authors - keei

Authors

Lead Author : S. H. Shim (KEEI)

Co-Authors : H. S. Kim (Kyungpook National University)

K. H. Chung (Mokpo University)

J. K. Kim (KEEI)

J. H. Ahn (KEEI)

Abstract | i

ABSTRACT

1. Research Purpose

From the year of 2015, GHG ETS(Emission Trading System) is scheduled to be implemented in Korea, replacing current GHG/Energy target management system which has been operative since 2012 to reach the target of reducing emissions BAU by 2020.

The government adopted ETS, because it is considered to be the most cost effective measure to meet the target. It should be noted, however this just means the companies will pay the less abatement cost of GHG than the one that they should have paid without ETS. ETS basically works on the 'Cap and Trade' principle, in which the companies that didn't have any regulations on GHG emissions before are now required to reduce the emissions within their allowances, so the occurrence of additional cost is inevitable. This makes the industry unwilling to adopt ETS, and in fact, introduction of ETS in Korea proceeded with difficulty in the course of policy preparation and its legislation because of the opposition of the relevant industry.

Since the GHG ETS is scheduled to be enforced in Korea, companies need to prepare the most cost effective strategy to meet their emission allowances. This paper proposes the strategies to minimize the GHG abatement cost by reviewing the best practices to treat the climate change and ETS in either domestic or foreign major industries.

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2. Summary

This paper reviews the domestic or foreign practices to develop the strategies for ETS in the following industrial sectors: Power and Heat Generation; Steel; Petrochemistry; Semiconductors and Electric Electronic.

∙ Power and Heat Generation

The major power generating companies in Europe that participate in EU ETS, including RWE in Germany and Vattenfall in Sweden, has corresponded ETS through the invest on (i) the efficiency of the existing power plants, (ii) renewable energy power such as wind, water, or geothermal heat, or (iii) offset investment such as CDM/JI. It is shown that the power generating companies in Korea have tried similar efforts as foreign industry; they are making an investment on the efficiency of the existing power facilities and equipments through the performance improvement of deteriorated steam and gas turbine, expanding facilities for renewable energy, and securing an early reduction target through the promotion of CDM. The domestic companies in this section mutually cooperated to correspond the imminent ETS by organizing 'Technology/Climate Change Cooperation Committee‘, through which they tried to share the information on new technology or renewable energy, analyze GHG reduction potential, and operate an education program for ETS.

∙ Steel

POSCO and its investment companies together launched a 'POSCO family green growth committee', which has been on operation since

Abstract | iii

2009. This Committee, sub-categorized by Low-Carbon Steel Technology, Climate Energy, and Green Business, opens a convention over twice a year to discuss the green growth strategy for the company. POSCO made its own road map for the improvement of energy efficiency by 2020 and has conducted about 2100 of related projects until 2008. This company also built a total information system on energy not only to spread the idea for energy saving or the skills for examination and management but also to share its outcome. From 2009 to 2015, POSCO has a plan to explore small or medium sized energy efficiency investments and adapt a fusion technology for energy efficiency improvement. By 2020, the company will try to increase the energy efficiency by developing a distinct and innovative technology and commercialize it.

∙ Petrochemistry

The major chemical corporations in Europe that participates in EU ETS, including Bayer in Germany and BASF in Swiss, have not only formed an internal organization to treat climate change and ETS but also operated a management system to check out the current status on its own energy consumption. Bayer, specifically, built a GHG emission monitoring system, called 'Bayer Site Information system and Bayer Climate Check', to analyze the data on energy consumption and GHG emission that occurs from production to distribution, and to estimate energy savings potential by analyzing over one hundred of plants and buildings. LG Chem. also organized a GHG/energy monitoring system, called GEMS, to analyze the statistics on energy and GHG emissions and to control emission reduction project.

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It is also shown that these companies are pursuing an active communication by sharing the information on their activities to treat climate change, such as a CDP report, and active to explore offset investments such as CDM.

∙ Electric Electronic

The world-famous electronic companies, such as Philips and Siemens, built an organization, called 'Sustainability Committee of Board of Directors', to enable sustainable administration. These companies, especially, built an information system on energy and environment, using its own intra-networking(SESIS for Siemens and EcoVision Reporting System for Philips) to consistently monitor the energy consumption and the GHG emissions of their own company. Based on this information, they are developing the strategy for energy efficiency enhancement, process improvement, and the expanded use of renewable energy. They are also very attentive in eco-friendly products market. Philips are so engaged in EcoDesign, acquiring eco-friendly labelling and ISO environmental certification accreditation. Besides, they are trying to increase a communication with external stakeholder by promoting eco-friendly movement and leading the action on climate change or an energy savings initiative.

3. Policy Recommendations

GHG ETS covers various units from overall industrial sections. Because each section and emitters has its own conditions, their corresponding strategies for ETS should be differentiated, on the basis

Abstract | v

of their status. There are, however, common strategies applicable for every industries and companies and they are as follows.

∙ Organizing an Internal Body Wholly Responsible for ETS

It is shown, according to the domestic or foreign practices, that major companies has organized and operated an internal body wholly responsible for corresponding the climate change. In this case, this organization should be one of the highest decision-making body in the organizational structure, like the Climate Change Committee of the Board of Directors or the Sustainability Committee, not in the departmental one.

To treat ETS effectively, the company should collect the data on energy consumption and GHG emissions of its own, analyze the reduction potential, estimate future emissions, manage financial or legal risk on trading emission credits, explore offset investments, or promote external communication and internal education program. Considering tasks for ETS covers various business departments and it needs a mutual cooperation among organizational bodies, it is desirable that the highest decision making body control the related activities directly.

∙ Building a Total Information System on Energy and GHG

ETS is basically the market-based system, in which the company reach its reduction target by choosing the most cost effective way through the comparison of emission credit price and the abatement cost. So each companies needs to collect an accurate information on marginal abatement cost of its own. They thus need the data on their

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own energy consumption and GHG emissions, the applicable reduction technologies, the effect of reduction, and the abatement cost etc. As shown in the best practices, those companies has built and operated an information system to keep monitoring their energy consumption and GHG emissions, and estimate their reduction potentials. Based on this information, they are developing their strategies for emission reduction and the utilization of emission trading market.

∙ Sharing the Vision of Action on Climate Change and the Target Establishment

Since GHG emission reduction was not considered to be related with core functioning of business in the past, it has not been easy for the companies to appreciate the importance of emission reduction and the need to share it. Thus, it is the most important job for the companies to establish their own vision of action on climate change and to help the members of their organization internally share it. Since corresponding ETS effectively needs a mutual cooperation among various business departments, as stated earlier, including the building of informational system, the evaluation and analyzation of reduction potential, the exploration of external reduction investment, and the legal or financial risk management etc., it should be preceeded that all the organizational members share the importance of action on climate change. CEO's strong determination is the most important for this and consistent internal education and promotion should be followed.

Abstract | vii

∙ Establishing GHG Reduction Target and Phased Perform Strategies

Companies should establish their own reduction target and phased perform strategies, based on the data from the information system for the energy and GHG emissions and its analysis of future emission potential. First of all, they should select the internal factor that enables emission reduction. Secondly, they should figure out their reduction potential and the marginal abatement cost by examining applicable reduction technology options and its cost. Lastly, they need to compare the internal and external reduction options by analyzing the types of external reduction investment and its economic efficiencies and risks. For the phased perform strategies, the project with least abatement cost and the most reduction efficiency should come first. If the abatement cost is too high, it would be better for the company to purchase emission credits and meet its allowances. It is necessary that the companies participating in ETS should keep observing new reduction technology trend and the market price of emission credits and analyzing the cost-effectiveness between the direct reduction options and the purchase of emission credits.

∙ Enhancing the external communication

Finally, companies should make efforts to help people recognize them eco-friendly business through consistent communication with external stake holders, for example, by promoting actively their activities to combat climate change. It is also desirable for the companies to share the information on international trend for climate change, emission trading market, GHG reduction technology, external reduction investment, best practices for emission reduction.

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Contents

Chapter Ⅰ. Introduction ····························································1

Chapter Ⅱ. Emission Trading Scheme in Korea and Measures to Reduce GHG Emissions ···································3

1. Banking and Borrowing of Emissions ············································52. Offset ···································································································73. Reduction from Early Action ···························································9

Chapter Ⅲ. Climate Change Actions by Major Foreign and Domestic Companies ·········································13

1. Cases from Power Industries ························································13 A. Global Cases ···············································································13 B. Domestic Cases ··········································································182. Cases from Petrochemical Industry ·············································21 A. Global Cases ···············································································21 B. Domestic Cases ··········································································253. Cases from Electric-electronics Industry ····································26 A. Global Cases ···············································································26 B. Domestic Cases ··········································································304. Cases from Steel Industry ·····························································325. Lessons from the Corporate Practices ········································34

Abstract | ix

Chapter Ⅳ. Investment in Low Carbon Technology Development, Banking and Borrowing ·········· 37

1. Overview ····························································································372. Analysis Model ·················································································383. When Banking and Borrowing Not Allowed ·······························444. Banking ······························································································485. Borrowing ··························································································536. Implications ·······················································································58

Chapter Ⅴ. Using Derivatives to Hedge Risks ················· 611. Profit Theory Using Target Utility Function ·······························63 A. Target Utility Function of Permit Sellers ·······························65 B. Expected Utility Function of Permit Buyers ··························682. Mean Reversion ················································································713. Analytic Model ·················································································74 A. Expected Utility ··········································································74 B. Mean Reversion Model ······························································76 C. Data and Properties ··································································77 D. Simulation Results of Target Utility Function ······················78 E. Testing for Mean Reversion ·····················································814. Summary and Implication ······························································83

Chapter Ⅵ. Conclusions ··························································85

References ··················································································98

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Tables ----------------------

<Table Ⅱ-1> Summary of the Law on Domestic Emission Trading System and Reduction Activities ·······························4

<Table Ⅲ-1> Dong Energy's Long Term Plan for Reducing GHG Emissions in 2007 ·····················································16

<Table Ⅲ-2> Vattenfall's Actions on Climate Change ················17<Table Ⅴ-1> Expected Utility and Average Selling Price of a Permit

Seller ·············································································79<Table Ⅴ-2> Paired Difference Test Results (Permit Seller) ······79<Table Ⅴ-3> Expected Utility and Average Purchasing Price of a

Permit Buyer ································································80<Table Ⅴ-4> Paired Difference Test Results (Permit Buyer) ······80

<Table Ⅴ-5> Variance Ratio Test Results of EU ETS Futures Prices························································································82

Abstract | xi

Figures ---------------------

[Figure Ⅲ-1] RWE’s GHG Reduction Actions ···································14[Figure Ⅲ-2] Progress Status of RWE's New Build Programme on

Coal-fired Power Plants ··············································15[Figure Ⅲ-3] RWE's Representative Renewable Energy Projects ··15[Figure Ⅲ-4] BASF’s Target to Improve Energy Efficiency and Reduce

GHG Emissions ······························································22[Figure Ⅲ-5] The Assessment Results on BASF’s Emissions Reduction

Potentials ·········································································23[Figure Ⅲ-6] Siemens's Sustainability Management Structure ····27[Figure Ⅲ-7] Hewlett-Packard's Sustainability Management Structure

··························································································30[Figure Ⅵ-1] Importance of Knowing Abatement Costs ··············90[Figure Ⅵ-2] Investing in Offset Projects ········································93

Chapter Ⅰ. Introduction | 1

ChapterⅠ. Introduction

From the year of 2015, GHG ETS(Emission Trading System) is scheduled to be implemented in Korea, replacing current GHG/Energy Target Management System, which has been operative since 2012 in a bid to reach the target of reducing emissions BAU by 2020. The government decided to adopt ETS, because it is considered to be the most cost-effective measure to meet the target.

It should be noted, however, that companies will pay less abatement cost under ETS than they should have paid without ETS. ETS basically works on the 'Cap and Trade' principle, in which emitters, who has not been subject to any GHG regulations so far, are now required to cut emissions down to their allowances, thus additional cost is inevitable. This makes the industry unwilling to adopt ETS, and in fact, introduction of ETS in Korea proceeded with difficulty in the course of policy preparation and its legislation because of the opposition of the industrial circle.

Since GHG ETS is scheduled to be enforced in Korea, emitters need to prepare the most cost-effective strategy to meet their emission allowances. GHG reduction often requires technological and engineering knowledges because one has to review a wide variety of reduction technologies to figure out the most cost-effective combination of technologies. It also requires understanding of market since its design adopts a market-based approach to provide flexibility into GHG

Research Paper 13-13

2 | Study on Firm’s Carbon Management Strategy under Emission Trading Scheme

reduction regulations. Besides market principles, there are more measures to give covered companies leeway to alleviate burdens, such as offset, banking, and borrowing. After all, GHG emission reductions is a cross-cutting issue which requires understanding of a several connected fields, including engineering and market economy. Emitters should be well aware of a set of prepared measures under GHG ETS to minimize their compliance costs.

