Warning: 30 October 2010 – It is now too late to avoid global warming of less than 2 per cent and too late to avoid “serious and pervasive ” climate change impacts that would “significantly disrupt the national economy” the federal government has said in a document released on Friday under the Freedom of Information Act, according to national newspapers today.

Highlights of the reports include that electricity prices will rise.  But a speech by a senior bureaucrat mid-year explained exactly how serious the outlook was, how very difficult if not almost impossible it will be to achieve a 5 per cent reduction target, how risk was unavoidable and why the allocation of risk was the principle urgent question, and its  price set to escalate the longer we remained indecisive, he said.

Key points in a Sydney Morning Herald report Include:

  • electricity prices will rise further unless power generators get a clear carbon price by 2012, and that Australia’s greenhouse gas reduction targets are already ”difficult to achieve”
  • uncertainty over climate-change policy was stalling long-term investment in efficient, cheaper power generation, which was ”resulting in sub-optimal investment and higher electricity prices with little environmental benefit”.
  • Even with a carbon price, the department warns the reduction targets accepted by the two main parties of between 5 per cent and 25 per cent of 2000 levels by 2020 would be ”difficult to achieve”.
  • Australian emissions are 4 per cent above 2000 levels, it says, and ”grinding upwards at a rate of 1 per cent a year”.
  • climate sceptics’ campaign are like ”earlier disputation about the science of tobacco smoking, asbestos and ozone-layer impacts” and advises a strong ”community engagement” program because ”climate change is a complicated communication challenge”.

How hard is to achieve a 5 per cent reduction in emissions by 2020 on the business as usual case?

Blair Comley, deputy secretary Department of Climate Change and Energy Efficiency put it something like this in a speech* he gave to the Committee for Economic Development Australia on 11 June this year: To reduce emissions by the 5 per cent target means savings of 140 megatonnes a year by 2020 on business as usual level.

Is this an easy number to achieve? Mr Comley said imagine we provided each household in Australia with solar panels to achieve 1.5 kw solar power, it would achieve abatement of only 16 Mt by 2020. And it would cost about $200 billion.

The massive risks imposed by the scenario exists, he said. The question is how to allocated them and to ignore them now will mean the risks and increase later.

Following is the full text of the speech

It is a pleasure to be here today to discuss climate change policy and the implications for the electricity market.

It is particularly pleasing to be here with such a distinguished set of speakers. The last two and a half years have been mainly consumed by intense consultations on every aspect of the design of the CPRS and other climate change initiatives. Many in this room have been key participants in that debate.

Today I want to take the opportunity to go back to first principles about climate change policy and relate this to the electricity market. Much of my talk today will be about risk management, or put another way, about decision making under uncertainty.

I will essentially be making three points.

First, the mitigation targets before this country and the world are not easy. They will require sustained political commitment both domestically and internationally for a very long period of time. This is not a policy where we can take a crash diet, drop a few pounds, and then return to our previous ways.

Second, while progress in the United Nations Framework Convention on Climate Change (UNFCCC) has been slower than many had hoped, there are clear markers in the Copenhagen Accord that imply very substantial mitigation commitments over time.

Third, electricity markets will need to deal with the implications of climate change policy. I will return to this in some detail later, but at this stage the key point I would like to make is that they key issue for electricity markets over time is allocation of risk given the extent of mitigation ambition. The level of mitigation ambition drives the need for structural transformation and sets the context of specific policies that governments will choose to adopt.

Domestic mitigation targets are difficult
Australia’s domestic mitigation targets will require significant mitigation activity. Chart one provides a graphic illustration of the range of mitigation targets that have been endorsed by both the Government and the Opposition.

The lowest target is a 5 per cent reduction below 2000 emission levels at 2020. This is an unconditional target, that is unconditional on international action.

Many commentators have assumed that this an easy target to hit. Many in this room are acutely aware that this is not the case.

I suspect that the view that the targets are easy to hit has partly been due to inadequate account being taken of the likely path of emissions without further mitigation activity – the so-called path of business-as-usual or BAU.

