The document is a response from the Sussex Energy Group to the EU's Green Paper on energy strategy. It discusses some of the tensions between pursuing sustainability, competitiveness, and security of supply as goals of energy policy. Specifically, it notes that sustainability and competitiveness may conflict if competitiveness is defined solely as low energy prices. It also argues that some government interventions to improve security of supply could conflict with competition objectives. However, sustainability and security may be mutually supportive if developing EU renewable resources reduces import dependence. Overall the response aims to provide a more nuanced perspective on balancing and potentially reconciling the different policy objectives.

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Sussex Energy Group, SPRU, University of Sussex
Response to EU Green Paper
“European Strategy for Sustainable, Competitive and Secure Energy”
22 September 2006
Contact:
Professor Gordon MacKerron
Sussex Energy Group
SPRU (Science and Technology Policy Research)
Freeman Centre, University of Sussex
Falmer, Brighton
BN1 9QE
Tel. 0044-1273 678166
E-mail: g.s.mackerron@sussex.ac.uk
Introduction
The Sussex Energy Group (SEG) at SPRU (Science & Technology Policy Research),
University of Sussex is a team of 15 researchers dedicated to understanding the
challenges and opportunities for transitions to a sustainable energy economy. We
undertake inter-disciplinary social science research that aims to be centrally relevant to
the needs of policy-makers and practitioners. We pursue sustainability research questions
in close interaction with a diverse group of those who will need to make the changes
happen. Core funding is provided by the UK Economic and Social Research Council.
This response draws upon research experience from past and current projects undertaken
by members of SEG.
This response to the EU Green Paper consultation is structured in two sections. The first
section discusses general considerations that we consider as critical for a future common
energy strategy. Section 2 addresses specific issues addressed in the consultation
questionnaire.
1 General Considerations
1.1 The Green Paper and Policy Trade-offs
The Green Paper raises a number of critical issues, and we welcome the Commission's
desire to address what are serious challenges facing the EU. At the most general level, the
Commission is right to stress that the heart of energy policy is how to pursue sustainable
development, competitiveness and security of supply. While the Commission has never
ignored the supply security issue (a Green Paper addressed this issue in 2000), it is clear
that the issue has added political urgency and is to some extent driving current debates.
However in practice the relationship between these different objectives (and the

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underlying assumptions and mechanisms associated with each one) may be as much
conflicting as complementary. While, for understandable political reasons, the
Commission underplays the potential trade-offs among these three objectives, we
highlight some of the difficulties and some of the possible solutions.
Sustainability and Competitiveness
The most unavoidable tension in the pursuit of the three main energy policy objectives is
between sustainability and ‘competitiveness’. The Green Paper is noticeably light in its
treatment of the dynamic between these two objectives (for example it identifies the
environmental benefit of a competitive European electricity and gas market in the narrow
terms of the closure of energy inefficient plant – page 5, para. 2.1). Yet it is clear that, to
a large extent, the Commission's view of competitiveness can be understood to mean low
energy prices. Everyone can agree that if ‘competitiveness’ is to do with overall
economic efficiency and the minimisation of costs (appropriately defined to include
environmental costs), there is no necessary conflict with sustainability. But minimising
costs is not the same thing as minimising prices to consumers. It is in fact difficult to
imagine the achievement of a low-carbon economy in the face of low consumer prices,
because – all else equal – low prices encourage relatively high energy consumption.
Sustainability objectives require a ‘mark-up’ on costs in the form of well-targeted
environmental taxes or tradable permits. It is worth recalling that, at the time of the 1986
energy price slump (when oil prices fell to $15/barrel) one of the member states which
has been most effective in shifting to a more sustainable energy policy – Denmark –
opted to increase energy taxes to ensure that the momentum of policy was not lost (IEA
energy review 1986).
Indeed the Green Paper scarcely addresses the link between tackling the environmental
consequences of energy use and the price of energy per se. The Commission, rightly
from a Europe-wide policy perspective, puts the EU Emission Trading Scheme (ETS) at
the forefront of the climate change part of the sustainability agenda (p. 10, para. 2.4). But
if the ETS is to ‘bite’ and play the central role that the Commission intends, the traded
price of carbon needs to be substantial and relatively stable – or there will be insufficient
incentive for the investing and consuming behaviour necessary (see section 2 for a more
detailed discussion). The Commission recognises this (p. 13, para. 2.4 (iii)) in saying that
CCS technology will potentially become viable in the market-place once ‘emissions
trading can make this a profitable option’. This means relatively high energy prices.
Similarly the objective of reducing energy consumption by 1% per annum between now
and 2020 is unlikely to be met without high energy prices. Research into the rebound
effect appears to suggest that, in the absence of high energy prices, the economic gains
from investments in energy efficiency are likely to translate into additional energy
consumption in other areas.
Relatively high energy prices do of course raise significant social issues – poorer private
consumers may struggle to find energy ‘affordable’ in such circumstances. This is a
challenge for both energy and social policy in the EU. It is important to protect