Then, how to prepare for the upcoming GHG ETS? It is a challenging issue to Korean companies, which happen to have no experience in similar schemes to ETS. The good news is that there are lots of exemplary practices of European companies, which have been working under the EU ETS, and some Korean corporations which already started moves to reduce carbon emissions even before regulations forced them to do so. In addition, Korean emitters can resort to literary review on the subject of effects of ETS flexibility mechanism on abatement costs. This paper aims to formulate strategies to minimize companies' compliance costs under Korea's new ETS scheme. In order to do so, we reviewed domestic and overseas best practices of complying with ETS schemes and studied cost-saving effects of a few combinations of flexibility measures.

Chapter Ⅱ�of this report will introduce Korean GHG ETS scheme and its flexibility measures that help lift companies' burden. Chapter Ⅲ�will review best practices of companies home and abroad and deliver implications. Chapter Ⅳ�will study economic relations between ETS flexibility measures -- specifically banking and borrowing -- and companies' individual clean technology development. Chapter Ⅴ�will cover risk-hedging strategies through derivatives. Lastly, Chapter Ⅵ�will propose a checklist for companies to gear up for ETS.

Chapter Ⅱ. Emission Trading Scheme in Korea and Measures to Reduce GHG Emissions | 3

Chapter Ⅱ. Emission Trading Scheme in Korea and Measures to Reduce GHG Emissions

There are three categories in GHG reduction options; namely, direct reduction, purchase of emission credits, and indirect reduction.

The direct reduction means a participating company actually cuts its emission by introducing new technologies, using alternative fuels and developing technologies. Direct reduction options include energy efficiency R&D projects, creation of new units committed to cutting GHG, new product development, eco-friendly product designing, alternative fuels, adoption of cleaner technologies, investment in new and renewable energy, and establishment of new facilities.

A company can also meet its compliance reduction by purchasing emission credits on the market. This option is not available under GHG regulations schemes other than ETS.

Indirect reduction ranges from recognition of early actions (only during the 1st phase), and offset to banking and borrowing. It should be noted that early actions, banking, and borrowing are classified as indirect not direct, because the time of reduction and the time of trading do not coincide.

At this Chapter, we will give a closer look at measures to indirectly reduce emissions such as banking, borrowing, and early actions under ETS.



Article Description

Early Reduction

Performance

• The amount of allowance from early action is limited to 3% of total allowances allocated for the 1st phase

• If the total reduction from early action exceeds the planned limits, additional allowances will be allocated, equivalent to the amount after applying the early action factor.

• Additional allowanced for early actions is subtracted from the reserves

* Early reduction contribution factor = Early reduction by a subject company / Total early reduction by all companies regulated by ETS

Emission Trading

• Allocated allowances can be traded and ETS participants register an emission trading account in the emission trading registry

Banking and Borrowing

•Companies can bank allowances for the next year or next phase, and borrow allowances from the next year if not meeting the requirement of the emission submission

• Borrowing is limited to 10% of the allowances allocated to that year.

Offset

• Exchange ratio between offset and allowances is 1:1, limited to 10%, and the details are specified on the allocation plan.

• Overseas offsets: Limited to 50% of the offset limit, but not accepted during the 1st and 2nd phases

Penalty•Not exceeding tripled amount of the average emission market

prices, ceiling the market price for one ton of CO2 under 100,000 KRW

<Table Ⅱ-1> Summary of the Law on Domestic Emission Trading System and Reduction Activities


1. Banking and Borrowing of Emissions

Banking is a system allowing ETS participating companies to transfer their remaining allowances to the next year of within the same phase or to the first year within the next phase. Meanwhile borrowing is a system allowing ETS companies to borrow allowances from other years within the same phase when their submitted emissions fall short of their required amount.

There is not limitation to the amount for banking, but the amount for borrowing is limited to 10% of the emissions required to be submitted.

Article 28, Law1) (Banking and borrowing of emissions) ①�Anyone possessing allowances can bank their allowances for the next year in the same phase or the first year of the next phase under the permissions from the regulating authority.② Following article 27, companies regulated by ETS can borrow a

portion of their allowances allocated for the next year in the same phase under the permission from the regulating authority to fulfill the emissions submission requirement if eligible by the president decree.③ The limit of borrowing in relation to the clause 2 shall be

defined by presidential decree. ④ After permitting companies to bank or borrow their allowances

according to the clause 1 and 2, the regulating authority shall enter the record into the allowance registry. In this case, the allowances banked or borrowed are considered as allocated within the same year in accordance with clause 12.⑤ The detailed procedures of banking and borrowing in relation

to the clause 1 and 2 shall be defined by presidential decree.



Article 36, Ordinance2) (Borrowing of Emissions) ①�Eligibility by the president decree' according to clause 2 of article 28 of the law, indicates cases of facing difficulties to fulfill its obligations to submit required allowances due to the lack of possessing allowances. ②� The amount for borrowing in accordance with clause 3 of

article 28 of the law shall be limited to 10% of the total allowances that the regulated company has to submit to the regulating authority, following clause 1 of the article 27.

Clause 37, Ordinance (Banking and borrowing procedures) ①�Any company of banking and borrowing allowances in accordance with clause 2 of the article 28 of the law, shall submit an online application for banking and borrowing to the regulating authority following article 25 of the law, within ten days from the date being notified with the results of their GHG emissions approval. ②� Any party of possessing allowances besides the regulated

companies shall submit an online application for emission banking to the regulating authority within ten days after 5 months from the end of implementation period. ③�The Regulating authority shall approve or reject after reviewing

applications in regard with above article 1 and 2 within 10 days before allowance submissions in accordance with clause `of the article 35.

1) Hereafter “the law” indicates the Law no. 11690, on 「The Allocation and Trading of GHG Emission Allowances」

2) Hereafter“Ordinance” indicates the presidential decree no. 24429「The Ordinance for the law on the Allocation and Trading of GHG Emission Allowances」


2. Offset

Offset is a scheme of allowing ETS regulated companies to use the GHG reduction performance achieved from elsewhere, up to 10% of their total compliance reduction.

Offset projects applicable to offset credit shall be the ones defined by the government (Will be announced later), and the credit shall be exchangeable with emission allowances at a ratio of 1:1. Also offsets obtained from CDM are not accepted for the 1st and 2nd phases, and limited to 50% of the total allowed offsets. Offset credits can be submitted as allowances for submission within that year or banked for the next year. If not used for these purposes, offset credits should be managed with care as the credits become invalid after 6 months from the final date of each implementation year. Regulated companies should establish offset project strategy upon analyzing the cost of implementing offset projects, reduction costs and the future carbon price, because the time difference between the dates of GHG reduction taking place and credit submission can further extends.

Article 29, Law (Offset) ①� Companies subject to the ETS regulations can request the regulating authority for an exchange of their GHG reduction performance (hereafter offset credit) with emission allowances if they possess or have obtained offset credits through a legitimate method following the international criteria.②�Regulating authority shall provide an exchange of offset credits

to equivalent amount of allowances following the criteria clarified by presidential decree and enter the record into the offset registry



upon receiving application in regard with the clause 1.③�Regulated companies can withdraw the allowances from their

offset registry (hereafter offset credit) to meet the regulation of allowance submission to the regulating authority, defined by article 27. In such case, the regulating authority can limit the amount for submission and define the valid period for the offset credits following presidential decree, considering the impacts of the submitted offset credits on the national GHG target and the emission prices.

Clause 38, Ordinance (Offset) ①�Following clause 1 of article 29 of the law, offset performance is only allowed for regulated companies to apply for conversion to allowances, if the project is actually registered in the company's offset registry and approved by regulating authority②�1 tCO2-eq reduced from the offset projects defined by the

clause 2 of article 29 of the law, shall be convertible to 1 allowance. ③�Following the no. 2 of clause 1 of article 30 of the law, the

regulating authority shall provide measures to prevent any possibility of windfall profit creation from duplicated allowance sales when approving GHG reduction performance that companies achieved from Clean Development Mechanism (GHG reduction projects implemented on site of the regulated organization, hereafter CDM) projects defined by the article 12 of Kyoto Protocol to the United Nations Framework Convention on Climate Change. ④�The amount of offset credits following the latter part of clause

3 of article 29 of the law shall be limited to 10% of the total


3. Reduction from Early Action

Early reduction is accepted only for the 1st planning phase (2015~2017) if verified by the verification authority and not counted in the company's compliance reduction. Also reduction performance exceeding the company's compliance reduction that the company achieved for the period from the following year of designation as subject to ETS regulation to the point of application submission, is accepted as early action performance.

The regulating authority shall allocate additional allowances equivalent to the early reduction amount to the subject company for their 3rd year of the 1st planning phase. However, if early reduction exceeds 3% of the total allowances allocated for the 1st planning phase, the regulating authority shall allocate the reserved allowances to each subject company by the weight of their performance. In other word, each subject company shall receive additional allowances for

allowances that the subject company has to submit to the regulating authority, following the clause 1 of the article 27 of the law. Submission of offset credits converted from the reduction performance obtained from overseas projects is limited to 50% of the total offset credits allowed for submission. ⑤�The offset credits become invalid after 6 months from the final

date of the implementation year if not submitted to the regulating authority in accordance with clause 3 of article 29 of the law or banked for the next year in accordance with article 28 of the law.



their early reduction performance after applying the following formula to their actual performance.

for

Article 15, the law(Approval of early reduction) ①� When establishing an allocation plan, the regulating authority can count the reduction performance (hereafter early reduction) to the plan that regulated company achieved and verified by external verifier(qualified by clause 9 of article 42 of the basic law) before allocation following president decree, or allocate additional allowances to the subject company in accordance with the article 12. ②�When counting early reduction performance into an allocation

plan or allocating additional allowances in accordance with clause 1, the regulating authority can limit the amount of counted or additionally allocated allowances under a certain percentage of the total allowances following presidential decree, to meet the national GHG reduction target efficiently and operate the emission trading market stably.

Article 19, Ordinance (Approval of early reduction) Early reduction performance following clause 1 of article 15 of the law, shall be defined as follows.

1. Reduction performance that the subject company voluntarily achieved up to the 31st of December of the year that the company was designated as a subject to the ETS regulation and given with their compliance reduction, shall be considered as early reduction,


if the performance has been verified in accordance with clause 33 of the ordinance of the basic law and not counted in their compliance reduction performance.

2. Reduction performance additionally achieved over the compliance reduction during the period from the second year that the company was designated as a subject to the ETS regulation and given with a compliance reduction to the point of application submission in accordance with clause 2. ②� Regulated organizations possessing early reduction shall

submit the online application for the performance approval to the regulating authority within 8 months after the second year of the first phase starts. ③�The regulating authority shall allocate applicant companies with

emission allowances for their 3rd year of the 1st phase, equivalent to their early reduction performance after reviewing the application for performance approval following clause 2. If the approved early reduction performance exceeds the allocation amount defined by clause 4, the regulating authority shall additionally allocate allowances, multiplying total emissions allowances by the early reduction contribution factor defined as below.

Early reduction contribution factor = Approved early reduction by the company / Total approved early reduction by all regulated companies ④�The amount of additional allocations following the clause 3 is

limited to 3% of the total allowances allocated for the 1st year. ⑤�Additional allowances allocated following the clause 3 shall be

withdrawn from the emission allowance reserves(hereafter



"allowance reserve") in accordance with the article 18 ⑥�Beside the details of regulation defined from clause 1 to 5, the

regulating authority shall clarify the details of the application process for early reduction approval, the approval criteria and assessment methodology in cooperation with the related central government's bodies and announce it on the official gazette.

Chapter Ⅲ. Climate Change Actions by Major Foreign and Domestic Companies | 13

Chapter Ⅲ. Climate Change Actionsby Major Foreign andDomestic Companies

Global leading companies in regions where emission trading system is under operation have adopted various GHG management system suitable for their company's conditions. There are a few number of domestic companies which have led industrial GHG reduction although ETS system has been yet introduced in Korea. Therefore, we will review on their good practices for climate change actions and corporate growth strategies by domestic and international companies. We will find lessons for domestic companies to learn which will be regulated by ETS system in the near future through analyzing best actions on climate change by international and domestic companies and identifying the common themes to adopt.

1. Cases from Power Industries

A. Global Cases

1) RWE(Rober William Environmental)

RWE is a representative power and gas supplying company of Germany, which established clean carbon technology, renewable energy development, and CDM/JI development as the company’s core strategy to climate change. Preparing to construct a zero carbon thermal power plant with a plan to operate Clean Coal Technik from



2041, the company also invests in carbon separation/storage technology development and constructs a thermal power plant running on gas and steam turbine combination technology (fluidized bed combustion technology). Focusing on developing Integrated Coal Gasification Combined Cycle (IGCC) for clean coal-fired power generation, RWE plans to commercialize IGCC based power plants of 450 MW and construct a facility to separate and store carbon dioxide (Plan to invest 10 billion euros by 20143).