This chart includes a BAU line that shows emissions 21 per cent above 2000 levels in 2020. As my Secretary, Dr Martin Parkinson, has noted in a recent speech, this BAU takes into account all non-CPRS measures, such as the renewable energy target without which emissions would be even higher. What this means is that emissions will have to be reduced by more than 25 percentage points below the BAU level to meet the unconditional 5 per cent reduction target.

I also suspect that one of the reasons that this target has been considered by some to be easy to meet is that the general debate is a relatively new one where there is yet to be a widespread understanding of “what is a big number”.

If we were debating macroeconomics and I told you that inflation would be 10 per cent next year, then everyone in the room would know this is a big number. However, in the climate change debate we do not have the same common anchor.

To give a sense of the scale of the 5 per cent target it is useful to think of it in terms of the number of megatonnes of abatement that will be required.

The five per cent target is equivalent to a reduction from BAU of around 140 Mt per year in 2020.

Again, is this a big number? Well, imagine that it was decided to provide a 1.5 KW solar panel for every household in Australia. What would the level of abatement generated by such a measure? The answer is roughly 16 Mt in 2020. What would be the resource cost of pursuing this policy? The answer is roughly $200 billion. That is a big number and it gives some sense that 140 Mt is a large number in terms of required mitigation.

Or take another example closer to today’s topic – the implications of replacing a large coal-fired power station with a combined-cycle gas power station. What would this save in terms of emissions per year? A 1000 MW coal-fired generator with an emissions intensity of 0.9 tonnes per MwH, running at close to full capacity, would emit around 7 Mt in a year. A combined cycle gas generator might have an emissions intensity of around 0.4 tonnes per MwH. If this produced the same amount of power as the coal-fired station it replaces, then it would emit around 3 Mt per year, resulting in a saving of around 4 Mt per year.

There are some coal-fired power stations in the National Electricity Market with emissions-intensities above 1 so the savings could be a little higher this, but this example does put the 140 Mt required reduction into context.

I have deliberately avoided saying how much this thought experiment would cost. This is a complicated question, partly because there are many different concepts of cost, and because a full analysis would require detailed forecasts of capital and fuels costs over the full life of the relevant assets.

However, if I were asking the narrow question of the level of capital investment required to establish the 1000 Mw of combined-cycle gas capacity, then based on recent figures from Acil Tasman for the Australian Energy Market Operator, the amount would be in the order of $1.2 billion.

The 25 per cent target would naturally be more difficult to meet. It would require a reduction from BAU of around 250 Mt per year in 2020. This bi-partisan target is conditional on international action.

These are the targets to 2020. The Government indicated before the last election that it was committed to a 2050 target of 60 per cent below 2000 levels by 2050. Chart 2 illustrates this target. What this chart does not show is the BAU line out to 2050. If it were shown, and it were similar to the trend of recent times, then it would show BAU grinding inexorably upwards at around one percent per year.

This chart illustrates that the real challenge in climate change policy is not only to reduce emissions by between 140 and 250Mt by 2020, but in fact to break the nexus between emissions and growth – that is, to establish a long-lasting framework which changes the way decisions which affect emissions are made in the economy. Carbon markets have an important role to play in delivering on this challenge.

Finally, before moving to the Copenhagen Accord, I want to make it clear what I am not saying. I am not saying that because the targets are difficult that this necessarily means that they will be, or will be seen to be, sufficient from an environmental perspective. That is a debate for another time, particularly in discussing the nature of targets for a particular country. I am merely stating that the scale of the targets will require sustained political commitment and that this is a fundamental issue for anyone analysing or engaging in carbon markets.

The Copenhagen Accord
I would like to focus on one aspect of the Copenhagen Accord related to my theme of the ambition of mitigation targets.

The Copenhagen Accord includes the following statement:

“We agree that deep cuts in global emissions are required according to science, and as documented by the IPCC Fourth Assessment Report with a view to reduce global emissions so as to hold the increase in temperature below 2 degrees Celsius, and take action to meet this objective consistent with the science and on the basis of equity”
The Accord also states that:

“We should cooperate in achieving the peaking of global and national emissions as soon as possible, recognizing that the time frame for peaking will be longer in developing countries…”.