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vulnerable people from high energy prices. Indeed, it is surprising that the Commission
does not consider such equity issues and possible protective measures (such as the design
of regulated "lifeline" tariffs for low income energy users, or targeted investments in
energy efficiency). However it is misguided to hope that all consumers can have the sorts
of low energy prices which have underpinned high energy use lifestyles. Beyond the
realm of the household, moreover, the Commission’s concerns with price seem aimed at
protecting not the vulnerable but rather energy-intensive European businesses (p. 7, para.
(v)). There is a quite different ‘competitiveness’ agenda here, outside the energy system –
the desire that energy-intensive European industry is competitive in world markets.
But ‘competitiveness’ – within the energy system – also refers to competition. There are
issues about the Commission's underlying assumptions about market structure in the
energy sector and its implications for energy (see below). Here however we are more
concerned about the use of the Commission's powers in this area and their impact on
sustainability. As is well known the Commission has significant powers to curb collusive
behaviour amongst firms and to control the amount and nature of aid given by
governments to firms. Such powers could be a serious constraint on inter firm
cooperation or government support to the development of more sustainable energy
options. Yet, for the most part, the Commission has deployed its powers in these areas
with discretion, permitting support for energy efficiency, renewable and CHP schemes
(amongst others). It is surprising that the Green Paper does not highlight such cases as
indications that in a trade off between the goals of competition and sustainability, it is
prepared to take the long view against short term distortions.
Security of Supply and Competition
The Commission argues that security of supply is best assured by the completion of the
internal energy market. In some respects this is a reasonable argument. Market liquidity,
better physical inter-connections and so on undoubtedly help the resilience of the system
to shocks. But the Commission also rightly suggests that government action, at national
and European level, need to be intensified if security is to be enhanced. The potential
problem is that some government interventions in pursuit of security may come into
conflict with competitive market objectives - for example in protecting some
technologies for security reasons (especially renewables and potentially nuclear power).
The Commission needs to analyse in more detail the circumstances where public policy
action in favour of security may cut across competition and ‘level playing field’
objectives, and give more thought to the costs and benefits of giving greater weight either
to the security or the competition agenda. The tone of the Green Paper is to stress that
security is the new and urgent issue. If so, the Commission might give greater attention
to the extent to which this will probably cut across part of its own competition agenda.
Security of Supply and Sustainability
While it might be possible to consider cases where these two objectives come into
conflict, potentially there is a good deal of reciprocity between them. The development

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of sustainable energy resources within the EU could reduce import dependency
significantly. Interestingly the Green Paper appears to recognise this synergy between
security and sustainability in its proposal for an "overall strategic objective" balancing the
different goals of energy policy.
Moreover such a commitment would have valuable economic consequences. An example
of these benefits can be seen in the use of renewable investments to offset the adverse
effects of oil prices. Oil (and gas) price increases and volatility can dampen
macroeconomic growth by raising inflation and unemployment and by depressing the
value of financial and other assets. This so-called Oil-GDP effect has been reported in
the academic literature for a quarter of a century, although it received little attention from
the media and energy policy makers prior to the recent oil price spikes. The Oil-GDP
effect is sizeable. Our research1
suggests two important conclusions:
i. A 10 percentage-point increase of the share of renewables can help avoid GDP
losses in the EU of €28–€53 billion.2
This may be more than a one-time effect though
research has not yet shown this clearly.
ii. EREC/EWEA projected the investment levels required to attain the 20% RES-E
target in the EU15.3
Our analysis suggests that fully one-third of this investment
would be ‘sheltered’ or offset by avoided macro-economic oil-GDP losses.
Energy security is enhanced when nations hold better, usually more diverse, generating
mixes that minimize exposure to fossil volatility. Renewable energy sources provide a
joint set of benefits: they enhance energy diversity/security while they reduce overall
generating costs.4
The EU Renewable Energy Road Map should therefore include
ambitious targets for renewable energy sources by 2020. Such targets are likely to
require significant incentives if they are to be met (a point underlined by the fact that
current renewables targets in the EU are unlikely to be met in most member states). This
will necessitate both a greater degree of support from government and the continuation -
and even intensification - of a permissive competition policy regime.
1.2 Who is the Green Paper for?
While the Green Paper rightly addresses many challenges for energy policy in the EU and
does so on behalf of the EU as a whole, we are concerned that there is a tendency to give
too much weight to the interests and concerns of the major players in both energy supply
and energy consumption. This is reflected in an ambiguous attitude to questions of
1
Awerbuch, S. and R. Sauter (2006): Exploiting the Oil-GDP Effect to Support Renewables Deployment.
Energy Policy, Volume 34, Issue 17, pp. 2805-2819.
2
Based on EU25 GDP of €10,844 billion (Eurostat, Yearbook 2005).
3
EREC (European Renewable Energy Council) (2004): Renewable energy target for Europe 20% by 2020,
http://www.erec-renewables.org/documents/Berlin_2004/targets/EREC_Targets_2020_def.pdf
4
Awerbuch, S., Stirling, A. and J. Jansen, Portfolio and Diversity Analysis of Energy Technologies Using
Full-Spectrum Uncertainty Measures, in David Bodde and Karyl Leggio (Eds.) Understanding and
Managing Business Risk in the Electric Sector, Elsevier. 2006.