The company reduces GHG emissions through implementing power-plant moderation programme on existing thermal and gas power plants. Reaching the final stage, the power plant modernization programme is under implementation across Europe including Germany, UK, and Turkey. Implemented on the 16 power plants of 150 MW which were constructed during 1960’s in the Neurath region, the programme contributes to GHG emission reduction by 60,000 tCO2 annually and has improved energy efficiency by 30-43% compared with the previous level.4)

[Figure Ⅲ-1] RWE’s GHG Reduction Actions

Source：RWE(2012)

3) RWE(2012) p.50, and Korea Energy Management Corporation(KEMCO)/Business Institute for Sustainable Development(BISD) of the Korea Chamber of Commerce and Industry (KCCI) (2012a) p.26

4) RWE(2012) p.50


[Figure Ⅲ-2] Progress Status of RWE's New Build Programme on Coal-fired Power Plants

Source：RWE(2012)

RWE modernized hydro power plants, extended the plant life, developed geothermal power technologies, and invested 650 million euros in renewable energy development. In 2008, RWE established RWE Innogy, the subsidiary company, and plans to build a production capacity of 2,800 MW from renewable sources by 2014. RWE Innogy made 5 billion euros of investment in renewable energy for the past 5 years, especially in wind power projects.5)

[Figure Ⅲ-3] RWE's Representative Renewable Energy Projects

Source：RWE(2012)

5) RWE(2012) p.51, KEMCO/BISD of KCCI (2012a) p.26



2) Dong Energy

Dong Energy, producing more than 50% of the total domestic power generation and 40% of the regional thermal energy in Denmark, establishes annual GHG reduction target and acts to achieve it, placing its focus on developing CCS and renewable energy6) The company will further develop CCS technology and triple renewable energy production capacity by 2020, with the plan to launch 20 wind power projects. 7)

Goals Target Year

Power Plants

Improving efficiency of coal-fired power plant All the time

CCS Technology：Operation of pilot plant of CO2 storage(underground) technology adopted 2015

CCS technology development 2020

Renewable

Energy

Expand renewable energy production by threefold (972MW->3000MW) 2020

Investment 10 billion DKK in wind power projects 201020 Wind power projects 2020

Energy Consum

ption

Reduction in the operational/transport energy consumed by Dong energy

(Reduced 1 tCO2 per staff from 2006 level) 2012

R&D Provision of a funding of 350 million DKK for sustainable energy development research 2008

JI/CDM Reduction of 10 million tCO2 by investing in projects in Eastern Europe and developing countries 2012

<Table Ⅲ-1> Dong Energy's Long Term Plan for Reducing GHG Emissions in 2007

Sources：KEMCO/BISD of KCCI (2012a)

6) KEMCO/BISD of KCCI(2012a) p.267) KEMCO/BISD of KCCI(2012a) p.26


3) Vattenfall

Vattenfall established three management innovation strategies, such as management considering environment protection and climate change, economic profits, and stable power supply. Vattenfall applied Oxy Fuel technology for the first time in the world to the pilot project of a zero-GHG emitting power plant construction, and constructed a new power plant adopting a technology for utilizing lignites more efficiently8). The company reduced GHG emissions by 35% from the 1990 level through these efforts, and plans to operate zero GHG power plants after 20209).

Year International Actions on Climate Change

2008 Implemented 3C(Combat Climate Change) Initiative10)

Agree by 55 global companies and organizations, the goal of the initiative is to include climate change issues in the

global market and transactions

Fall, 2008 Pilot operation of the Schwarze Pumpe Plant(30MW Oxyfuel thermal pilot)

~2020Technology commercialization

Improvement of net efficiency by 51% Operation of zero carbon power plants

<Table Ⅲ-2> Vattenfall's Actions on Climate Change

Source：KEMCO/BISD of KCCI(2012a)

8) KEMCO/BISD of KCCI(2012a) p.269) KEMCO/BISD of KCCI(2012a) p.2510) 3C(Combat climate change) which ABB, Vattenfall, Bayer, Duke Energy, GE, and

Siemens participate in has announced the roadmap for 2007 and proposed governments in the world with detailed implementation steps to make in order to reduce the impacts of climate change.



B. Domestic Cases

Domestic power producers subject to the GHG․energy target management system and renewable energy portfolio standard regulations starting from 2012 make actions on climate change in 4 directions, such as investment in research projects to improve existing facilities' performance, investment in renewable energy projects and CCS technology, and collaboration with other companies to make joint actions. The power companies' actions on climate change are described below.

1) Efficiency Improvement of Existing Facilities

Due to the aging facilities of coal-fired power plants constructed in early age, improving energy efficiency as well as reducing GHG are not easy if there is no special measures applied to the plants. Each power company has continuously expands investment in R&D projects since 2000 in order to improve performance of old power facilities. Renovating existing facilities is not only more cost-efficient considering the land purchase cost to construct a new power plant and the investment in new facilities, but also expects to reduce the maintenance cost by reducing facility failures and CO2 emissions.11)

The 5 largest domestic power producers are preparing for the up-coming emission trading system by expanding investment in technology development projects to improve the efficiency performance of existing aging facilities such as ｢Reinforcing coating technology development for gas turbine compressor｣, ｢Aging steam turbine performance improvement process development｣, ｢

11) KEMCO/BISD of KCCI (2012a) p.64


Performance assessment of the flue gas denitrogenization facilities (SCR) and technology development to extend the lifetime of catalyst｣, ｢System development for automatic optimization of boiler combustion for counterflow thermal power generation｣, ｢Technology development for lifetime extension of aging 500MW thermal power plant and performance improvement｣, and ｢System integration technology development to increase the output of aging facilities｣.12)

2) Increasing Investment in Renewable Energy

Domestic power producers are expanding their investment in renewable energy in order to comply with the GHG target management system and emission trading system while increasing investment to improve facility performance. Since March 2010 when the ｢New and renewable energy development, utilization, and promotion law｣ was amended, power producers with certain production capacity had to supply a certain portion of their total production with renewable energy starting from 2012, which has increased domestic power producer's interest and investment in renewable energy. The current status of renewable energy production by domestic companies are described below.

The major investment areas for renewable energy by domestic power producers are mostly wind, solar PV, and mini hydro power production. Domestic power producers have invested especially in wind power production as it is relatively easy to install a large power capacity. A company installed 101 MW wind power plant by investing 163,100 million KRW and B company plans to expand the capacity of

12) KEMCO/BISD of KCCI(2012a) p.64~65



its 87 MW wind power production up to 200 MW in the future. Domestic companies have also expanded production from solar PV,

such as C company which installed 8 MW of solar PV plant by investing 33,600 million KRW. It is interesting to note that power companies have tried to implement CDM projects bundling solar PV and mini-hydro power generation, register the performance into UN's CDM registry, and obtain emission allowances. Companies also expand renewable energy power generation with various power sources such as fuel gas, fuel cell, and biomass.13)

3) Carbon Capture and Storage

Carbon Capture and Storage is one of the emerging technologies of GHG emissions reduction in power sector. International Energy Agency(IEA) in fact prospected that CCS technology will contribute to 17% of the total GHG reduction over the world by 2035. Domestic power producers are expanding investment in R&D for CCS technology development considering CCS as one of the strong measures to reduce GHG emissions. Currently a CCS pilot project is under implementation at the thermal power plant in Hadong. Since there are concerns on the limited land capacity to store the captured CO2 in Korea, it will be a challenge for industries to find out measures to solve the problem.

4) Establishment of Joint Action Platform on Climate Change

Domestic power producers have operated ｢Technology·Climate Change Cooperation Committee｣ as a part of voluntary GHG reduction activities since 2005, to prevent double investment in project and

13) KEMCO/BISD of KCCI(2012a) p.64~65.


share information on GHG reduction technologies and renewable energy.14) The major five power producers jointly act on climate change by implementing joint research project on GHG reduction and training programs, analyzing GHG reduction potentials in power sector and establishing voluntary reduction target by jointly organizing ｢Power sector action team｣.15)

2. Cases from Petrochemical Industry

A. Global Cases

1) BASF

Declaring combatting climate change as company’s core task, BASF, the world’s biggest petrochemical company, has established and run a governance system to meet its commitment. BASF appointed Climate Protection Officer responsible for all corporate actions on climate change, and operates its corporate sustainability council under the officer’s leadership. Sustainability council is the central decisions making body providing advice to the board on corporate climate change issues.16)

The company established GHG reduction targets and makes corporate wide efforts to accomplish its targets. BASF targets to improve energy efficiency by 25% and reduce GHG emission by 25% by 2020 from the 2002 levels, and expands investment in R&D projects on energy efficiency and climate change.17)

In order to achieve the targets, BASF measures the GHG emission

14) KEMCO/BISD of KCCI(2012a) p.6315) KEMCO/BISD of KCCI(2012a) p.6316) KECO (2010) p.74 and BASF(2012)17) KEMCO (2010) p.75 and BASF(2012)



from all of its plant sites over the world by 2 times a year, while collecting the emission data from Europe region in every month. The company normally reviews climate change risks on a yearly basis and continually reports to management officers if an emergency case happens.

[Figure Ⅲ-4] BASF’s Target to Improve Energy Efficiency and Reduce GHG Emissions

Source：BASF(2012)

The company primarily focuses on reducing direct and indirect emissions (Scope1,2), while making efforts to reduce scope 3 emissions as well. BASF developed an Eco-Efficiency Analysis, a methodology to assess the company’s sustainability, evaluates the GHG reduction effects of company’s products compared with other products, and calculates products carbon footprints based on the analysis result.18) Eco-Efficiency Analysis is an important basic element to create a

18) KEMCO(2010) p.75 and BASF(2012)


virtuous cycle of measuring and evaluating BASF’s performance of climate change activities, and improving in-house emissions reduction policy based on the assessment results.

[Figure Ⅲ-5] The Assessment Results on BASF’s Emissions Reduction Potentials

Source：BASF(2012)

BASF also actively implements offset projects. The company currently implements a joint implementation project for clients in Poland and Lithuania, and invested 25 million dollars in CDM projects in developing countries after registering as a member of the Community Development Carbon Fund (CDCF) of World Bank in 2002.19)

BASF actively communicates with stakeholders related to climate change issues. The company discloses the details of corporate actions on climate change through publishing annual/sustainability reports and operating a homepage for reporting, and has actively

19) KEMCO(2010) p.76 and BASF(2012)



been involved in international cooperation activities on climate change after signing partnership with UN and EU organizations.20)

2) BAYER

Similar to BASF, Bayer also addresses sustainability management as the core management strategy. The company operates the Bayer Climate Program office, which is responsible for providing measures to combat climate change both on corporate and customer's levels. An interesting point to note is that Bayer runs a process of running online public opinion surveys and open discussion with stake-holders such as government, NGO, and suppliers, analyzing and adopting the results when establishing sustainability management strategies.21)

In order to identify the company’s GHG reduction potentials, Bayer established Bayer Site Information System(BaySIS) which monitors GHG emissions from all of its business sites. The company establishes GHG reduction targets based on this monitoring system and has reduced GHG emissions by 35% between 1990 and 2007. The company makes efforts to meet its target of maintaining the GHG emissions at 2007 levels until 2020.22)

Active in external communication, Bayer has published CDP reports since 2004, and informs on the company’s activities of reducing GHG emissions through annual report, sustainability report, and research reports. The company also actively participates in activities with international civil societies such as co-organizing with UNEP an international painting event for children.23)

20) KEMCO(2010) p.76 and BASF(2012)21) KEMCO(2010) p.76~7722) BAYER(2009) p.25 and KEMCO(2010) p.77


B. Domestic Cases

1) LG Chemical

LG Chemical established environmental/climate change action team which directly reports to CEO, appointed a climate change manager in the energy management team at all business sites as well as the planning team of the headquarter, and built a organic network by connecting all business sites and headquarter together in order to act on climate change in a systematic way.24)

The major tasks of environmental /climate change action team are such as analyzing the domestic and overseas risks and opportunities of climate change, establishing strategies and detailed implementation methods to reduce GHG, and supporting implementation of GHG reduction projects and registration the project performance achieved at business sites. The responsibilities of business divisions and division officers are managing and reporting data on GHG emissions and the emission sources, as well as identifying and implementing potential GHG reduction projects.25)

LG Chemical has operated Greenhouse Gas and Energy Management System(GEMS) since 2007, an energy･GHG management system consisting of energy management module, inventory module, and GHG reduction project module. With the energy management module, the company manages energy consumption data and plans, and stores in the database the energy statistics and analysis results by each unit business site. The company manages GHG emissions data following

23) BAYER(2009) p.19 and KEMCO(2010) p.7824) LG Chemical(2012) p.42 and KEMCO(2012)25) LG Chemical (2012) p.42 and KEMCO(2012)



IPCC guidelines and WRI’s GHG protocol with the inventory module. With reduction project module, the company registers potential GHG reduction project models on the website, monitors the project implementation progress, and manages the reduction performance. Also LG Chemical registers GHG reduction technology into energy･GHG management system and manages the data.26)

LG Chemical also actively implements offset and early actions projects such as CDM projects. The company expects to obtain 225,000 tCO2 of CER in the next 10 years from the clean fuel switch project at Naju plant, and actively implements CDM and KCER projects by registering 24 projects for KCER including ｢high temperature type steam recovery project from quenching process｣ at Yeosu VCM plant and ｢NPG refinery process improvement project｣ at Yeosu NPG plant.27)

3. Cases from Electric-electronics Industry

A. Global Cases

1) Siemens

Similar to the petrochemical industry described above, Siemens, the representative company in electric-electronics industry, established and operates an internal governance to act on climate change. The sustainability committee of Siemens reviews corporate sustainability strategies and action plans whether they are under implementation in harmony with other corporate projects. Sustainability team establishes project plan, conducts performance evaluation and monitoring, and

26) LG Chemical (2012) p.42 and KEMCO(2012)27) KEMCO(2012)


delivers communications with stakeholders.28)

[Figure Ⅲ-6] Siemens's Sustainability Management Structure

Source：Siemens(2009)

Siemens measures and manages GHG emissions of scope 1 and 2 after developing an in-house intranet system, SESIS (Simens Environmental and Technical Safety Information System), and makes efforts to measure scope 3 emissions as well. The company optimizes energy usage and maximizes efficiency by managing existing facilities primarily in order to comply with the emission trading system, and tries to develop high efficiency technologies to replace the existing

28) Siemens(2009) and KEMCO(2010) p.70



facilities.29)

Simens also actively invests in developing clean technologies in order to prepare for tightening regulations on GHG emission and to meet the rising customer demands for high performance and eco-friendly products. Simens also actively invests in developing clean technologies in order to prepare for tightening regulations on GHG emission and to meet the rising customer demands for high performance and eco-friendly products. Through theses activities, Simens continuously promotes the eco-friendliness and the high performance of the company’s products to their stake-holders including customers.

