Europe faces [euro]500 million power charge.

New legislation from Brussels has prompted fears of a huge hike in energy costs for the region's mills. If you're an avid trader of energy futures on the European markets, then you know that prices took a sharp blip upwards after the European Commission passed new environmental regulations last year. The EU Emissions Trading Scheme (ETS), which was accepted by the Council of Ministers and the European Parliament in July 2003, is essentially a tool for European regulators to offer a financial incentive for Euro zone consumers to reduce their C[O.sub.2] emissions (so-called greenhouse gases) and thereby help the community to meet its environmental obligations under the Kyoto protocol (the international agreement to reduce greenhouse gases).

As both forest owner and major energy user, the paper industry obviously plays a role in C[O.sub.2] production and conservation, so the initiative generated some interest. Comments and technical issues were taken on board during the consultation phase of the legislation and the new scheme was passed into law for implementation in 2005. Yes, it added extra bureaucracy and some extra costs for paper companies, but nothing too serious.

Or so, they thought.

The problem: now that the industry has had a chance to assess the potential implications of the new rules, it realizes why the futures traders on the energy markets were so interested in the introduction of ETS.

The new rules will inevitably mean some direct costs for paper producers. But according to estimates from Cepi (the Confederation of European Paper Industries), ETS could also saddle European paper companies with huge indirect costs and leave them looking down the wrong end of a [euro]500 million addition to their annual power bills ETS could even re-shape global trade flows as cheaper imports flood into Europe. On top of that, the environmental benefits may even turn out to be negligible.

MARGINAL COSTS 

The root of the industry's woes lies in the area of "marginal cost." For those of you who fell asleep during your economics class that day, marginal cost is the cost of making "one more" of something. As you can see from Figure 1, the Nordic energy market (Nordpool) boasts a little bit of wind power, a chunk of cheap hydro power, combined heat and power (CHP), nuclear power, district CHP plants, up through the power production cost-curve into oil/coal and finally, natural gas--the most expensive energy source.

Since the rules of economics usually mean that the "market price" (in this case, of energy) is the "marginal cost" of producing the little bit that offers enough to satisfy current demand, you would expect the market price to hover around the right hand side of the diagram as demand fluctuated. It also tends toward the highest cost when peak demand uses the highest capacity.

In the Nordic region, that last and most expensive part of the production cost base--oil/coal and gas--is also the part that will come under the new ETS rules and be subject to emissions charges. Under the marginal cost pricing mechanism that applies in the European energy market, this means the "market price" of energy will go up by the extra cost incurred by the ETS. The thing is, the energy producers won't pay emissions charges on the wind, hydro, CHP, or nuclear power generated by their business. The power companies only pay that on the oil/coal and gas parts of their business that generate significant C[O.sub.2] emissions. As a result, the market price rises for large consumers and the power companies gain their windfall profit stream--up to [euro]2.7 billion in the Nordic region alone, according to Cepi figures.

FIGHTING BACK

Europe's largest paper producer, Stora Enso, is now among those working through Cepi and in concert with other energy-intensive industries such as glass, cement, iron and steel to try and mitigate the effects of this worstcase scenario.

Stora Enso's vice president for corporate affairs management, Frank Brannvoll, takes up the story. "We made an assessment of the implications when we knew the shape of the final legislation. At that stage, we thought that the direct costs seemed acceptable--after all, we know we all have to play our part in meeting the Kyoto objectives. But it was when we came later to look at the indirect costs that we were really surprised. We found that instead of a small increase, we could actually see rises of anywhere between 15-40% and this was not based on the real cost but based on the constraints of the pricing mechanism. Basically, the utilities would be using emissions trading as an excuse to make a windfall profit. In fact, the phrase 'windfall profit' comes from a report written by one of the power companies, so I think we're right to be concerned."

Cepi calculates that approximately 0.7 metric tons of C[O.sub.2] is released for each MWh of electricity generated by fossil fuel. Taking a price of [euro]10/metric ton of C[O.sub.2] generated in the trading market, the marginal cost increase comes in at [euro]7/MWh--the figure that the power companies would like to charge under the new scheme.

However, in the first phase of the emissions trading scheme (ETS), 90% will be given in free allowances. In addition, only 20% of Nordic power is fossil fuel based, so the "true" cost of the emission trading charge should be around [euro]0.14/MWh--quite a way off the [euro]7/MWh that appears on the marginal cost.

A similar calculation for the German market (Figure 2) puts the "true" cost at around [euro]0.42/MWh, since Germany generates electricity with more fossil fuels. Finally, an average price between the markets is about [euro]0.25/MWh.