It is important to emphasise who the “we” is in these statements. The “we” includes all the major developed and developing countries, including the United States, the member countries of the European Union, China, India, Brazil, Indonesia and South Africa.

The Copenhagen Accord for the first time includes a commitment by major developing and developed countries to hold increases in temperature below 2 degrees Celsius. But, again, in a debate where there is a poor appreciation of what a big number is, what does this really mean?

Today I am not going to canvass what a 2 degree temperature rise would mean for the environment. The IPCC reports have documented extensively the likely impacts of a 2 degree temperature increase. Suffice it to say that many of them are not pleasant.

Instead I would like to discuss what such a goal means for global mitigation targets. I deliberately want to discuss global targets to avoid a discussion of the appropriate apportioning of targets between countries. Apportioning inherently requires value judgements within a moral and ethical framework. By focussing on the global task we can identify the mitigation requirement which is the backdrop to national requirements and collective mitigation effort.

I recently attended Senate Estimates. In those estimates Professor Will Steffen provided the most succinct and compelling description that I have heard of what would be required to meet a goal of holding temperature increases below 2 degrees Celsius.1

There are a range of different emissions pathways to achieve a goal of holding temperature increases below 2 degrees. For this reason, it is simpler to consider an overall carbon budget over a 50 year period from 2000 to 2050, rather than a specific emissions pathway. To have a 75 per cent chance of holding temperature increases below 2 degree Celsius we, on a global basis, can emit around 1000 gigatonnes (Gt) of carbon dioxide over that 50 year period.2 When you look at all gases, not just carbon dioxide, this is equivalent to 1500 Gt.

Now is 1000 Gt of carbon dioxide over 50 years a large or a small carbon budget? Well, to put it into context estimates of carbon dioxide emissions over the first 10 years of this period, are around 350 Gt.3 That is, we have used around 35 per cent of the allowable budget in the first 20 per cent of the period.

Furthermore, emissions are growing rapidly. There have been a range of estimates of BAU greenhouse gas emissions at 2020.4    Project Catalyst, a prominent international NGO, has estimated that annual BAU emissions in 2020 could be as high as 58 Gt carbon dioxide-equivalent (CO2-e).5    Lord Nick Stern has a slightly lower estimate of BAU emissions of around 54 to 56 Gt CO2-e per year in 2020. 6

Focusing on carbon dioxide only, current annual global emissions are about 34 Gt per year.7 With the Copenhagen Accord pledges taken into account, by 2020 carbon dioxide emissions will reach about 38 Gt.8 Therefore, if I did a crude calculation, not an official estimate, of roughly straight-line growth in emissions from 2010 to 2020 from around 34 Gt per year to 38 Gt per year, then the conservative total over 10 years would be around 360 Gt over the decade.

If I combine this 360 Gt with the 350 Gt that we have collectively already spent, then around 70 per cent of the budget would have been spent in the first two decades, with the remaining 30 per cent of the budget to be spread over the last three decades to 2050.9    This clearly illustrates the scale of the mitigation task that is ahead of the world.

Some might say that this is a very long-term goal and therefore will have little impact on policy making today.

I beg to differ.

I recall clearly discussions in 2008, before the Government had announced medium term targets and before other details of the CPRS had been finalised. The discussions ran roughly along the following lines.

The Government has committed to a 60 per cent reduction in emissions by 2050.
As a result the 2020 target must be a credible pathway to meeting that target. This will require a very substantial reduction from business as usual.

As a result it will be necessary to ensure that as large a part of the economy shares in the task of reducing emissions as possible.

The point I am making is that a seemingly innocuous long-term target sets off an inexorable chain of logic and this logic has critical implications for anyone participating in carbon markets. If it is credible, then it provides critical information about the likely shape of policy, a theme to which I will shortly return.

Some might also say that this commitment under the Copenhagen Accord was entered into without all parties understanding fully the consequences of the commitment. This may be so, but I would argue that there is plenty of evidence that the implications of such a long-term target were front of mind for many of the negotiators.

Many countries had resisted for some time making such a commitment precisely because of the logical consequences of the implied carbon budget outlined above. In addition, it has been widely reported that some developing countries were reluctant to include a specific target for developed countries in 2050 because of the implications for developing countries within a broader carbon budget.