2) Philips

Philips manages climate change actions and GHG reduction activities through its sustainability management committee established at the board level. Philips targets to improve products’ energy efficiency by 50% in 2015 from the level of 2009, and reduce GHG emissions from production process by 25% in 2012 from the level of 2007. Philips introduced an in-house intranet system, EcoVision Reporting System, to manage all operation-related environmental data and GHG emissions, and the collected data functions as a basis to establish corporate GHG reduction target. The company even computes GHG emissions by their suppliers to figure out total GHG emissions from each production process and implements projects to reduce GHG emissions by each product.30)

Philips makes efforts to establish eco-friendly corporate image and

29) Siemens(2009) and KEMCO(2010) p.7130) KEMCO(2010) p.78~80


produce eco-products considering green business is a new profit creating opportunity. Philips have all of its electronic products gone through eco-design process, and try to achieve various standardized environment certifications and eco-labels by placing its focus on improving energy efficiency.31)

Philips also participates industrial joint climate change actions to reduce energy GHG emissions. The company started the incandescent lamp replacement campaign across EU in 2006, under a cooperation with the government, non-governmental organization, energy suppliers, and lamp producers. The company is at the forefront of establishing industrial climate change strategies while seeking corporate role model to solve international environmental problems caused by climate change.32)

3) Hewlett-Packard

Hewlett-Packard established Nominating and Governance Committee and operates councils for each sub-division under the committee such as environment and sustainability management, ethical management, supply change management, and encourages participations of various experts in the council.

Targeting to reduce GHG by 20% and improve energy efficiency by 40% in 2013 from the level of 2005, HP has consistently made investment. The company met the GHG target earlier than planned in 2011, and improved its energy efficiency by 50% in 2011, well above the original planned target.33)

31) KEMCO(2010) p.78~8032) KEMCO(2010) p.78~8033) HP(2011) p.19



[Figure Ⅲ-7] Hewlett-Packard's Sustainability Management Structure

Source：HP(2011)

B. Domestic Cases

1) Samsung Electronics

Samsung Electronics acts on climate change by establishing Green Management Committee led by the CEO, Eco-Operation Council, and GHG/Energy Council. Eco-operation council, consisting of management officers in the areas of environmental management and energy, establishes GHG reduction target for each business site in every quarter and manages the performance, while GHG/energy council, run by mostly managers, reports on the climate change and energy efficiency performances of each business site and share their experiences together. Officers from various management divisions including environmental and energy management, product quality, win-win partnership, procurement, human resources, legal affairs, marketing, and finance participate in the green management committee and discuss the corporate-wide climate change strategies and performances


under the leadership of CEO.34)

Samsung Electronics developed and introduced Global Eco Management System(GEMS), a corporate-wide GHG emissions monitoring and management system, to manage all corporate climate change activities such as building a corporate inventory, improving energy efficiency of production facilities, carbon labelling on products, and product energy efficiency. Also the company expands and promotes on sustainability management system on corporate level, through disclosing their climate change activities on their sustainability reports and website as well as training management officers on green management on a regular basis.35)

Based on the data on the corporate-wide energy consumption and emissions characters analyzed through GEMS, Samsung Electronics defined major reduction activities such as reducing PFC and SF6, improving energy efficiency of facilities, introducing a heat recovery system, and optimizing production facilities. The company implements corporate-wide activities upon establishing GHG target to reduce the emissions from the production process by 50% in 2013 from the 2008 level and by 84 million tons emitted throughout the product use life. Samsung Electronics actively communicates with stakeholders by sharing information with domestic and international industries on the market trends of climate change and energy products, as well as disclosing reports on corporate climate change actions and GHG reduction performances. 36)

34) KEMCO(2010) p.58~5935) KEMCO(2010) p.58~5936) KEMCO(2010) p.58~59



4. Cases from Steel Industry

For steel industry, we will review the practices of POSCO's which is our representative company widely acknowledged as a global leader in energy efficiency.

POSCO, the biggest domestic steel producer, established its target as "reducing the CO2 unit emissions from production by 9% in 2020 from the average emission of the past 3 years as well as reducing GHG emissions by 14,000 ktCO2 by promoting high efficiency steels, and creating 87,000 green jobs in 2018 by investing 7 trillion KRW in low carbon steel and green businesses.37)

POSCO implements climate change action strategies and low carbon green growth management by establishing and running POSCO family green growth committee in order to achieve its corporate target. POSCO family green growth committee appoints CEO as the committee chair, operates 3 subcommittees such as “low carbon steel technology, climate energy, and green businesses,” and discussES all aspects of POSCO’s green growth strategies such as climate change policy and low carbon steel technology development.38)

POSCO has established and implemented a long term energy efficiency improvement road map for 1999 and 2020. After signing volunteer reduction agreement with the government, POSCO has implemented various projects such as introducing FINEX fuel gas combined cycle, heat recovery system from steel making process, and CDQ facility related investment, as well as introduced energy recovery facility to 97% of all energy facilities and reduced energy consumption

37) POSCO(2011) p.1238) Chungnam Green Environment Centre(2012) p.94


by 2,910 thousand toe by investing approximately 1400 billion KRW. The company also established an incorporated energy information system storing energy saving operational technologies in order to spread and share energy saving ideas, energy audit and management technologies.39)

As most of the large scale energy recovery facility projects were completed in 2008, the company has focused on small and medium scaled energy efficiency investment projects and implemented various projects adopting various convergence technologies since 2009. POSCO introduced a heat recovery facility at the steel making plant of Gwanyang #3 in 2010, as well as coke dry quenching and heat recovery facilities at #5 cork plant and sintering plant in the first half of 2011.The company has implemented energy efficiency improvement projects on small and medium sized facilities since 2009, applying inverter technology to high pressure motors in all areas of the steel plant. Through implementing such projects, POSCO saved 313 thousand TOE of energy for the year of 2010, and has been implementing smart industry test-bed projects converging IT and steel plant operational technologies at Gwangyang oxygen plant since 2010.40)

The company is making efforts to commercialize company’s unique innovational technologies such as net oxygen combustion furnace, slag sensible heat recovery and closed sintering sensible heat recovery, since additional energy efficiency is hard to achieved with the conventional technologies after 201541)

39) KEMCO/BISD of KCCI(2012b) p.50 and POSCO (2011) p.20 40) KEMCO/BISD of KCCI (2012b) p.50 and POSCO (2011) p.20 41) KEMCO/BISD of KCCI (2012b) p.50 and POSCO (2011) p.20



5. Lessons from the Corporate Practices

We have examined the best practices of combating climate change by foreign companies regulated by ETS and domestic leaders. There differences exist between industries on their climate change actions as reviewed in the corporate practices on combating climate change. Companies producing similar products such as steel industries place a focus on increasing energy efficiency in the production process while companies of electric electronics make efforts not only to reduce emissions from production process but also improve the corporate brand images though increasing eco-friendliness of products and expanding business opportunities.

We can still find common features identified among company practices elaborated so far.

First of all, most of the companies have established and run an office wholly responsible for climate change actions and compliance with ETS. The power status that climate change office has in the organization is of course different from each industry and company. There are cases such as LG Chemical that in-house environmental/climate change team is responsible for corporate climate change actions, and Samsung Electronics, POSCO, Siemens and BASF that CEO-led committee manages climate change issues as a part of sustainability management. Although there are differences existing in their organizational structures, what is commonly found is the fact that they established a structure entirely responsible for climate change issues. Therefore, domestic companies which will be regulated by ETS in the near future need to establish a corporate unit entirely responsible for climate change and build their capacity.


Secondly, major foreign companies such as Siemens and BASF as well as leading domestic companies such as Samsung Electronics and LG Chemical have established a system to assess corporate GHG reduction potentials by all-the-time monitoring and managing their energy consumption and GHG emissions data. Complying with ETS starts from the point that companies precisely figure out its corporate position, companies should establish an information system to compute and manage its GHG emissions, and keep finding out GHG reduction potentials cost-efficiently based on the data management system.

Thirdly, companies described above have established climate change action targets suitable for their corporate situation and have made corporate-wide efforts to accomplish the goal by active internal communication. There might be differences in the forms of corporate target depending on industrial and company situations. Companies like POSCO set energy efficiency target by step and companies like Samsung electronics establish GHG reduction target against a baseline set on a certain year. The reduction target can be either unit based or an absolute value. The important point is that companies should set their target suitable for their situation and achievable in a realistic sense, and the target should be shared amongst the staff as a corporate goal, not as a target only for management team or CEO. Seen in the case of Samsung Electronics, climate change action is a cross-sectoral issue including environment, energy, product, supply chain management, purchase, human resources, legal affairs, marketing and finance, and it is difficult to achieve the target without systematic corporate-wide efforts. Thus ETS participating companies should establish climate change action strategy at a corporate level and make



efforts to share the goal with all company staff. Finally, domestic and international companies make efforts to

promote their climate change activities to their external stake-holders and improve their eco-friendly corporate image. External stateholders not only include customers of their products but also various parties such as external investors, government, environmental organizations and international organizations. Since social pressure on corporate responsibility for environment has grown recently, promoting their climate change activities to external stakeholders can improve the corporate image and create a good business opportunity of increasing sales. Therefore, companies should strengthen their link with potential customers by sharing with societal communities the profits created from environmental management activities, out of a near sightedness focusing only on the short-term profit creation, and make efforts to establish a sustainable management system.

Chapter Ⅳ. Investment in Low Carbon Technology Development, Banking and Borrowing | 37

Chapter Ⅳ. Investment in Low Carbon Technology Development, Banking and Borrowing

1. Overview

Companies regulated by ETS must meet the reduction compliance assigned by regulating authority for each year and each implementation phase. Measures to fulfill the compliance reduction are such as reducing unit carbon emission (emissions/energy consumption) by introducing new technology of increasing energy performance or reducing emissions directly by investing in technology development to improve facility efficiency. Also companies can meet compliance reduction by switching fuels with zero carbon or low carbon emitting energy sources. Besides these measures, companies can also purchase emissions from carbon market or bank and borrow emissions. Emission trading system, efficient and flexible in the sense the various reduction measures can be applicable, is considered more cost-efficient than directly regulating scheme such as GHG target management system.

In this chapter, we will theoretically compare the level of incentives for investing in low carbon technology development between the case of reducing emission directly by investing in low carbon technology development while adopting indirect emission reduction methods such as banking and borrowing, and the case where these measures are not



available. Through the comparison, we will learn lessons for establishing reduction project portfolio by figuring out the situations for ETS- regulated companies to apply baking and borrowing strategies.

Therefore, we will examine the impacts of low carbon technology investment on corporate profits under scenarios when low carbon technology development investment is allowed without banking and borrowing options, and when banking and borrowing are allowed for ETS regulated companies to meet the compliance reduction assigned by regulating authority. The following models are modified by this research team for an easier analysis of banking and borrowing impacts, based on the Montero's model on reduction technology investment.

2. Analysis Model

In this section, we introduce a basic model under an assumption that oligopolistic companies( ) regulated by ETS are not allowed to bank or borrow emissions. ETS regulated companies are , and we assumed that these companies are under Cournot competition (Cournot model).42) Company is having a demand defined by a function , and assumed to have the same marginal cost to company which is symmetric as they produce the same products. indicates market price of final consumption goods and the total

42) The majority of studies on the impacts of emission banking on investment incentives for low carbon technology development made their analysis assuming a perfect competitive market. Please refer to Cronshaw and Kruse(1996), Rubin(1996) and Kling and Rubin(1997) for more detail. Also Rubin and Kling showed by conducting measuring analysis that banking can relieve the cost burden of GHG reduction activities. Unlike theses studies, the model in this research paper is based on an imperfect market competition.


production() indicates the total production of companies ().

To make the model simple, we assume that the marginal cost of production by companies is zero, and they emit GHG as much as they produce without implementing any reduction measures. The cost to reduce GHG emission is defined as . Reduction performance

() is equal to the amount by subtracting emission counted after

company's reduction activities () from the emission counted before

the reduction activities (). Domestic companies regulated by ETS can

use the banking and borrowing options to fulfill their compliance reduction. The banking and borrowing by company is defined as

and ≤ . in the equation is assumed to be exaggerated

by the government that the value is greater than the most feasible amount for borrowing or banking for ETS regulated companies.