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competitiveness (note above) and to the conduct of "energy diplomacy" as well as in a
generally producer-led bias in the analysis overall. While the major energy utilities and
the energy intensive industries are important components of the EU economy and the
energy economy in particular an EU energy policy has to address a wider range of
concerns.
The ambiguity in the Commission's thinking is illustrated in its attitude towards the
restructuring of EU energy markets. It is clear here that the Commission is keen to see
consolidation in the energy sector, subject to the application of competition and merger
policy: as the Commission notes, ’the consolidation of the energy sector should be
market-driven’ (p. 3). In other words, the Commission recognises that there has been a
major wave of mergers and takeovers and that a relatively small number of Europe-wide
companies are emerging in the energy utility business. It rightly points to the need for a
full internal market, and freedom of consumer choice, so that the market is as structurally
competitive as possible.
But real competition also needs companies to behave competitively. If a few very large
Europe-wide companies do emerge, creating conditions of oligopoly, they may have
sufficient market power that company behaviour may not always be as competitive as the
Commission and European consumers would wish - even if the current nationally-based
obstacles to the single energy market are overcome. What then? Minimising the risk of
harm to consumers from oligopoly in the European market would, ideally, require
regulatory powers over market conduct at a European level but the Green Paper only
envisages a European regulator dealing with cross-border issues (p. 6, para. (i)) leaving
the bulk of regulation to national authorities and, ex post, the Commission's exercise of
its competition powers.
The Commission's confidence that even more consolidation in the EU energy market will
translate into a competitive market is unfortunately not borne out by experience (as the
Commission's own competition investigations seem to demonstrate). Moreover, the
longer term risk of ‘consolidation’ in terms of market power is not really addressed by
the Commission. Energy markets – particularly those associated with the traditionally
monopolistic and vertically integrated businesses of gas and electricity supply – do not
conform to text book notions of perfect competition and consumer sovereignty. Energy
markets have a reputation for anticompetitive conduct and collusion at various stages of
the supply chain and regulators have a poor record in tackling such behaviour. The
Commission’s record in restructuring the corporate landscape is mixed. The
Commission’s ambition seems to be to replace national champions with European
champions but what this means in practice is less clear. European electricity and gas
markets are indeed already dominated by a relatively small number of players. Moreover
a number of these players are already operating on a European scale and some national
markets are already populated by suppliers based in other member states. However
market conditions are at the moment very uneven and it is worth noting that the firms
with the biggest “European” presence (RWE, E.On, Vattenfall, EdF) have done so on the
basis of a very strong base in their home market (often the result of domestic
consolidation).

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The impact of EU competition policy on this consolidation has been mixed. Although
many cross border mergers have been overseen by the Commission authorities the
number of negative decisions has been very small. Of the 150 cases involving electricity
and gas only one – the EdP-GdP-ENI planned merger – has been blocked. While
conditions have been imposed in a number of other cases these have not prevented EdF,
Vattenfall, etc establishing significant market positions in other parts of Europe and such
consolidation has not generally been accompanied by clear increases in competition. It
appears that while oligopolies of the sort emerging in the energy sector can be
competitive, there are few signs of it so far in the case of the EU electricity and gas
sectors.
The risks of a bias towards producer interests are arguably strongest in the following
areas;
• Energy Technology: The Commission's emphasis on innovation is to be
welcomed but there is a risk that in both the Strategic Energy Technology Plan
and the Research budget the emphasis upon links with "high level stakeholders"
and "public private partnerships" seems to indicate that the priorities are likely to
set by the major players in the EU energy market. Of course given the wealth of
expertise and their own investment capacities such players are important but we
question whether this means they should set the agenda for future energy policy
and technology choice.
• Energy Monitoring: Similarly there is a danger that the planned strategic energy
review and mechanisms such as the energy supply observatory and centre for
energy networks will tend to reflect the interests of established players in the
energy sector. To this end the Commission needs to engage in a variety of
participatory ventures to ensure a wider range of stakeholders and perspectives.
Defining the terms of reference for such activities needs to be a broad based
exercise rather than a matter for a closed policy community.
• Energy Diplomacy: Here perhaps is where the risks of promoting the interests of
European companies are greatest. While it is clearly important that the EU
maintains a strong diplomatic presence in international energy matters – and
where there are good reasons for supposing that an EU role rather than disparate
national roles might be most appropriate – the nature of that engagement needs to
be handled carefully. The emphasis in the Green Paper on opening energy
markets in terms of investment and access seems, in the wider tradition of EU
trade policy, more designed for corporate Europe than for the citizens of either the
EU or the host countries. Similarly the emphasis on using energy for
development is to be welcomed if it is geared towards development rather than
investment opportunities (e.g. from imposing conditions of privatisation on local
markets). Experience in Latin America, Russia and North Africa suggests that
pushing for investment access can be counterproductive, triggering a backlash
resulting from one-sided contractual terms, sometimes poor performance or other
shortcomings.