Electricity Markets
Let me now turn to electricity markets.

The implication of the discussion above is that the realisation that climate change is a problem, and the carbon pollution that we are putting into the atmosphere contributes to the problem, has increased the level of risk that society must bear.

That point I think is worth repeating. The realisation of climate change has increased societal risk.

It has increased risk due to the consequences of unmitigated climate change, but also due to the risk associated with climate change mitigation.

The reason that I think it is worth repeating is that I often have discussions with people lamenting the riskiness of a particular situation as if the relevant comparator is a world with zero risk.

I should also note that I should also be more careful in distinguishing between risk and uncertainty. This is a long topic, but for today’s purposes let me define risk as situations where it is possible to define an ex ante probability distribution of outcomes (regardless of whether this probability distribution is a subjective distribution based on judgement) and situations where no such probability distribution can be used as a basis for decision making.

While the science does provide us with a range of possible outcomes, in practice much of the decision making around climate change is made under conditions if uncertainty rather than conditions of risk.

What are the implications of acknowledging that societal risk have increased, and to put it more concretely, what are the implications for the electricity sector?

From society’s perspective building a carbon-intensive power station involves taking a risk. This is both the risk associated with increasing atmospheric concentrations of greenhouse gases, and the risk that future policy responses to the increased risk posed by the increased emissions will require the writing-off of part of that asset.

One possible policy approach would be to allocate all the risk associated with such investments to the government, and through the government to the broader community.    There are different ways of doing this, but in broad terms the implication would be that power prices would not price in the risk premium associated with building the asset, power prices would therefore be lower and neither power producers or power consumers would be asked to take account directly of the elevated risk profile of society. In circumstances where the society required the asset to be prematurely retired, then the community would bear the costs associated with that closure.

Full risk allocation to government is rarely the best policy option. Indeed, I can think of no area of policy where there is not at least some sharing of risks.

Another approach would be for the risk to be allocated strictly to the private sector. With such an allocation the private sector would itself need to allocate the risk between a number of parties, including the generation sector, retailers, consumers and the financial sector.

I have heard some contemplate the latter scenario and explicitly or implicitly state that “none of the parties” will accept the risk. This comment has been made in the context of financing arrangement with respect to carbon risk, both for the allocation of existing capacity potentially subject to a carbon price, and for new investment currently being contemplated.

It is precisely comments of this type that have contributed to a pause in investment that I am sure many today will discuss.

However, with this risk allocation, and under circumstances where it is credible that the risk allocation to the private sector is a permanent feature, it seems implausible that this impasse will last forever. I would contend that the real point is the various participants in the market will demand adequate compensation for the risk they are assuming, not that they are unprepared to assume risk per se.

If everyone is risk averse, and have their expectations anchored partly in a less risky world, then it may be some time for risk expectations to realign and for the compensation for risk to reach levels necessary to drive further investment.

In the meantime, while expectations are realigning, what is likely to happen? Well, first of all, demand is likely to rise, increasing the return on current assets in the electricity market. Every year of investment delay is beneficial to incumbent generators as the shift in the supply-demand balance puts upward pressure on prices.

As this process continues the difference between the expected revenue stream from a new asset and the cost of building and operating such an asset also increases. At some point, the anticipated excess return provides sufficient compensation for the risk associated with building the risky asset.

It is beyond the scope of my discussion today to speculate on the best allocation of risk. However, I would make the following observations on the allocation of risk under the Government’s CPRS policy.

First, the CPRS attempts to mitigate some forward-looking risk by providing a clear framework for how society is going to meet its emission reduction targets and structured information about the likely shape of key parameters within this framework for up to 15 years. That said, as many in this room have often pointed out, 15 years is much shorter than many of the asset lives being considered. Unfortunately, over these time-horizons there is a degree of irreducible risk and uncertainty for society that must be allocated.

Second, the CPRS provides targeted assistance for assets that were committed prior to 3 June 2007, the date at which there was bi-partisan support for emissions trading. Implicitly after this date the risk is primarily allocated to the private sector, mitigated by mechanisms designed to provide some enhanced certainty over the short to medium term. There is currently some uncertainty regarding the precise timing of the application in Australia of a carbon price, or an equivalent regulatory intervention.