If banking or borrowing is allowed, reduction( ) is equal to the

value of adding banked or borrowed amount() to the result of

equation , subtracting emissions after reduction activities()

from the emissions before reduction activities(). (

or ). Therefore, the reduction cost for

phase 1 can be defined as if banking is allowed, and

the reduction cost for phase 2 can be defined as

if borrowing is allowed, while C is assumed as a

general cost function characterized by ′ ″.Company can reduce GHG reduction costs by developing low

carbon technologies during the phase 1 and 2.43) The GHG reduction



cost for company for the phase 1 equals to upon investing

in technology development, and the cost for the phase 2 equals to upon investing technology development. The effects

of Company 's investment in and technologies during the phase

1 and 2 can be calculated through the following functions,

and , while f is characterized by , ∞,

′ , ″ and ″′ ≤ , ″′ ≤ equations. In other word, investment in technology reduces GHG reduction cost() for the

phase 1 by and investment in technology reduces GHG

reduction cost() for the phase 2 by . The technology

investment costs for phase 1 and 2 are defined as and

respectively.The sum of emissions by all ETS regulated companies during the

phase 1 and 2 is defined by and

respectively, since ETS imposes an emission cap for each year and phase. Also the total emission for phase 1 and 2 is limited to the

amount defined by

. These emission allowances are the

conditions when banking or borrowing is not allowed. If banking or borrowing is allowed, emission for each phase is equal to the value

43) Please remind that we have applied a model drawing a certain result of low carbon technology development to ease the analysis. However, the qualitative results of this research does not make a big difference even if the result of investment in low carbon technology development is uncertain. Godby et al(1997), Requate(1998) and Yates(2001) analyzed the effectiveness of banking on the social welfare, and concluded that banking increases social welfare by smoothing the carbon market. Meanwhile, Phaneuf and Requate(2002) concluded that banking can distort the investment incentives for GHG reduction if uncertainty does not exist, while increasing the social welfare if uncertainty exists.


after subtracting or adding the banked or borrowed amount. But the total emissions for phase 1 and 2 still must satisfy the equation

, even if banking or borrowing is allowed.

The government controls the intensity of reduction compliances imposed on ETS regulated companies with the amount for free allowances(≥). In the beginning stage of ETS, government usually

provides 100% or a very high level of free allocation to the companies to give them a chance to prepare. After certain time passed, government usually allocates allowances through auctioning. Since the case of free allowance exceeding actual emissions is not taking place under ETS, we only consider the case that free allowances are lesser than actual emissions (≤≤). For a simplicity of the model, we assume

that free allowances for phase 1 is equal to the amount for phase 2 ( ). If , free allowances for phase 1 are lesser than the

amount for phase 1, which means that reduction compliance becomes strengthened under ETS. Therefore, the carbon prices will increase for the phase 2. Because such strengthening compliance can encourage companies to invest in GHG reduction technology development, it must be separately understood from the effectiveness of investment in low carbon technology development due to emission banking. Companies are assumed to participate in the ETS market for

both phase 1 and 2 (t=1, 2) and have Cournot competition. In the first stage, companies decide the level of investment in low carbon technology development ( and ) for each phase (t=1, 2),

and decide the amount for banking( ) or borrowing( ) in the

second stage. In the last stage, the companies compete on the mount



of their production ( ). Companies can use their banked emissions

achieved over their compliance level during the phase 1 in order to fulfill their compliance reduction imposed in phase 2, while borrowed emission can only be withdrawn from phase 2 to meet the compliance reduction for phase 1. Therefore, companies purchase allowance after subtracting banked amount() from the emissions for phase 2() if

banking their allowances, while purchasing allowances after subtracting borrowed amount() from the emissions for phase 1() if borrowing

their allowances. The effectiveness of investment in low carbon technology

development can be estimated by maximizing the profits for company and the value of the profit function for phase 2, , which discount factor () is applied

to. is the profit company for phase 2 if the investment in

low carbon technology is for phase 1, and is the profit for

company for phase 2 if the investment in low carbon technology is .We compare the incentive levels of investment in low carbon

technology development between the cases when banking and borrowing is allowed and not allowed, by totally differentiating the profit functions() for company with and instead of calculating

the most feasible and

from the functions, and

by totally differentiating the profit function for

company , .44)

44) Montero(2002a, 2002b) compares the order of the investment incentives for low carbon technology development for each environmental regulation, by calculating reduced cost of GHG reduction projects induced by investment, instead of calculating the investment scale. Please refer to Montero(2002a, 2002b) for further explanation.


′ (1)

′ (2)

Formula (1) and (2) mean ′ ″ , which implies that , increases as the absolute values of , increase.

We use backward induction to analyze the company's profit maximization for phase 1 and 2. We solve the problem by following step. In the 3rd stage, companies calculate the most feasible sales amount() from Cournot competition for phase 1 and 2, and decide the balanced amount for emission() as well as the amount for

banking or borrowing( ) in the 2nd stage. Finally, companies decide

on the investment level in low carbon technology development ( ,

) in the first stage. In the next section, we will consider the basic scenario that ETS is

introduced without banking and borrowing options. This is to compare with the effectiveness of low carbon technology investment made by companies if banking and borrowing are allowed as described later. We will rank the incentives of investment in low carbon technology development under oligopolistic market by arranging the impacts of and on corporate profits( ) in an order by its

scale.



3. When Banking and Borrowing Not Allowed

This section will analyze returns of investment in carbon reduction technologies when banking and borrowing are not allowed.

A company attempts to maximize a present value of profits from period 1 and period 2. Profits from period 2 are discounted by a discount factor and turned into a present value. Profit maximization of Company appears as shown in equation (3).

(3)

Discount factor equals

, where is a discount rate.

≥ indicates emission allowances that Company received from

the government for free in an early stage of ETS. Suppose that free allotments from period 1 and 2 are same ( ). Prices of emission

credits from period 1 and 2 are respectively noted as . Carbon

reduction low-carbon investment of period 1 () results in period 1

carbon abatement costs of , while carbon reduction low-carbon

investment of period 2 () puts period 2 carbon abatement costs at

.

In the product market, the first-order condition(FOC) of Company 's profit maximization appears as shown in equation (4).

′

′ (4)


′

′ (5)

Equation (4) and equation (5) gives us , which is Company 's optimized production. Then, we can get us onto the profit function of Company , which is

. We differentiate this

profit function with respect to , and apply the same rule on

Company as well.

′

′ (6)

′

′ (7)

(8)

(9)

Since emissions of Company and Company cannot exceed the

government's caps( ), it is to emitters' advantage to produce

emissions as same as the amount of the caps. Therefore, emitters

decide to produce of emissions. The lump sum of emissions

from period 1 and 2 equals

. Holding Company 's

optimized production and emissions constant, take the derivatives of the profit function with respect to and .

′

(10)



′

(11)

We can observe in equation (10) and equation (11) that carbon abatement costs ( ), discount factor (), free allowances ( ),

marginal effect of technology investment on the other competitor's production(, ), and marginal effect of technology

investment on allowance prices(, ) affect participating

companies' decisions to make low-carbon investment.We differentiated equations (4) to (9) with respect to and and

this gave us and , which stand for marginal effect of

low-carbon investment on the other competitor's production and marginal effect of low-carbon investment on allowance prices.45) And then, we inserted the values obtained and to equations

(10) and (11) and took an absolute value of each.

′

″ ″

′

′ ′

′ ″

(12)

′

″ ″

′

′ ′

′ ″ (13)

′ ″

″

′ ′

′ ′

″

′

″ ″

′

′ ′

′ ″

(14)

45) Refer to Annex (1) to see the details.


Equations (12) and (13) indicate investment effects of period 2 and period 1. The results vary along with costs( ), marginal costs

(′ ′ ), discount factor(), free allowances( ), and cost reduction

caused by investment( ).When a company has no choice of banking and borrowing, its only

choice is to make investment into carbon-cutting clean technology development. However, when banking and borrowing allowed, it basically has three options to meet a reduction target. To wit, banking and borrowing can be chosen as an option after a company assesses its

abatement costs ( ), marginal abatement costs(′ ′ ), discount

factor (), and percentages of free allocations( ) and decides that

banking and borrowing are more economical than technology investment.

When ≥, it indicates that ETS period 2 places a heavier burden

on covered companies. When a percentage of free allocation declines in the period 2, a company has to make more efforts in carbon reduction in the period 2 than it did during the period 1. The company is given three options: introduction of new technologies, development of new technologies, and purchase of carbon credits. If there is no technological progress, the company has to spend more money to buy credits in the period 2 than in the period 1( ≤ ).

Therefore, if all period 2 variables except the percentage of free allocation stay same with the period 1 counterparts, the company would choose to invest in clean technology development. This is because free allocation is not determined along with production or emissions. In this study, we assume that the free allocation percentage



does not change over periods 1 and 2 ( ) so that we can simplify

the analysis model to measure effect of banking and borrowing on low-carbon investment decisions.

Meanwhile, when all the variables except abatement costs stay same in both periods, if abatement costs and marginal abatement costs

satisfy ≥ and ′ ≥ ′ , a company tends to invest in clean

technology development in the period 1 rather than in the period 2.

4. Banking

When Company banks emission credits() of the period 1 and

uses them in the period 2, FOC:

(15)

where discount factor , and = discount rate. and are

free allowance of periods 1 and 2 ( ). are prices of permits

of periods 1 and 2. Carbon-cutting clean technology development costs of periods 1 and 2 are and respectively.

is summation of emissions before reduction efforts() subtracted by emissions after reduction efforts() and stock

of banked emissions(≤). The summed value is different from

, which signifies abatement costs when banking is not

allowed. Costs to purchase allowances in the period 2 stand at , which is also different from , the costs


to purchase allowances when banking is not allowed. In the product market, profit maximizing Company sets:

′

′ (16)

′

′ (17)

Equations (16) and (17) give us equilibrium production of Company

, which is . And then, we differentiate the profit function of

Company , which is

with respect to

and apply the same process to Company .

′

′ (18)

′

′ (19)

Take the derivative of the profit function of Company , which is

with respect to and

apply the same rule on Company . Then, we have

′

′ (20)

Equation (20) implies that banking amount is determined at the point where the companies' period 1 marginal costs and present

values of period 2 permits equal. If ′ , Company would

make additional reductions in the period 1, or if ′ , it would



not do so because it will face additional losses.Banking plays a role of smoothing abatement costs over ETS

periods, thus making the whole ETS more flexible. In this sense, banking has to satisfy complementary slackness conditions: i)

≥, ii) ≤, and iii) .

If , emitters would want to purchase an indefinite amount

of permits during the period 1 and sell them during the period 2, so in order to meet no arbitrage condition between the periods, there should be ≥. In other words, to make banking feasible,

present values of permit prices of the two periods have to be same. This means that companies would use banking as a tool to distribute abatement costs in the most cost-effective way and bank reductions only if period 2 marginal cost exceeds period 1 marginal cost. If

′

′ , it is to advantage of Company to make greater

reductions in the period 2 than in the period 1, thus no banking occurred. In conclusion, companies would consider banking when

and ′ ≤′ .

Company and are allowed to emit more in the period 2 as much as they have banked in the period 1. However, the sum of period 1

and -2 emissions is capped at , so it gives us

.

(21)

(22)

Equation (21) and (22) indicate that even if banking is allowed, the sum

of emissions of the periods 1 and 2 amounts to no more than .


Holding Company 's optimal production, emissions, and banking amount constant, differentiate the profit function with respect to

and .

′

(23)

′

(24)

The first right-side terms of equation (23) and (24) have positive values since they signify abatement costs ( ). The second

right-side terms indicate effects in the product market, where the competitor increases production as its costs fall due to technology investment helps bring down permit prices ( ). The third right-side terms are effects in the emissions trading market, where technology investment helps reduce total emissions and in turn, cut permit prices ( ).

Let's figure out effect of technology investment on company profits.46)

′″″

′ ′′′″

(25)

′″″

′ ′′′″ (26)

46) Refer to Annex (2) to find out in detail.



′″″

′ ′′′″

′″″

′ ′′′″

(27)

We can figure out the role of banking in determining effect of technology investment by comparing the equation (27) and (14). We can see at the equation (27), which assumes banking allowed, effect of technological development vary along with abatement costs

( ), marginal abatement costs(′ ′ ), discount factor(), free

allowances( ), and cost savings owing to technological

advancement( ). effect of banking on technology investment is a summation of direct effect (the first right-side term in the equation (27), positive), indirect effect on the product market (the second right-side term in the equation (27), negative), and another indirect effect on the emissions trading market (the third right-side term in the equation (27), positive). If a sum of direct effect and indirect effect on the emissions trading market is grater than negative indirect effect on the product market, allowing banking would encourage companies to invest in technologies. However, negative indirect effect on the product market is smaller than the sum of the other two, banning banking would lead many companies to invest in technologies.

Conclusion 1. When allowance price is and marginal


abatement cost is ′ ≤′ , participating

emitters have a good chance to choose banking. When banking is allowed, the inducement to invest in technology is stronger or equal compared to when banking is not allowed.