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1.3 Where should Energy Policy be conducted?
While the Green Paper makes reference to the need to balance out EU activities with
those of national and subnational energy policy making, the exact allocation of tasks is
left unclear. At first glance however the assumption of the Paper is that a very significant
range of energy policy tasks need to be carried out at the European level. A more
realistic approach might have been explicitly to apply the principle of subsidiarity to the
conduct of energy policy. Originally intended to encourage the design and
implementation of policy at the level closest to the citizen, subsidiarity is too often
interpreted as justifying the scaling up of policy to the EU level. While the Green Paper
does not make direct reference to the principle per se, its ambitions suggest a rather top
down reading of subsidiarity.
There is no doubt that some aspects of the EU's energy problems are best addressed at the
EU level - there may be economies of scale and coordination in regulating energy
markets, reconciling conflicting objectives, in conducting energy diplomacy with major
exporting nations or in negotiating global instruments to tackle climate change. Equally
however there may be important aspects of managing energy supply and demand which
are better tackled at the national or the local level. Given the importance of action at the
community (i.e. local) level to address and decide upon the sustainable use of energy -
and given the opportunities to foster and learn from diversity that a more decentralised
approach implies – it is surprising that more emphasis is not given to this dimension in
the Paper. (It is all the more surprising since the Commission has to some extent been a
pioneer in encouraging the development of energy planning activities at the subnational
level, acting as a facilitator (through funding) and spreading good practice.) Instead the
emphasis in the Paper appears to be towards broader Pan European initiatives. This is
particularly apparent in the discussions on European networks where the emphasis on
Europe wide grids seems unrelated to the implications for networks of the envisaged
increase in renewable energy supply.
1.4 Security of Supply and Energy Imports
A central assumption of the Green Paper is that the EU’s increasing dependence on
energy imports constitutes a major energy policy challenge. Most analyses agree that this
dependence is likely to increase from around 50% at present to around 70% by 2020. To
understand whether or not this presents a major problem for the EU it is necessary to look
more closely at the nature of the “energy gap” which appears to be emerging, that is the
difference between EU energy demand and EU origin energy supply, as domestic energy
production peaks and falls away and is replaced by net imports. This ‘gap’ is often
expressed in terms of energy security and much of it is unnecessarily alarmist – most
industrialised countries are net energy importers and have been for a long time. While
imports raise some specific risks they are not likely to be unmanageable. Such ‘gap
scares’ have been a feature of energy debates since at least the Second World War and
they were a major part of the energy debate of the late 1970s. Over this period, they have
been associated with a limited and unhelpful ‘predict and provide’ approach to energy

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policy. There seem no good grounds for supposing that the ‘gap’ currently perceived is
qualitatively much more potentially serious than earlier gaps.
Perhaps surprisingly, security of energy supply has not received much robust analytical
attention either in the academic or policy community. It has many dimensions, including
timescale, various sources of insecurity and then some wider dimensions of security as
well as the various consequences of different kinds of security failure. Although it is a
vitally important issue, fears about insecurity in supply are often promoted by those with
a particular vested interest, often in a supply technology or fuel whose costs are too high
for the private market to support. Much of the current security debate is narrowly framed,
often in an unduly alarmist way, around the single issue of ‘dependence’ on foreign gas
supply. Some risks to security may come from such dependence but there is a wide range
of other risks – especially in relation to all kinds of infrastructure, domestic as well as
overseas – that need to be managed.
All else equal, a diversity of supply sources will lead to greater security, not less.
Moreover trade, normally a major objective of economic policy, usually benefits both
parties, rather than one. Policy still needs to pay attention to the security of individual
supply sources, and heavy reliance on one distant source of natural gas will probably
increase insecurity. Much publicity has surrounded the potential threat to the EU’s
security of supply posed by dependence on Russia as a significant source of gas imports.
Increased imports do raise new security questions but effective responses are likely to be
available. Potential problems of energy insecurity need to be analysed across all possible
sources and need an empirical answer, not pre-judgement. The best response to
potentially raised levels of insecurity due to rising imports is to address the risks where
they may arise – in the gas market itself, rather than following the distinctly second-best
option, often advocated, of artificially expanding alternative domestic supply sources.
This will undoubtedly include the use of Europe-wide diplomacy and broad negotiation
with countries such as Russia – but our concern is that this single dimension of potential
insecurity distracts attention from other sources of future insecurity – especially those
related to European energy infrastructures, including terrorist threats.
2 Specific Issues
Rather than address all the issues raised in the questionnaire (many of which we have
alluded to in our general comments on the Paper in section 1), the rest of this submission
focuses on some key components of the Green Paper agenda.
A. Competitiveness and the internal energy market
2. In order to develop a single European grid, what should a "European Grid Code"
contain? (optional)
The Green Paper tends to address energy infrastructure issues in terms of the current
networks. The associated recommendations regarding the conditions of access are