That said, over the expected life of electricity assets it would seem a quite reckless position to assume that there is no probability that a carbon price will be introduced over this time frame given the bipartisan emission-reduction commitments.
Finally, on the question of risk, my suspicion is that the rest of the day will be largely focussed on the question of the allocation of risk. I hope that in that discussion the fact of the change in the irreducible risk associated with climate change is not lost.
Concluding comments

In conclusion, I have attempted to step back today from the current debate to consider the longer-term issues that face the electricity sector.

The key climate-change driver for the electricity markets is the level of mitigation ambition, or put another way the extent to which the sector must be transformed from the development path it would have taken in the absence of appropriately taking account of environmental concerns.

Australia’s bipartisan emission reduction targets require substantial reductions from business as usual. The Copenhagen Accord, endorsed by both developing and developed countries, provides a critical backdrop as it implies a very high level of global mitigation commitment over the coming decades.

Mitigation ambition, and uncertainty around the extent of mitigation ambition, is a risk that society must bear. Any policy approach must recognise this societal risk and be mindful of the consequences of allocating this risk, either collectively or individually.

I hope you have found these observations useful. I am happy to take questions.

*The views expressed in this Speech are not the views of the Government or the Department of Climate Change and Energy Efficiency.

1 Commonwealth of Australia, Communications and the Arts Legislation Committee Estimates, Senate, 27th May 2010, page ECA 67, ( https://www.aph.gov.au/hansard/senate/commttee/S13008.pdf) 2 For further information see Meinshausen M., Meinshausen N., Hare W., Raper S. C. B., Frieler K., Knutti R., Frame
D. J. and Allen M. R., 2009, Greenhouse-gas emission targets for limiting global warming to 2?°C, Nature 458, page
1158-1162. 3 Commonwealth of Australia, Communications and the Arts Legislation Committee Estimates, Senate, 27th May 2010, page ECA 67, ( https://www.aph.gov.au/hansard/senate/commttee/S13008.pdf) 4 These estimates include all Kyoto gases 5 Project Catalyst (2010) Taking stock – the emission levels implied by the pledges to the Copenhagen Accord, (https://www.project-catalyst.info/images/publications/project_catalyst_taking_stock_february22_2010.pdf) 6 Stern N. and Taylor C., 2010, What do the Appendices to the Copenhagen Accord tell us about global greenhouse gas emissions and the prospects for avoiding a rise in global average temperature of more than 2°C?, Centre for Climate Change Economics and Policy, Grantham Research Institute on Climate Change and the Environment, and the United Nations Environment Programme (UNEP), (https://www.unep.org/PDF/PressReleases/Accord_targets_paper.pdf) 7 International Energy Agency, 2009. World Energy Outlook 2009 8 Chief Scientists office, 2010, How Close Are We to the Two Degree Limit?, United Nations Environment Program, (https://www.unep.org/PDF/PressReleases/temperature-briefing-21-02-10-final-e.pdf). The estimate of 38 Gt carbon dioxide has been calculated as 76% (the ratio of carbon dioxide to total greenhouse gas emissions in 2005 from the IEA, 2009 – see endnote 10) of the midpoint estimate (50 Gt) of total greenhouse gas emissions in 2020. 9 For comparison, assuming that the ratio of carbon dioxide to total greenhouse gas emissions remains at 2005 levels and linear emissions growth from 2010 to 2020 (using IEA data and UNEP projections respectively); we estimate that CO2-e emissions from 2000 to 2019 inclusive reach approximately 935 Gt of our 1500 Gt CO2-e budget. This reflects that Meinshausen et al assume that non CO2 emissions will make up one third of cumulative greenhouse gases from
Foot note: The views expressed in this Speech are not the views of the Government or the Department of Climate Change and Energy Efficiency.
12
2000-49, while the IEA estimate that CO2 emissions were 24% of total emissions in 2005 and a similar proportion in 2020.
Foot note: The views expressed in this Speech are not the views of the Government or the Department of Climate Change and Energy Efficiency.
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Compiled by Tina Perinotto

tperinotto@thefifthestate.com.au