Conclusion 1 was made from FOCs and complementary slackness conditions presented in the previous part. Equation (20) shows that a company would bank their emissions reductions until the point where period 1 marginal abatement cost is equal to the present value of period 2 allowance price. It is a rational decision for Company to make investment in the period 1 provided that period 1 marginal costs are lower than period 2 marginal costs. Unless, Company would bank emissions reductions for the forthcoming period. Comparison between equations (14) and (27) implies that under an imperfect competitive structure, effect of banking on technology investment decisions depends on abatement costs and effects on the product and emissions markets.

5. Borrowing

When Company borrows emission allowance from the period

2, it would try to maximize profits. More formally:

(28)

The cost of purchasing allowances equal period 1 emissions

minus purchasing amount . Meanwhile, period 2 reductions are



emissions before reduction efforts minus emissions after reduction

efforts and plus borrowed allowances .

In the product market, Company considers the following first order equation.

′

′ (29)

′

′ (30)

We can solve for Company 's equilibrium production in

equations (29) and (30). We insert this value into the profit function

and differentiate it

with respect to . And then, same process applies for Company .

′

′ (31)

′

′ (32)

Differentiate the profit function of Company

with respect to .

′ ′ (33)

Equation (33) tells us that Company would borrow emissions reductions until the point where the present value of period 2 marginal


cost equals period 1 allowance price. If ′ , it is to

disadvantage of Company to make additional reductions in the

period 2. To the contrary, if ′ , the company would rather

earn profits by making additional period 2 reductions.As well as banking, borrowing plays a role of smoothing abatement

costs over the periods. Therefore, borrowing has to meet complementary slackness conditions: i) ≤, ii) ≥ , and

iii) . Suppose and then companies would

borrow infinite amount of allowances from the period 2 and sell them during the period 1. Therefore, ≤ has to be met in order

to satisfy no arbitrage condition between the periods. In other words, borrowing turns out a viable option when period 1 allowance price and the present value of period 2 allowance price are same.

We can learn from this that emitters would choose borrowing only when the present value of period 2 marginal abatement costs is lower than period 1 marginal costs. If the present value of period 2 marginal abatement costs is higher than period 1 marginal abatement costs

(′ ′ ), Company would make investment in the period 1

rather than the period 2, smoothing costs over periods. In short, when allowance prices and marginal abatement costs satisfy

and ′ ≥′ , emitters would consider

borrowing.When borrowing is not allowed, emissions of each period of

Company and do not exceed each period cap ( ,

). However, when borrowing is allowed, period 1



emissions could exceed or period 2 emissions could fall short of . Borrowing does not allow the total emissions from the both

periods to exceed the total cap ( ).

(34)

(35)

Equation (34) demonstrates that period 2 cap( ) minus borrowed

allowances equals period 2 emissions from Equation (35) states that period 1 emissions from Company and amount to borrowed

allowances added by period 1 cap( ).

Now holding Company 's optimal production, emissions, and borrowing constant, differentiate the profit function with respect to and .

′

(36)

′

(37)

The first right-side terms for equations (36) and (37) are positive abatement costs ( ). The second right-side terms are effects on

the product market, which hold negative values, meaning that technology investment brings down prices of allowances, and in turn, the competitor's abatement costs, leading to an increase in the


competitor's production ( ). The third right-side terms are effect on the emissions market, which hold positive values, because technology investment leads to a decrease in emissions, thus bringing down allowance prices ( ).

Effects of period 1 and period 2 investments in clean technology development on companies' profits appear as shown in equations (38) and (39).47)

′

″ ″

′

′ ′

′ ″

(38)

′″″

′ ′′′″ (39)

′ ″

″

′ ′

′ ′

″

′

″ ″

′

′ ′

′ ″

(40)

Equation (4) shows the effect of technological advancement of the both periods when ETS allows borrowing. The size of the effect would differ along abatement costs( ), marginal abatement costs

(′ ′ ), discount factor(), free allowances( ), and level of

decreases in abatement costs( ), which is a similar kind of pattern with the case of banking.

47) Refer to Annex (3) to see how we get .



Conclusion 2. When allowance prices are and marginal

abatement costs meet ′ ≥′ , companies

are likely to resort to borrowing. When borrowing is permitted, the inducement to invest in technology is stronger or equal to when borrowing is not allowed.

We learn from the Conclusion 2 that borrowing will occur under the exact opposite conditions for banking to occur. Equation (33) indicates that borrowing occurs to a point where the present value of period 2 marginal abatement costs are same as period 1 allowance price. To put it another way, Company increases period 2 investment when the present value of period 2 investment is lower than period 1 investment, meaning that Company borrows from the period 2 until the present value of period 2 investment is equal to period 1 investment. Like the case of banking, the size of effect of borrowing on low-carbon investment depends on abatement costs and sizes of effects on the product market and emissions trading market.

6. Implications

In an oligopolistic structure, participating emitters can benefit from flexibility mechanism that includes banking and borrowing when it is assessed to be better strategies than low-carbon investment. It is future abatement costs and allowance prices that play a critical role in choosing banking or borrowing. Therefore, it is crucial for policy makers to deliberate on the issue whether banking or borrowing would have positive or negative effect on clean technology development. Unlike existing studies, which mostly evaluated relations between


banking and clean technology development in a perfectly competitive market, our game theory-based study supposed an oligopolistic market and assessed relations between banking or borrowing and clean technology development.

To sum up, companies would choose banking when period 1 marginal abatement costs, including clean technology development, falls short of the present value of period 2 marginal abatement costs. The size of the effect of banking on low-carbon investment varies according to abatement costs and effects of technology investment on the product market and emissions trading market. To put it another way, effect of low-carbon investment is determined by many variables including abatement costs, marginal abatement costs, discount factor, free allowances, and level of decreases in abatement costs.

When period 1 abatement costs, including clean technology development, are equal to the present value of period 2 marginal costs or higher, emitters would choose borrowing. The size of the effect of borrowing on low-carbon investment varies according to abatement costs and effects of low-carbon investment on the product market and emissions trading market.

Banking tend to boost carbon-cutting projects in the first periods. The tricky part is to assess cost effectiveness of these projects in the first periods because the assessment has to be done in comparison with future costs. For example, let's say that future abatement costs are far less than those in the first periods. Then, a company would put off early investment as possible. This lead us to a conclusion that when banking is not allowed, early investment would stay minimum and technologies that will be developed in late periods will help bring down the total abatement costs. Burtraw and Mansur(1999) pointed



out that a U.S. SO2 allowance trading program's banking option led to increases in abatement costs. This was because emitters invested a lot in the early periods to bank their reductions, but later on as the program runs over periods, technological progress was so outstanding that abatement costs in later periods were not as much as early ones. This result implies that technology investment is affected by price signals in the emissions market and outlook on future technological progress.

This study presents similar political implications as Burtraw and Mansur(1999). Participating companies that are given an option of banking or borrowing would compare their abatement costs through periods and decide to make investment when costs are lower than the other periods. More specifically, when there is a great chance that the present value of future abatement costs is far lower than current abatement costs, companies would borrow allowances from the future periods and invest more in the future. In contrast, when it is anticipated that future allowances will decrease and allowance prices will hike, companies would invest in clean technology development in earlier periods and bank the reductions for rainy days.

Chapter Ⅴ. Using Derivatives to Hedge Risks | 61

Chapter Ⅴ. Using Derivatives toHedge Risks

In the previous chapters, we drew up meaningful implications regarding corporate responses to climate change and established criteria to decide whether to choose banking or borrowing in making carbon reduction decisions. The problem is that emissions trading always has uncertainties primarily because of changes in allowance prices. Therefore, participating companies have to make choices everytime allowance price changes either to maximize their profits (i.e. when selling emissions permits) or to minimize their costs (i.e. when buying emissions permits). In other words, companies are always exposed to risks in trading permits and they need to come up with strategies to mitigate risks.

This chapter addresses the issue of minimizing risks embodied in emissions trading. There are numerous risk-hedging strategies, but we will focus on profit margin hedging, which is shown to be the optimal strategy to corporations using derivatives. Many previous studies have analyzed benefits of profit margin hedging (Purcell and Koontz, 1999; Parcell and Pierce, 2009; Kim, Brorsen and Anderson, 2010). Profit margin hedging strategy is a way to optimize sales profits by using derivatives. Let's say that a company now deliberates on how to sell its new product. The company compares futures price and target price, the minimum price that the company is willing to charge,



and if the former is higher than the latter, the company will choose the former, and if the other way around, it will choose to sell products at the end of the spot market. In other words, if futures price is higher than target price, the company would hedge all the risks regarding sales, or if target price is higher than futures price, the company would sell the stocks on the spot market at the terminal point. Let's see an opposite case where a company would like to buy raw materials. At the point when the company would make a purchase, it would compare target price, in this case, the maximum price it is willing to pay, and futures price. If target price is higher than futures price, the company would buy raw materials in the futures market hedging risks, but if target price is below futures price, it would buy the spot on the spot market at the terminal point.

This profit margin hedging rule can apply in the context of emissions trading. When a company produced emissions lower than the cap and tries to sell emission permits, it would sell permits on the futures market if futures price exceeds target price, or would sell on the spot market at the terminal point if target price exceeds futures price. In case of a company willing to purchase emission permits, if futures price is higher than target price, it would buy permits through a process of hedging or if futures price is lower than target price, it would buy them on the spot market at the terminal point.

This paper proves theoretically that profit margin hedging is the optimal strategy in the emissions trading market. We applied a target utility function of Holthausen(1981) on both permit buyers and permit sellers. The purpose of this paper is to derive a theoretical conclusion that profit margin hedging is a more profitable choice than other strategies such as always hedging and spot trading strategy.


With a view to verifying the working in actual practices, we reviewed EU ETS statistics, conducted simulations using target utility function and variance ratio tests. Based on results of this empirical analysis, we drew up policy recommendations.

1. Profit Theory Using Target Utility Function

The mean-variance model is a risk-return model which is the most commonly used to analyze choices under uncertainty. Johnson(1960) and Stein(1961) and Lence(1996) used the mean-variance model to determine producer's optimal hedging strategy under uncertainty but they failed to prove that profit margin hedging was the most optimal choice in an efficient futures market. A number of previous studies have tried the mean-semivariance model or the mean-target semivariance model to prove the same point, but they all failed (Dejong, de Roons, and Veld, 1997; Lien and Tse, 2000; Lee and Yang, 2000; Chen, Lee, and Shrestah, 2001; Turvey and Nayak, 2003). However, it is argued that mean-variance analysis has several well-known theoretical shortcomings in a setting of uncertainty. The most widely-known theoretical drawback is that the mean-variance model variance does not correspond to expected utility heory when variance is not a suitable measure of risk or a producer's utility function is not quadratic. Fishburn (1977) proposed a mean-risk model which generalized mean-target semivariance model to address the limitations of the mean-variance model. Fishburn’s model measured return as the mean of the outcomes, but defined risk as weighted deviations of outcomes below target and the model assumes risk neutrality above the target. Equation (1) is a producer's utility function



in a mean-risk analysis.

for all ≥ (1)for all ≤.

where is a producer's profits, is target profits, is positive constance, and reflects the risk preferences. If , then the producer is risk seeking, or if , the producer is risk averse.

Holthausen (1981) adapted Fishburn’s model by using the same measure of risk but defining return as weighted deviations above the target to avoid the risk neutrality restriction. To measure producer’s expected utility, this study adopts Holthausen’s model in which the utility function is equation (2) and the expected utility function is equation (3).

for all ≥ (2)for all ≤.

∞

∞

. (3)

where is probability density function of which is normally

distributed with mean, and variance . Kim, Brorsen and Anderson(2010)

adopted this model to determine the conditions where profit margin hedging is the optimal strategy and prove its profitability. This paper adopted target utility function theory in emissions trading, analyzed profitability of profit margin hedging through simulations comparing with other strategies. We classified participating companies into permit sellers and buyers, because companies are given two options of either selling or buying permits.


A. Target Utility Function of Permit Sellers

Profit of a permit seller is written as

. (4)

where indicates production, represents price of product , is

production cost function, is permit price, indicates emission allowances allocated by the administrator, and is a producer's actual

emissions. The producer would sell permits as much as and

make profits as much as . After ruling out profits that came

from production, the remaining profits are written as

. (5)

If the producer would place hedge before the last trading days of futures contracts, its profit function would be defined as

. (6)

where , represents futures price at the time of hedge,

indicates futures-spot basis, is future price at the terminal point

of hedge, and is hedge ratio. If basis risk does not exist in futures market and the producer wants to maximize its profits per unit of permit through hedging, equation (6) is redefined as

′ . (7)

where ′ is profits per unit of permit. Assuming that futures price



equals spot price at the terminal point of futures market, equation (7) is rewritten as

′ . 48) (8)

Insert equation (8) into equation (3) and redefine expected utility function.

′

∞

′ (9)

∞

′.

where is a choice variable. where is

target profits per unit of permit. Expected utility function ′ will

be optimized when the first derivative with respect to the choice variable equals to zero. The first order condition of equation (9) is

′

∞

(10)

× ′

∞

′

×

′

48) where the variance of is , the variance of ′ , , equals

.


∞

× ′

∞

′

×

′

.

Then the first and third terms of equation (10) will be zero because

. When the producer has the same level of

risk preferences above and below target () and weight of losses , equation (10) is rewritten as

′

∞

(11)

× ′

∞

′

×

∞

× ′

∞

′

× .