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entirely understandable in that context. However by focusing on the established physical
and policy structures there is a risk that the Green Paper may have focused on the pan
European level, overlooking the need for reconfiguring networks for a more decentralized
energy economy.
More integrated European power grids have to overcome a network system that was built
around dispatchable, fossil-fired central station generation.5
Instead of fitting the
variable6
output of wind and other energy sources into the existing system, a new grid
system based on 21st century needs and technologies should be developed. This will
require new approaches, including different system architecture and protocols and
powerful parallel information networks to manage electricity grids in a decentralised,
market-responsive manner.
These changes involve adopting mass-customization concepts from manufacturing and
moving decision making to loads, which have better information about their hour-to-hour
requirements than a central dispatcher. At any moment, the system’s total load consists
of thousands of transactions, each with a different value. Electricity to power water
pumping or heating does not have the same value as electricity required for microchip
processing.7
Adapting to these realities will yield a more efficient, more market-oriented
production-delivery paradigm under which the network operator becomes the electricity
market enabler. The traditional transportation function of the network becomes obsolete
in an environment characterized by a large number of distributed resources.
Today’s network is based on outmoded mass-production concepts. Electricity mass
customization will allow users to take power in the forms that best match their various
applications. Implementing these ideas requires new strategies for regulating network
system operators, who hold a key position in an electricity system that has been partially
deregulated in the belief that markets, not regulation, produce the greatest efficiency.8
Yet the system operator continues as a monopoly entity with no incentives to create new
market-driven products or to diversify the mix to broaden consumer access to
competitively priced supply markets that include traditional generation along with wind
and other renewables.
5
This section is based on: S. Awerbuch (March, 2004), “Restructuring Our Electricity Networks to
Promote Decarbonization: Decentralization, Mass-Customization and Intermittent Renewables in the 21st
Century,” Tyndall Centre Working Paper No. 49;
www.tyndall.ac.uk/publications/working_papers/wp49.pdf; Awerbuch, S. (July-August, 2004),
Restructuring Electricity Networks: decentralization, mass-customization and intermittency, Cogeneration
and On-Site Power Production.
6
“The widely used intermittency concept is misleading. Wind blows a high percentage of the year, at least
at better sites, although its force varies so that output is variable. There are very few fully calm days
implying that variable-output is a better concept.” (S. Awerbuch, “Output Variability as an Issue
Surrounding the Integration of Wind in Ireland,” Sep 2005. www.awerbuch.com
7
Ibid.
8
Awerbuch, S., Hyman, L. S. and Vesey, A. (1999), Unlocking the Benefits of Restructuring: A Blueprint
for Transmission, Vienna, VA: PUR, Inc., Chapter 3.

