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Impact of CO2 quota allocation to new entrants in the electricity market 2 MethodologyThis project examines the consequences of allocating CO2 allowances to new entrants under the EU emissions trading scheme (EU ETS). The EU ETS includes all major energy producing units and the majority of the energy intensive industry, including among others cement and steel factories. However, in this study focus is confined to the power and district heating sector. Four hypotheses are examined in the project, namely that allocations to new entrants will: 1) Move investments from renewable energy plants and gas power toward coal power plants (thus increasing CO2 emissions and thereby the demand to buy quotas from other sectors or through the flexible mechanisms of the Kyoto-protocol) 2) Move investments to the countries with the most generous allocation principles (which may erode the security of the power supply in other countries) 3) Move investments in time (the allocation works as an investment subsidy which in a liberalised market is likely to move investments forward in time) 4) Lead to a welfare-economic loss for society because investments in the power and heat sector are skewed away from the optimum (the size of this loss is estimated in the project). This report is structured in four main chapters. First (chapter 3), the basics of the EU emissions trading scheme are described, including the theoretical arguments for applying emissions trading as an economic incentive. The chapter also accounts for the approaches used for allocating quotas to new plants in selected North European EU member states. Secondly (chapter 4), the electricity market is analysed in detail. What are the principles for dispatching power plants in electricity markets and what conditions and criteria are important for investments in new power plants? Our focus is on the market based investment decisions. These issues are important because CO2-allocation to new entrants is effectively an investment subsidy and therefore will become an integrated part of investment decisions. It is examined how free allocation to new entrants can in principle affect technology choice, location of new plants and timing of investments. These circumstances are illustrated by the use of comprehensive explanations and graphs demonstrating the competitiveness of different technologies w/without allocation. To show the consequences of allocation in more detail model analyses are carried out examining future investments the German and Nordic electricity and heat markets (chapter 5). The calculations are made using Balmorel (See www.balmorel.com and appendix A), which is an economic partial equilibrium model which includes detailed information of power/heat plants and electricity transmission system in the affected countries. With the model it is possible to determine how investments and production patterns will develop depending on the allocation conditions for new plants. Two basis simulations are compared: a simulation with allocation to new entrants and a simulation without new entrant allocation. In addition sensitivity analyses are made examining: - Economic consequences of different CO2-price levels - Economic consequences of a lower discount rate - Impacts of combining the CO2-emissions trading scheme with renewable energy targets - Impacts on the CO2-price level when emissions are capped and consequent economic consequences The results from the model provide an overview of investments in different technologies, fuel use, CO2-emissions and generating costs. By comparing the costs and prices in the different simulations it is possible to estimate the welfare-economic loss of allocating quotas to new entrants. The more detailed modelling assumptions are accounted for in Appendix A.
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