The first and third terms of equation (11) are deleted. If futures price

is higher than target price at the point of decision making, the

producer would sell permits at the price and then becomes one.

This leads the second and last terms to equal zero. Equation (11) will be zero, satisfying the first order condition of expected utility optimization. In conclusion, expected utility function will be optimized when the producer is risk neutral and , weight placed on losses, is 1.

B. Expected Utility Function of Permit Buyers

In the case of a permit buyer, target utility function and expected utility function can be written as equations (12) and (13) respectively.

for all ≤ (12)for all ≥.

∞

(13)

∞

When a permit buyer tries to minimize its costs by placing hedge before a trading year ends, its costs per unit of permit (′) is defined

as49)

49) Equation (14) is derived as equation (8) was, whereas the only difference is that , which makes ′ costs that the producer aims to minimize. In addition,

,

the variance of ′ will be when the variance of is

.


′ (14)

We insert equation (14) into equation (13) and redefine expected utility function.

′∞

′ (15)

∞

′.

where . In order to optimize the producer's

expected utility ′, the first derivative with respect to the choice

variable needs to be 0. The first order condition of equation (15) is

′ ∞

(16)

× ′

∞

′

×

′

∞

× ′



∞

′

×

′

.

In equation (16), the third and last terms are equal to zero because

. If the producer has the same level of risk

preferences above and below targe t() and , equation (17) is rewritten as

′ ∞

(17)

× ′

∞

′

×

∞

× ′

∞

′

× .

The first and third terms of equation (17) cancel out. If futures price


is lower than target price, the producer would buy permits as

much as , the amount needed in the first place, so and the

second and last terms will be zero. Then equation (17) equals zero, meeting the first order condition for expected utility optimization. In short, expected utility function of a permit buyer is optimized when the buyer is risk neutral and .

2. Mean Reversion

With expected utility function, we just found out that profit margin hedging is a strategy that helps optimize producer's utility in an efficient futures market. If profit margin hedging is proved to work better for companies maximize profits and minimize costs than other strategies, companies are highly likely to resort to profit margin hedging. To prove this point, this section assumes mean reversion in futures price.

Consider futures price that has mean reversion. Futures price will evolve according to:

(18)

where is spot price that will coincide with futures price at the

terminal point of hedge, is futures price at the point of hedge, is long-term average spot price, and is error term when average

is zero and variance is . Coefficient estimate indicates the rate

by which reverts toward .



Expected profit function of a permit seller is defined from equation (8) as

′ (19)

Consider futures price having mean reversion. Then, equation (19) is rewritten as

′ (20)

.

On the assumption that a permit seller sets a targe price same as

long-term average spot price, when futures price is higher than in equation (2), the seller would sell all its permits on the futures

market, making . Hence, equation (20) is rewritten as equation (21).50)

′ ′ (21)

′

50) A permit seller would normally set targe price at the level equivalent to its marginal abatement costs, which in most cases, are same with long-term average spot price in the sense of long-term equilibrium. Therefore, it is safe to say that target price would be equal to long-term average spot price.


Where represents profit margin hedging, is always hedging,

is always spot trading at the ending point of a year. Rate of

reverting toward the mean () is always a positive constant, so when

futures price is above at the point of decision making, profit

margin hedging is equally profitable as always hedging strategy and more profitable than always spot trading strategy.

In contrast, when futures price is below target price , equation

(2) is rewritten as

′ ′ (22)

′

In the same manner, is always a positive constant and ,

so profit margin hedging is equally profitable to always spot trading strategy and more profitable than always hedging strategy.

Unlike the case of a permit seller, a permit buyer's profit margin hedging will turn out this way; it buys futures permits when futures price is lower than target price, and buys spot permits when futures

price is higher than target price. More formally, when , the

buyer goes long futures contracts, and when , buys spots.

Let's compare profitability of strategies assuming that futures price has a tendency to revert to the mean.

Expected utility function of a permit buyer is defined in the same manner with equation (20) as

′ (23)



When futures price is lower than target price , the permit

buyer would go long futures contracts, making . As a result, equation (23) is redefined as

′ ′ (24)

′

When futures price is higher than target price , equation (23)

is written as

′

′ (25)

′

In summation, when futures price is expected to revert to the average, profit margin hedging is a more profitable strategy than others, both for permit sellers and permit buyers.

3. Analytic Model

A. Expected Utility

The previous section theoretically proved that companies covered by ETS can maximize their profits through profit margin hedging. Based on this result, now we will carry out simulations to see if profit margin hedging proves more profitable than always hedging or always spot trading in the one-the-ground realities. Data of EU ETS, especially on futures and spot prices of emission allowances, helped compare expected utility of profit margin hedging, always hedging and always


spot trading.We chose a perfect foresight model to conduct simulations,51)

indicating that futures basis is perfectly predictable at the point of corporate decision making. A permit seller would sell all its permits when the sum of futures price and basis exceeds target price. In contrast, it would sell all its permits in the spot market when the sum of futures price and basis falls short of target price. A permit buyer would buy all the permits it needs when the sum of futures price and basis is below target price, and would trade spot stocks when the sum of futures price and basis is above target price.52)

We made an assumption that companies are risk neutral and and are both 0.5. First, we identified utility of permit sellers and buyers from 2005 to 2012 by using equation (2) and equation (12) and derived expected utility from average utility like in equation (26).

(26)

We also carried out a paired difference test to check actual differences in expected utility among profit margin hedging, always hedging, and always spot trading. Through this test, we will check a null hypothesis that the average of differences in expected utility is zero.

51) We actually analyzed two cases, one of which has no basis risk in the futures market and the other has basis risk. The two analyses led to the same results, so we decided to talk about no basis risk case in this paper.

52) Consider a basis-risk case. A permit seller would go short futures contracts on all its remaining permits when the sum of futures price and the average basis is higher than target price at the moment of hedge, or otherwise, would trade spot stocks at the expiration point. A permit buyer would go long futures contracts when the sum of futures price and the average basis is lower than target price at the moment of hedge, or otherwise, would buy spot stocks at the expiration point.



B. Mean Reversion Model

We already are aware of that when futures price has the mean reversion, profit margin hedging is more or equally profitable than always hedging and always spot trading strategies. This section covers variance ratio test, a way to check EUA futures prices really reverted to the mean.

Suppose is the natural logarithm of a price series under a random

walk. In variance ratio test, the variance of profits of period equals that of one period times . Variance ratio of period , or is defined as

(27)

where represents variance of th difference, indicates variance of the first difference, and the null hypothesis of variance ratio test is equal to one ( ). If equals one, price index follows random walk, and if is less than one, price index reverts to the mean.

Lo and MacKinlay (1988) provided variance ratio test, in which variance ratio is calculated as

(28)

where , , and are defined as


(29)

(30)

(31)

In equation (31), and represents prices at the initial and

terminal points of time respectively. Several researchers, including Yang and Brorsen (1993), attributed distribution of futures returns to the presence of conditional heteroskedasticity. Hence, we identified asymptotic variance of variance ratio on the assumption of conditional heteroskedasticity in equation (32) and (33) and found standard normal distribution, which is written as equation (34).

(32)

(33)

(34)

C. Data and Properties

Our work used EUA futures prices of the EU ETS phase 1 and 2. We



considered third Monday in November as a producer's decision making point, which is one month prior to the last trading day, third Monday in December. To identify basis, we looked at EUA spot prices.

To conduct variance ratio test to identify mean reversion of futures price, daily EUA futures prices were used. All of EUA price data was sourced from Point Carbon database.

D. Simulation Results of Target Utility Function

<Table Ⅴ-1> shows expected utility and average selling price of a permit seller by its sales strategy. Simulations indicated that profit margin hedging always brings about higher expected utility than always spot trading strategy does as we already anticipated, but lower expected utility than always hedging strategy does, which runs counter to what we expected on the theory. Moreover, average selling price is shown to be the highest when always hedging, followed by profit margin hedging and always spot trading. This conflict with the theory can be explained by efficiency of the EUA futures market. In theory, the basic assumption of efficient market enabled profit margin hedging to be the optimal strategy. However, the working of actual EU ETS of the both first and second phases was not assessed efficient due to oversupply of emissions permits. Therefore, profit margin hedging showed a poorer performance than always hedging in simulations. Nevertheless, profit margin hedging was analyzed to be more profitable than always spot trading strategy on grounds of expected utility and average selling price.


<Table Ⅴ-1> Expected Utility and Average Selling Price of a Permit Seller

IndicatorSales Strategy

Profit Margin Hedging

Always Hedging

Always Spot Trading

Expected Utility -0.97 -0.83 -1.05Average Selling Price(€) 10.85 11.44 10.59

We ran paired difference test to see if there was statistical significance in gap between expected utility and average selling price. <Table Ⅴ-2> presents an overview of the test results.

Indicator-Value

Profit Margin Hedging vs Always Hedging

Profit Margin Hedgingvs Always Spot Trading

Expected Utility -2.19* 0.87Average Selling Price(€) -1.91* 1.03

<Table Ⅴ-2> Paired Difference Test Results (Permit Seller)

As shown in <Table Ⅴ-2>, statistical significance is found in 'profit margin hedging vs. always hedging.' This means that a seller in the EU ETS market pursuing always hedging strategy would have higher expected utility than it would have with profit margin hedging and expected utilities of the two strategies are significantly different. However, profit margin hedging and always spot trading were not significantly different, so there is little evidence that the former strategy ensures a higher expected utility than the latter.

In short, always hedging strategy brings about the highest expected utility. Profit margin hedging was found to be less profitable when market inefficiencies were considered.



The following table shows Expected Utility and Average Purchasing Price of a Permit Buyer.

IndicatorStrategy

Profit Margin Hedging

Always Hedging

Always Spot Trading

Expected Utility 1.99 0.83 1.05Average Purchasing Price(€) 11.18 11.44 10.59

<Table Ⅴ-3> Expected Utility and Average Purchasing Price of a Permit Buyer

As clearly shown in <Table Ⅴ-3>, a permit buyer has the highest expected utility when it implemented profit margin hedging, which is a bit different conclusion from a permit seller. We can notice that even though the emissions trading market is not efficient, profit margin hedging remains an optimal strategy in case of buying emissions allowances. And also, always hedging strategy proved better than always spot trading strategy on expected utility ground.

With a view to identifying statistical significance in differences between expected utility and average purchasing price, we carried out a paired difference test, of which results are presented in <Table Ⅴ-4>.

Indicator-Value

Profit Margin Hedgingvs Always Hedging

Profit Margin Hedgingvs Always Spot Trading

Expected Utility 1.88* 1.53Average Purchasing Price(€) -1.03 1.91*

<Table Ⅴ-4> Paired Difference Test Results (Permit Buyer)

<Table Ⅴ-4> indicates that difference between profit margin hedging and always hedging is statistically significant. This means that


a permit buyer under the EU ETS will reap the highest expected utility when choosing profit margin hedging than choosing always hedging, although it is not always the case that unit purchasing price is lower when profit margin hedging than always hedging. Meanwhile, profit margin hedging did not statistically prove better than always spot trading in terms of expected utility. However, average purchasing price under profit margin hedging was lower than under always spot trading.

In summation, regardless of efficiency of EU ETS, profit margin hedging guarantees higher expected utility and lower purchasing price than always spot trading does.

E. Testing for Mean Reversion

The previous section discussed simulation results to see how profit margin hedging, a theoretically optimal strategy, actually works under EU ETS. This section contains test results of theories dealt in Chapter Ⅱ-Section 2, of which main idea was that when futures price follows mean reverting process, profit margin hedging is more or equally profitable than always hedging or always spot trading.

We conducted variance ratio test and overview of results is presented in <Table Ⅴ-5>. More specifically, besides the years of 2005, 2009, 2010, and 2011, in which , mean reversion of all EUA futures prices was not statistically significant. Even variance ratios of the results that proved significant are larger than one, implying that there is just a trend lesser than mean reversion. After variance ratio test, we concluded that EUA futures price has no mean reversion, and furthermore, there is no proof that profit margin hedging is better



then the other strategies.In short, although profit margin hedging was an optimal strategy in

trading emissions from a theoretical point, simulations and mean reversion tests have not backed the idea from a statistical point. It is possibly attributed to inefficiencies of the first and second phases of EU ETS: overallocation, nosediving demand, and declining prices.

Year Value

20052 1.31 3.06*

5 1.56 1.5610 1.87 1.58

20062 1.12 0.595 1.31 0.7810 1.54 0.92

20072 0.84 -0.785 0.79 -0.5910 0.95 -0.11

20082 1.08 1.515 1.12 0.7710 1.12 0.46

20092 1.10 2.13*

5 1.12 0.8010 1.12 0.49

20102 1.07 1.65*

5 1.07 0.5310 1.08 0.36

20112 1.09 2.13*

5 1.10 0.8610 1.13 0.67

20122 1.07 1.885 1.07 0.6310 1.04 0.24

<Table Ⅴ-5> Variance Ratio Test Results of EU ETS Futures Prices


4. Summary and Implication

The main subject of this paper is to identify a hedging strategy that maximizes profits or minimizes costs for companies participating the Korean ETS scheduled to start in 2015. The common wisdom is that profit margin hedging is an optimal strategy and this paper proved in theoretical terms that this wisdom was right. In our theoretical analysis employing expected utility function, we found out that when a producer is risk neutral, profit margin hedging is the most profitable strategy. In addition, we also proved that when futures price follows reverting process, profit margin hedging is equally or more profitable than always hedging or always spot trading.