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New European grid regulation provides opportunities to create effective electricity
markets that promote economic efficiency and sustainability. Attaining such outcomes
within a new regulatory framework requires that we conceive of transmission operators—
the essential facilitators of energy markets— as more than caretakers of the wires with no
incentive to enhance overall system performance.
3. Apart from ensuring a properly functioning market, how can the EU stimulate
investments in infrastructure and generation capacity? (optional)
4. How can it be ensured that all Europeans enjoy access to energy at reasonable prices?
(optional)
Energy policy that aims to achieve lowest costs needs to consider risks related to the
electricity generation portfolio. This must be reflected in the analytical tools used for the
formulation of future European energy policies and would contribute to a ‘proper
economic analysis of different policy options and their impacts on energy prices’ (Green
Paper, p. 7).
For a sound economic appraisal of any technology (e.g. nuclear or renewable energy) it is
impossible to reach a definitive and reliable answer on the basis of ‘engineering’ or
construction costs alone; any technology’s overall costs will depend on many other
factors within the overall energy system. Energy generation technologies should be
assessed in their context (or portfolio) including technology specific risk (e.g. variations
in fuel costs). This is particularly true for new and unproven technologies.9
As a consequence, we suggest that the relevant parts of electricity policy should be based
on modern portfolio theory concepts, which reflect the cost as well as the risk
contribution a given generating technology makes to the generating mix of a given
country or region. Financial investors routinely use portfolio optimization techniques to
value stocks and other additions to their holdings. Applying these techniques to energy
generation portfolio consistently shows that when added to a conventional generating
mix, wind and other fixed-cost renewables serve to lower overall generating costs. This
outcome, which is predicted by finance theory, holds even if it is assumed that the stand-
alone costs of wind exceed those of gas. This so-called portfolio effect10
, holds even if
wind costs more on a stand-alone basis. Wind’s generating costs are uncorrelated to
fossil costs which means that it diversifies the mix and reduces expected overall cost and
risk the same way diversification improves the expected performance of financial
portfolios.
A standard risk-adjusted approach based on the Capital Asset Pricing Model CAPM
suggests consistently through periods of both low and high fossil prices that gas
generation costs more than wind and other renewables. This is in stark contrast to the
9
This section based on: Awerbuch, S. (May, 2006) “Portfolio-Based Electricity Generation Planning:
Policy Implications for Renewables and Energy Security,” Mitigation and Adaptation Strategies for Global
Change, Volume 11, Number 3 (May); S. Awerbuch, “Risky Business: Fossil Risk mitigation and
enhanced energy security from renewables ,” Renewable Energy World, July-Aug 2006.
10
E.g. Brealey, R. and Myers, S. (2003) Principles of Corporate Finance, McGrawHill (any edition)

11. 11
results produced by national and multinational agencies. CAPM-based models tell us
that over the next 25 years the expected cost of gas-fired generation is at least 75% higher
than widely cited engineering-based estimates and well in excess of the CAPM-based
cost of wind. The CAPM kWh cost estimates use the same set of projected fuel and other
input costs, but have a precise economic interpretation: they provide a conservative proxy
of the firm, 25-30 year fixed-price offers investors would submit for producing electricity
in efficient markets.
Investors in gas generation do not worry as much about the risk of fluctuating gas prices
since these are more readily passed on to customers, potentially leading to more
investment in gas generation than may be optimal from a societal perspective. This is
where policymakers need to step in on behalf of consumers. They need to recognize that
today’s fossil generation investments create risk by way of long-term consumer
obligations to purchase electricity generated with highly speculative fossil commodities.
This risk is reflected when energy companies justify final energy price increase with
increased purchase cost for primary energy sources. Traditional cost estimates for gas–
(and coal–) fired electricity do not reflect the speculative nature of these fuels.
Energy planners need to learn from financial investors, who are used to dealing with risk.
It matters little that gas might appear to be the lowest cost alternative (on the basis of
conventional costing models). Even if correct today, that picture could change
dramatically, suggesting that electricity planning and energy policy making in general
must abandon its fixation with identifying alternatives with the lowest stand-alone cost
and focus instead on trying to develop optimal generating portfolios and strategies.
High system integration costs for renewable energy sources – particularly wind – that are
put forward as argument against an increased share of variable renewable energy sources
are misleading and do not recognize progress in new network technologies. Wind is
perceived as a direct substitute for dispatchable fossil technologies, which it is not.
Efficiently integrating wind and other new, passive, variable-output renewables will
ultimately require fundamental changes in our current electricity production-delivery
paradigms. Technically the grid system plays a central role in such a step change (see
discussion above on European grid integration).
D. Sustainable development
9. How can a common European energy strategy best address climate change, balancing
the objectives of environmental protection, competitiveness and security of supply?
(optional)
A common European energy strategy can make use of a variety of policy initiatives and
policy instruments to address climate change. Possible initiatives include the adoption of
national targets for renewable energy or energy efficiency, while possible instruments
include tax incentives and market based regulations such as the EU ETS. Multiple
objectives create a need for multiple instruments, but also the risk that the resulting