As Brannvoll explained, "The true cost of the rise is really only about [euro]0.25/MWh and we will accept that if they pass that along to us as the cost. The problem is that they want to pass on the [euro]7/MWh. Of course we want to do our share for the environment, but if the energy producers are also going to add on [euro]7/MWh for hydro and nuclear power as they would under the current marginal price setting regime, that represents a massive money transfer from the industrial manufacturing sector to the power companies."

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So somewhat perversely, ETS actually creates an incentive for power companies to keep the top end of their capacity dedicated to fossil fuels as it will help maintain this windfall profit within the marginal cost pricing mechanism.

PLAIN LANGUAGE

Even if you haven't kept up with all the economics jargon or the vagaries of marginal cost, 90% allowances and C[O.sub.2] releases/MWh, Brannvoll puts the problem in terms anyone can appreciate. "We calculated that it comes out to a cost increase of around [euro]18/metric ton of newsprint for one of our northern mills, whereas the price for our own emissions plus the real cost of the power emissions should be [euro]0.50. Of course, the price increase from the emissions trading scheme follows through the cost chain until it gets to an area where international competition means it can't be pushed down further and that means us in this case. Let's face it, [euro]18/metric ton is a lot of our marginal profit on newsprint. And we're not even the worst off. In the cement sector it's a question of being in business or not as energy is about half of their product cost."

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In terms of economic power, the energy companies appear to have the upper hand on this one. First, they do not directly add the [euro]7/MWh--the market pricing mechanism does that for them. Second, anyone with a power hungry mill looking to switch suppliers in Europe is going to be hard-pressed to find a suitable alternative since the Nordic region, Germany, France and the UK tend to operate as distinct generating regions with few practical possibilities of getting power from outside any given area.

As Brannvoll said, "In Europe, there are distinct regional electricity markets in the Nordic area, Germany, France and the UK. They are far from being connected markets in any real sense and even the International Energy Agency has said that there is a lack of competition. The biggest producers tend to dominate and control their own markets because of the consolidation that has been taking place. There's no international competition, so really I become a price taker at Stora Enso."

And that is why the big utilities players are looking forward to a long run of nice "windfall profits" on the back of the scheme.

SOLUTIONS SEARCH

Cepi and the big paper companies have already started lobbying hard in an effort to find some solutions to this particular issue. Member states with responsibility for setting up the ETS are being asked to ensure transparency in the process so that emissions prices are not simply bundled in with production costs on the bill. Trading emissions and trading energy should be kept separate, they argue.

On top of that, many of the bigger groups, including Stora Enso, are in talks with their power companies to ensure that the utilities groups know that they will not take such increases lying down. Brannvoll pointed out that "the power companies could win in the short term, but in the long term it's their problem just as much as it is ours if we have to shut mills or stop producing certain grades and they don't have a customer."

The key issue remains global competitiveness for all the big producers. "We can't push the cost down to our customers because they have the choice of importing, which we don't have with our energy costs," Brannvoll explained. "According to our people, it costs about [euro]21/metric ton in transport costs to import paper from the United States. If we are then obliged to pay for our own emission costs at the mill and then a further [euro]18/metric ton on top of that in extra energy costs, it's definitely going to have an impact on trade flows in the industry."

With a weaker dollar also making exports attractive, it all might turn out to be good news for papermakers on the other side of the Atlantic. But it is clear that now Europe's big energy consumers have identified the potential danger in the new legislation. They are going to fight hard to ensure that the emissions trading scheme is operated in a fair and transparent manner.

It is now up to the consumers, the power companies and the governments of the various member states to thrash out a workable solution. The talking is getting started, but it is already clear that any failure to find an equitable compromise could prove costly for all concerned: governments could lose tax revenue, power companies might see business move away, and paper companies could end up as the biggest losers of all.

IN THIS ARTICLE YOU WILL LEARN:

* Why a new Emissions Trading Scheme (ETS) may hit paper companies with huge energy charges.

* How the new pricing mechanism may hurt large energy consumers.

* Paper companies' options for modifying the ETS.

ADDITIONAL RESOURCES:

* Cepi web site: www.cepi.org.

JIM KENNY, CONTRIBUTING EDITOR/EUROPE

ABOUT THE AUTHOR

Jim Kenny is contributing editor/Europe, for Solutions! magazine, and is based in Brussels, Belgium. He is the former vice president of editorial for Paperloop and today heads his own company, DSI. Contact him by phone at [phone], or by email at [e-mail].

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