European Infrastructure Finance Yearbook - Investing In Bonds ...

UTILITIES
34 ■ NOVEMBER 2007
their respective governments’ national allocation
plans (NAPs). These plans are vetted and
approved by the EU. Allowances for Phase 1 are
already known, while Phase 2 allowances are
currently being finalized. Even though a generator
will have received free allowances to cover its
carbon emissions, it will still price emission costs
as if it had purchased the allowances from the
market, leading to higher wholesale prices. For
many generators, these higher wholesale prices
drop directly to the bottom line as windfall
profits, either because the allowance was never
purchased or because the generator (nuclear and
hydro plants, for example) does not emit
greenhouse gases. Companies currently benefiting
from windfall profits are those operating in the
U.K., German, and Nordic electricity markets,
and include E.ON AG (AA-/Watch Neg/A-1+),
RWE AG (A+/Negative/A-1), EnBW Energie
Baden-Wuerttemberg AG (A-/Stable/A-2),
Vattenfall AB (A-/Stable/A-2), Scottish and
Southern Energy PLC (A+/Stable/A-1), Scottish
Power PLC (A-/Watch Neg/A-2), and EDF Energy
PLC (A/Stable/A-1).
Approved NAPs indicate a tighter market in
Phase 2 of the ETS
The European Commission has now decided on
the first 20 national plans for allocating CO2
emission allowances to energy-intensive industrial
plants and the power sector for Phase 2 of the
ETS (see table on next page). Seventeen of the 20
member states were told to reduce proposed
allowances by almost 12.5% on average, while
allowances for the U.K., France, and Slovenia
were approved as presented (the adjustment to
Spain’s proposed cap was negligible). To date, the
overall cap allowed by the EU for Phase 2 is
about 9% lower than the cap allowed for Phase 1.
It is likely the electricity generation companies
will take a significant share of this tightening
through a lower allocation of free allowances in
Phase 2. From an equity standpoint, the electricity
generation companies may be best positioned to
absorb a lower level of allowances given that they
benefit from higher CO2-induced power prices
while industrial and residential power users bear
the cost.
The tightening in Phase 2 could lead to stronger
CO2 and power prices, albeit that the precise
impact and direction for prices depends on a large
number of other factors such as the generation
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
mix, oil and gas prices, and demand. This
highlights the EU’s continuing commitment to
cutting greenhouse gas emissions, and to meeting
targets under the Kyoto Protocol.
Windfall profits will diminish as free allowances
go down
Under Phase 1 of the ETS, free allowances
covered a very significant share of generators’
actual and forecast CO2 emissions. Despite an
expected reduction of free allowances granted to
generators in Phase 2, we expect the windfall
profits generated in liberalized energy markets-such
as the U.K., Germany, and the Nordic
market--to continue, albeit to a lesser extent,
reflecting a pricing strategy based on the marginal
cost of generation (i.e. including emissions costs).
The windfall benefit remains controversial
because it applies not only to nonemitting
facilities but to all--including coal plants, which
emit the most GHGs. Many industrial end users
have voiced their discontent. They maintain that
while end users suffer from the higher cost of
electricity due to the cost of CO2 emissions, the
electricity generators--those actually releasing
much of the CO2--are gaining incremental profits.
As a result, Standard & Poor’s expects that the
level of free emission allowances granted to fossil
fuel-fired generators may continue to go down in
future phases of the ETS (2012 and beyond).
These generators will therefore either have to buy
a greater proportion of their carbon allowances in
the market or actually reduce CO2 emissions.
They could cut their carbon output by switching
generation from coal-fired to less CO2-intensive
gas-fired generation, improving the efficiency of
their coal plants, or by using carbon capture and
sequestration (CCS) storage technology.
Climate Change Policies Present
Investment Challenges
In addition to its focus on slowing climate change,
the EU is also trying to increase competition in
the power sector and to reduce dependence on
imported gas, two goals that it believes are
compatible. EU climate change and market
liberalization policies have to date favored gas
and--to a much lesser extent--wind power in the
generation mix at the expense of coal, as wind
and gas are cleaner than coal and it takes less
time to build a gas plant than it does to build a
coal plant, an important factor in liberalized