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policy-mix may be incoherent.11
Moreover, each initiative/instrument needs to strike a
balance between harmonisation and subsidiarity, and the appropriate balance may vary
from one initiative/instrument to another (see also discussion above). The EU ETS is a
rare example of an EU-wide policy instrument in which a considerable degree of
harmonisation has been achieved – but where further harmonisation is required. It is also
of critical importance to the European and global strategy for tackling climate change,
since it covers some 45% of EU CO2 emissions, is expected to cover a larger proportion
of total emissions after 2008 and is at the centre of the global carbon market. The
following discusses carbon pricing and the EU ETS in more detail.12
We consider that carbon pricing is a necessary but not sufficient condition for a transition
to a low carbon economy. The theoretical benefits of carbon pricing include minimising
the overall cost of environmental improvement, ensuring users pay the full cost of
resource use and providing a continuous incentive for technological innovation. These
theoretical predictions are increasingly borne out by real-world experience. However,
carbon pricing may not fully address distributional objectives and may not adequately
overcome other market failures, such as those inhibiting technological innovation. This
creates a need for additional policy measures in parallel with carbon pricing –notably to
facilitate and encourage the complex processes of technological change.13
Carbon pricing can either be implemented via taxes or a cap and trade system such as the
EU ETS. Cap and trade schemes have the advantage of complying with the framework
for international emissions trading established by the Kyoto Protocol and provide
considerable scope for achieving additional cost savings through links with other
regional, national and international trading schemes. While a range of other
considerations are also relevant, our view is that cap and trade schemes provide the most
appropriate framework for carbon pricing for the longer term. We agree with the
Commission that ‘The full review of the EU Emissions Trading Scheme gives an
opportunity for expanding and further improving the functioning of the scheme’ (p. 10,
para. 2.4). We therefore suggest some improvements to the EU ETS to increase its
efficiency and effectiveness.
The Achilles Heel of the current EU ETS is the devolution of target setting to individual
Member States and the resulting adoption of weak targets. For example, Grubb et al14
conclude that the aggregate (EU-wide) cap represents an increase of between 3% and 9%
over average historical emissions for the period 1998-2002, and a reduction of only 1%
from the (probably inflated) business-as-usual projections. For comparison, a linear
11
Sorrell, S., (2003), 'The Climate Confusion: Implications of the EU Emissions Trading Directive for the
UK Climate Change Levy and Climate Change Agreements', SPRU (Science and Technology Policy
Research, University of Sussex, Brighton
12
For more details see: Sussex Energy Group’s response to the UK Government’s 2006 Energy Review, 14
April, 2006, Annex 2: Detailed analysis of carbon pricing, pp. 59-72,
http://www.sussex.ac.uk/sussexenergygroup/documents/seg_energy_review_response.pdf
13
Grubb, M. J. (2005). ‘Technology innovation and climate change policy: an overview of issues and
options.’
14
Grubb, M., C. Azar, and U. M. Persson, (2005), 'Allowance allocation in the European emissions trading
system: a commentary', Climate Policy, 5, 127-36

13. 13
trajectory for achieving the EU Kyoto target would require total emissions from these
sectors to be reduced by 3% below 1998-2002 levels by 2006. Moreover, since abatement
costs for most EU ETS sectors are significantly lower than for other sectors (e.g.
transport), the proportional contribution of these sectors to the Kyoto targets should be
correspondingly higher. Weak caps (and low carbon prices) delay the technical and
structural change required for industry to move to a lower carbon economy and create the
risk that substantial and rapid emission reductions will be needed in the future that can
only be achieved at much higher cost. It also increases the overall cost to the EU of
meeting the Kyoto targets by requiring greater emission reductions from high cost sectors
outside the EU ETS. Furthermore, it makes the EU as a whole more reliant upon the
Kyoto mechanisms for achieving compliance with the additional cost of ERU/CER/AAU
purchases being largely borne by taxpayers.
It is essential therefore, that future caps are substantially below total projected ‘business
as usual’ emissions and provide real cuts for all sectors. There needs to be a movement
away from the use of emission projections in setting aggregate caps and towards the use
of benchmarking and other approaches, including a greater degree of harmonisation of
the EU level.
Weak caps result from concessions to industrial lobbying on the potential impact of the
EU ETS on industrial competitiveness - leading to a ‘race to the bottom’. But these
lobbying claims are often overstated and lack a sound analytical basis.15
Only a small
number of sectors (i.e. those that are both very energy intensive and heavily exposed to
international competition) appear likely to suffer as a result of Phase 1 of the scheme and
the use of freely allocated allowances means that many sectors will benefit.16
For
example, UK electricity generators’ profits are estimated to have increased by up to £1
billion/year during Phase 1.17
Meanwhile, vulnerable industrial and domestic consumers
are suffering higher electricity prices than necessary with little prospect of compensation
because freely allocated allowances do not raise any revenue.
The economic case for allowance auctioning (with the revenues used to reduce the
marginal rate of income and business taxes) is overwhelming. As an illustration, Smith
and Ross (2002) used a Computable General Equilibrium model of the US economy to
show that the economic costs of an upstream trading scheme were 80% higher with free
allocation than with auctioning.18
Similarly, Bovenberg and Goulder (2000) showed that
in an upstream trading scheme only a small fraction (less than 15%) of the auction
revenues need to be sacrificed to fully compensate the most vulnerable firms from
adverse impacts on their competitiveness – leaving the remainder to be used to meet
15
Carbon Trust, (2006), 'Allocation and competitiveness in the EU Emissions Trading System: Options for
Phase II and beyond', The Carbon Trust, London.
16
Carbon Trust (2005). The European emissions trading scheme: implications for industrial
competitiveness. London, Carbon Trust.
17
ILEX (2003). Implications of the EU ETS for the power sector. Oxford, ILEX Energy Consulting.
18
Smith, A. E. and M. T. Ross (2002). Allowance allocation: who wins and loses under a carbon dioxide
control program? Washington, Centre for Clean Air Policy.

