how best to reach emission reduction targets. Under the ETS, carbon allowances are distributed to EU member states, which then allocate them to industry. Over successive compliance periods of the scheme, the number of carbon allowances granted is expected to decrease, reducing overall carbon emissions. The reductions are also likely to increase the value of carbon allowances. While government-led market mechanisms can be seen to be working, there is also a place for private initiatives. The Chicago Climate Exchange (CCX) is an example. Launched in 2003, the CCX is a voluntary collaboration between North American firms that commit to a voluntary, but legally binding commitment to meet annual greenhouse gas emission reduction targets. The exchange has grown from its original 13 charter members in 2003 to now more than 300.

Carbon reduction strategy

Given these unmistakable drivers to reduce carbon emissions, electricity utilities need to establish a carbon reduction strategy. The first step in establishing such a strategy is to determine where you stand today in terms of carbon exposure. Arthur D Little, in conjunction with E-capital Partners, has developed a standardised methodology for ranking firms based on their 'carbon intensity'. It is defined as the ratio of the firm's carbon emissions to its economic activity (energy-produced). It reflects the efficiency of its business with respect to carbon emissions. Once you have a clear view of your current carbon exposure position, you can determine feasible carbon reduction goals and the challenges and opportunities to achieve them. The most appropriate route will depend on your company's position within the value chain, the available options and the technologies that exist or are in development to assist you in the transition. For a company such as Centrica, which already has a low-carbon fuel mix - something it uses to support its brand reputation and strong national retail position - there is an opportunity to engage more with consumers through its New Energy business. The company "offers green, low carbon products and services to customers who want to manage their impact on climate change". At the other end of the spectrum are companies that have large historical coal-fired generation bases, such as AEP in the US and RWE and Vattenfall in Europe. They all have significant coal reserves and, perhaps unsurprisingly, are looking more at technology developments like higher-efficiency coal technologies linked to carbon capture and storage (CCS). While it's by no means certain that these technologies will be economic on an industrial scale, companies that have built expertise in them will be better positioned should they be proven viable and adopted on a wider scale. This being said, these companies are also pursuing other options, including investment in renewables. In between the two ends of the spectrum are companies that have a mixture of generating plant and a wide geographic spread. They have been focusing more clearly than others on power generation from renewable sources. Scottish Power and Iberdola, two companies with proven track records in renewable energy that merged, have a business model in which they invest in different renewable technologies in different national markets. Iberdola now has large development programmes in the US, the UK and Spain, and is considering an IPO of 20 per cent of its renewables business - something also seen elsewhere with EDF's Energies Nouvelles IPO in 2006. In addition, the business model doesn't focus purely on wind and hydro - two proven technologies - but also looks at emerging technologies through Scottish Power's investment in wave technology. Whichever strategy a utility pursues, it must understand the carbon price-formation process and the relative merits of different carbon-reduction technologies.

Market view

The experience with the EU's ETS market mechanism has shown that the price of CO2 emission allowances can change wildly. The price has been on a rollercoaster in the two-and-a-half years since the scheme opened. Allowances had traded as high as €30/tonne CO2 until data showed that more allowances had been allocated than were required by industry. As a result, prices for the remainder of Phase I (2005-2007) are only just trading above €0/tonne CO2. The European Commission has demanded a greater reduction in national allocations during Phase II (2008-2012), and prices for Phase II have recovered to €20/tonne CO2.
But this is a market view. It's difficult to tell whether the price is 'correct'. One approach available to help management develop a strategy to respond to changes in the carbon price is the use of so-called marginal abatement curves. At the basis of marginal abatement curves are alternative technological options to reduce CO2 emissions such as a new nuclear power plant, carbon capture or wind turbines at sea. For each option, the marginal abatement curve shows the volume of CO2 that can be saved (in tonnes) and the cost per tonne required to achieve that saving. Other results from recent Little work are aimed at informing environmental
policy. The results show that, for each of 12 possible measures, how much money it costs to save one tonne of CO2. It is also possible to work out, again for each of the 12 possible measures, the total volume of CO2 that could be saved. There is the potential to use Little's work and expand it to, for example, all 27 member states within the ETS, which would enable companies to assess the impact of overall caps on emissions and potentially form a view on the price of carbon. Just as abatement curves help inform government policy at country level, so can abatement curves at company level help companies assess their own technology options. By assembling available options - such as switching to cleaner fuels, building renewable generation and investing in CCS - into their own abatement curve, company decision makers can easily review and rank different options on a level playing field, quickly establishing a way forward in meeting their carbon-reduction goals at the lowest cost. Obviously, producing a marginal abatement curve is only a good start. Additional effort will have to be spent on mapping dynamics such as the links between consumer demand and fuel mix. Furthermore, an assessment of future technology developments should come into play. For carbon capture and storage there are several technologies available, but which will become the dominant technology? Will it be the first one available that is also currently the cheapest, or will it be the longer-to-develop but ultimately cheaper technology? Key uncertainties like the cost of nuclear fuel and future prices of oil, coal and gas should be considered. Changes in the political and public mindset have left electricity utilities facing a future where continued high levels of carbon emissions are untenable. Understanding the drivers that lead or force utilities to reduce carbon emissions is vital to help leaders of today's global utilities make difficult and long-lived investment decisions. By knowing their current carbon exposure and understanding the carbon price-formation process and relative merits of different carbon-reduction technologies, they can make these decisions with confidence and devise clear low-carbon strategies

The authors all work for Arthur D Little. Ian Coveny, is a consultant at the company's Cambridge office, Jochen Gerber is a senior manager at the Wiesbaden office, Murray Hartley is a senior manager at the London office, Roger Hill is a director at the London office, and David Lyon is a senior manager at the Cambridge office.

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