14. 14
distributional objectives.19
While the required proportion may be somewhat greater in a
downstream trading scheme such as the EU ETS, the general conclusion is unchanged.
Hence, it is very unfortunate that the EU ETS only allows a maximum of 15% of the
allowances to be auctioned during Phases 1 and 2 and devolves the choice to do so to
each Member State – with the result that individual Member States are reluctant to use
auctioning if others do not. As a consequence, in Phase 3 of the scheme the Commission
should seek to ensure the greatest possible use of allowance auctioning, harmonised
between Member States to avoid any distortions. The impacts on competitiveness for
particular sectors could potentially be mitigated through additional measures, such as
border tax adjustments on imported and exported products.20
The critical importance of the EU ETS cap becomes even more apparent when its
implications for other policies and measures are considered. What is especially relevant
here are the implications of the cap for those policies and measures that directly or
indirectly affect the emissions of EU ETS participants. This includes, for example, any
policies that affect electricity demand or the carbon intensity of electricity production –
such as the promotion of renewable electricity. As Sorrell and Sijm21
have argued, the
coexistence of the EU ETS with such policies implies that the latter will contribute
nothing to global CO2 reductions during the EU ETS Phase in which they are introduced.
They only contribute to global CO2 reductions during subsequent EU ETS Phases if they
lead to a corresponding increase in the stringency of the EU ETS cap.
So, for example, the promotion of renewable electricity will have zero impact on global
carbon emissions unless and until such policies lead to a corresponding tightening of the
EU ETS cap. Without this, allowances will simply be displaced from one emitter to
another. This important point is often overlooked, but serves to underline the critical
importance of the aggregate EU ETS cap.
Overall, effective carbon pricing needs to be economy-wide, increasing over time, long
term and sufficiently predictable and credible to encourage private sector firms to invest.
Current lifetimes of 5-6 years for EU ETS caps determined by European and international
institutional arrangements may be too short to provide enough long-term security for new
investments. The Commission should therefore consider how greater long-term
predictability can be achieved within the EU ETS cap-setting process.
More generally, a common European energy strategy should explore how cap and trade
schemes can be extended to cover all sectors of the economy. For example, the
downstream EU ETS could potentially combined with an upstream scheme that covered
suppliers of coal, oil and gas to the European economy. These companies would need to
19
Bovenberg, A. L. and L. H. Goulder (2000). Neutralising the adverse the industry impacts of CO2
abatement policies: what does it cost? Behavioural and distributional impacts of environmental policies. C.
Carroro and G. Metcalf. Chicago, University of Chicago Press.
20
Carbon Trust, (2006), 'Allocation and competitiveness in the EU Emissions Trading System: Options for
Phase II and beyond', The Carbon Trust, London.
21
Sorrell, S. and J. Sijm, (2003), 'Carbon trading in the policy mix', Oxford Review of Economic Policy,
19(3), 420-37.

15. 15
surrender an allowance for each tonne of carbon contained in the fuel sold to eligible
customers, and would pass these allowance prices on in fuel prices. The incentive effect
for downstream consumers would be akin to a carbon tax.
To avoid double regulation and double counting, such a ‘hybrid’ system would need to
ensure that the fuel purchased by EU ETS participants did not include the price of carbon
allowances in the upstream trading scheme. This would require a ‘paper trail’ to be
established to track fossil fuel sales along the supply chain, via wholesalers and
intermediaries to final consumption. Upstream producers would require allowances for
all the fuel sold, unless they could demonstrate that a participant in the EU ETS
ultimately consumed the fuel.
The EU could introduce an upstream scheme in parallel with the EU ETS to create a
hybrid that covered the majority of CO2 emissions from the EU economy. This could
accommodate the expansion of the EU ETS in Phase 2 and beyond by simply modifying
the accounting system for fuel sales (i.e. extending the exemptions) and adjusting the cap
in the upstream scheme. Similarly, non-CO2 GHG emissions could be included in the
overall scheme by expanding the downstream EU ETS. Such a scheme would represent a
more radical departure than the existing EU ETS and may take some years to establish.
However, the scale of the threat posed by climate change demands that such radical
approaches be given serious consideration.