In order to verify the working of actual practical application, we derived expected utility of each strategy on the basis of the data of EUA futures and spot prices under EU ETS first and second phases and test mean reversion of EUA futures prices. After rounds of simulations, a permit seller using profit margin hedging would have a lower expected utility than when using always hedging strategy, which conflicted our theoretical conclusions. Moreover, expected utility of profit margin hedging was not significantly higher than that of always spot trading. To the contrary, a permit buyer using profit margin hedging would have a higher expected utility than when using always hedging strategy and pay lower prices to buy allowances than when using always spot trading.

Still, in our variance ratio test, we could not observe mean reversion universal throughout EUA futures prices. This means that profit margin hedging does not always excel the other strategies in keeping expected utility or expected profit around the average.



Why does this gap exist between theories and practical application? We identified the reason in inefficiencies of EU ETS. Under the initial phase of ETS, spot price of emission allowances declined almost bottoming at zero due to over allocation. This declining trend kept on until the second phase. This gap between theoretical analysis and practical application implies that the reason why profit margin hedging was not the optimal strategy in the on-the-ground work of EU ETS lies at market inefficiencies.

Nevertheless, it is noteworthy that a permit buyer using profit margin hedging can always have the highest expected utility regardless of market efficiency. In other words, a permit buyer would minimize permit purchasing costs when it chooses profit margin hedging strategy even under inefficient market structure.

Now let us sum up. Companies participating ETS are given the two options; buy or sell. Theoretically speaking, profit margin hedging enhance returns better than other strategies. However, inefficiencies in the 'real-world' emissions trading market are likely to constitute a barrier against performance of profit margin hedging. The first and second phases of EU ETS provides a good example of this. However, on a condition that the market moves toward efficiency in the long-term, profit margin hedging makes an unparalled contribution to hedging risks arising from permit price changes, maximizing gains on the sale of permits, and minimizing costs of purchasing permits. Now, at a time when the Korean ETS coming ahead in 2015, the pressing issue of Korea's market makers would be to design an efficient structure so that covered companies would envision clearer risk management strategies.

Chapter Ⅵ. Conclusions | 85

Chapter Ⅵ. Conclusions

Unlike the previous GHG Target Management System, upcoming ETS starting in 2015 adopts a different allocation approach. ETS administrator will grant to each company free allowances, of which amount will be determined by the administrator's own criteria. This top-down approach shows a stark contrast to GHG Target Management System, in which the administrator and companies worked together and reached a consensus on each emissions target. Considering that the annual GHG reduction targets released in 2011 were growing tighter after the year 2015, it is expected that companies under ETS would face increasingly challenging reduction targets, shouldering heavier financial burdens year after year. A piece of advice that we deliver to Korean policy practitioners through this paper is that the objective of ETS should be to drive companies to choose the most cost-effective ways to curb emissions not to just provide them profit opportunities.

ETS is known to offer the most cost-effective way of emissions reduction, but only given that it is implemented upon a deep institutional understanding and thorough preparations. In order to prevent unexpected and unnecessary costs that could arise from ETS, this paper covered case studies and flexibility measures.

Our case studies were developed with a range of overseas and domestic companies engaged in climate change mitigation. We



suggested preparatory strategies that would be rather commonly applied regardless of industrial sector than unique to sector, because suggesting sectoral strategies is time- and energy-consuming work that would probably surpass this paper's study scope. However, needless to say, a company should take into account its unique industrial features in determining emissions trading strategies. We hope that readers would understand that our carefully selected suggestions give a general, not sectoral, indication of corporate ETS strategies.

The Chapter IV addressed the issue how producers can take advantage from flexibility measures to alleviate their financial burdens imposed by ETS. Since flexibility measures -- banking and borrowing, in this case -- serves as replacement for direct investment in cutting GHGs, a producer can manage its emissions reduction efforts more effectively with help of banking and borrowing. In order to prove this point, we had the Montero(2002a, 2002b) model restyled and identified inter-temporal optimal allocation between direct technology investment and banking and borrowing. Our analysis contained major implications for the most cost-effective corporate strategies to cut down emissions.

Companies trading emission allowances are always exposed to financial risks arising from changes in allowance prices. Globally, emission allowance derivatives are generally traded on trading markets.53) Hence, Chapter V examined a few derivative strategies as a means of hedging market risk.

Based on all the analytic results in the previous chapters, we now recommend producers key strategies in trading emissions.

53) Korea's new emissions trading market is anticipated to be open to both spot and futures trading, following suits of other regional emissions markets.


∙ Organizing an Internal Body Wholly Responsible for ETS

It is shown, according to the domestic or foreign practices, that major companies has organized and operated an internal body wholly responsible for corresponding the climate change. Of course, it is almost impossible to draw up a standardized and uniform format of governance because each company differs in terms of size, operation, corporate culture, and the like. Rather it was clearly shown that major exemplary companies designed their GHG management unit fit for their conditions and environment. We would propose two success factors in organizing an internal body: (i) flexible decision making and (ii) cross-departmental control.

First of all, flexible decision making is crucial to cope with frequent changes in the market. Emissions permit price erratically moves along with policy trends, technological progress, and offset opportunities. Without flexibility in decision making process, a company never can respond to abrupt changes in the market.

To treat ETS effectively, the company should collect the data on energy consumption and GHG emissions of its own, analyze the reduction potential, estimate future emissions, manage financial or legal risk on trading emission credits, explore offset investments, or promote external communication and internal education program. Considering tasks for ETS covers various business departments and it needs a mutual cooperation among organizational bodies, it is desirable that the highest decision making body control the related activities directly.

In this case, this organization should be one of the highest decision-making body in the organizational structure, not in the



departmental one. Since cutting carbon emissions is a cross-cutting issue requiring cooperation from a various departments, the organization should be given a high authority to pass down coordinated directions.

Each company would have to consider its internal working when deciding whether the organization should be a large-scale department or a small specialized unit. Regardless of the scale of the organization, it is clear that the organization needs to implement a higher-level governance that would discuss and finalize cross-departmental decisions.

∙ Sharing the Vision of Action on Climate Change and the Target Establishment

As shown in our case studies with first runner companies in the climate change sector, a set of vision and targets is essential to encourage all employees to pay practical effort to climate change adaptation. It is true that it is not easy for companies to appreciate the importance of emission reduction and the need to share it, since GHG emission reduction was not considered to be related with core functioning of business in the past.

ETS is no longer a mere social corporate responsibility. It is directly linked to profit making of corporate operation. Thus, it is the most important job for companies to consider the climate change issue as a threat and a opportunity for corporate operation, establish their own vision of action on climate change and help the members of their organization internally share it.

It is necessary to rise above the existing narrow concept of emissions trading to see a bigger picture of climate change mitigation


or sustainable management. ETS is a good opportunity for a producer to turn its manufacturing line greener and enhance its brand image as well as minimize carbon reduction costs. In this sense, vision and targets should be set from a broader long-term perspective.

Since corresponding ETS effectively needs a mutual cooperation among various business departments, as stated earlier, including the building of informational system, the evaluation and analyzation of reduction potential, the exploration of external reduction investment, and the legal or financial risk management etc. Therefore, green efforts should be made with all the organizational members well aware of the importance of action on climate change.

CEO's strong determination is the most important for this and consistent internal education and promotion of vision, targets, and importance of the issue should be followed.

∙ Building a Total Information System on Energy and GHG

ETS is basically the market-based system, in which a company reaches its reduction target by choosing the most cost effective way after comparison of emission credit price and abatement cost. So each company needs to collect an accurate information on marginal abatement costs of its own. They thus need the data on their own energy consumption and GHG emissions, applicable reduction technologies, effect of reduction, and abatement cost and so forth.54)

54) The same goes for national and global-level GHG reduction efforts. At a global level, all Parties to the United Nations Framework Convention on Climate Change are required to periodically submit their national GHG inventories. At a national level, Framework Act on Low Carbon, Green Growth of Korea stipulates the responsibility of the administrator ministry to build an integrated national GHG information system.



Consider a company with a target of reducing 500 units of emission allowance, of which abatement costs are presented as [Figure Ⅵ-1]; this figure is a general diagram containing basic concepts of ETS. The most cost-effective way of reducing carbon emissions of this company is to invest in reducing 300 units and purchase the remaining 200 units from the market.55) Of course, the company is assumed to be well aware of its abatement costs. Needless to say, the company would suffer losses without reliable data of abatement costs.

[Figure Ⅵ-1] Importance of Knowing Abatement Costs

Price/Cost

Abatement Cost

Reductions

Reduction Target

It is noteworthy that companies can identify their marginal abatement costs almost exclusively by investing a considerable amount of time and efforts into building energy and GHG emissions information system. Information system gathers data of energy

55) where P represents price of a unit of emission allowance.


consumption, GHG emissions, available clean technologies, technical capability and costs to develop and apply clean technologies, all of which will definitely contribute to deriving an accurate marginal abatement cost curve. This is why a producer needs a real-time energy and GHG information system. To take full advantage of the scheme of emissions trading, comprehensive and accurate information is essential.

When designing an information system, one should be aware that the system will function far better if connected to technology database that compiles clean technologies in the company's possession, because the system would give insights to employees how to apply the company's technological potentials to deal with current energy and GHG emissions.

As shown in the best practices, advanced companies have already built and operated information systems to monitor their energy consumption and GHG emissions and estimate their reduction potentials. With help of information systems, they are developing smarter strategies how to reduce emissions and benefit from emissions trading.

∙ Conducting Positioning Analysis and Searching for Offset Project Opportunities

The next task is to set up a GHG reduction target and action plan. First, a company needs to do positioning analysis based upon its

marginal abatement costs and future GHG emissions. Positioning analysis helps find where the company stands in the market; if it is either a permit seller or a permit buyer. If the company is projected



to be a permit buyer, the strategic focus would be cost minimization, and if it is expected to be a permit seller, the focus would be profit maximization.56)

In fact, a company's market position is practically determined by the government's grandfathering plan, which, however, is not clearly set out yet in Korea. Grandfathering plan is to be released in the Plans to Allocate National Emission Allowances, which is still early in the draft process. Nevertheless, it is possible to look for some clues about future criteria for grandfathering in annual reduction rates in the 2011 reduction targets. Also, companies can expect that emissions will be allocated proportionately to the single emitters' historical emissions.

Second, companies should be aware that they have an option of offset project. Korean ETS allows covered entities to invest in offset projects, a mechanism to create emission offsets for projects outside corporate routine business. Therefore, companies are advised to review a list of offset projects and deciding which to participate in.

Now, recall the company introduced earlier with [Figure Ⅵ-1]. In the emissions market that does not recognize emission offsets, the company's best strategy was to cut down 300 units of emissions and buy the remaining 200 units. However, if the company is allowed to invest in offset projects as [Figure Ⅵ-2], it can save some of the costs by investing in offset projects and gain 200 units compared to just buying 200 units.

56) During the second trading period of EU ETS, power producers were granted a very limited number of allowances, while general industries got a larger number. Therefore, power producers mostly became buyers, and industries became sellers in trading.


[Figure Ⅵ-2] Investing in Offset Projects

Price / Cost

Reductions

Hence, tt is important to pay keen attention to possible offset projects.57) One of weak points in utilizing offset projects is that often they involve legal risks that could possibility arise from working with other entities and uncertainties in amount of emissions recognized by the authorities. Furthermore, they tend to have longer payback periods than direct investment does. To mitigate these risks and uncertainties, companies should study all investment options they have, such as direct participation, participating in alliance with consultants, and participation by a subsidiary.

57) In Korea, there is no specific regulations or stipulations about type and scope of offset projects. Therefore, it is hard to decide which offset projects to participate in for now. However, it is very clear that the government will finalize its stance on recognizing offset projects before the year 2015 will start.



∙ Predicting Future Clean Technologies and Laying Out Strategies to Use Flexibility Mechanism

Creating an optimal mix of offsets and flexibility mechanism is an essential part of preparing for ETS.

Chapter Ⅳ�proved that banking and borrowing do relieve corporate burden of ETS preparations, when they are carried out strategically on the basis of estimate of future technological progress. More specifically, if technological progress is so fast that present value of future marginal abatement costs is lower than present marginal abatement costs, a producer would better do borrowing and invest in technology development later. In the opposite case when a producer expects a slow technological progress and heavier burden in future, it would be a smart move to invest in present in technology development and bank surplus emission credits.

We can learn two important implications: (i) covered entities need to examine first their future technological level and (ii) they have to estimate future mandatory carbon cutbacks.

As banking and borrowing decisions are more or less affected by technological prospects in the coming years, producers are advised to first scrutinize effects and costs of existing and potential carbon reduction technologies that they have access to. By keeping and updating periodically a list of applicable technologies in GHG information system, producers would be able to make their technological forecasts. Predicting future technological level is especially important to businesses which require large initial investment and longer payback periods.

Expectation for future mandatory carbon cutbacks also plays a


dominant role in producers' reduction decision making. To minimize prediction errors, producers are advised to keep an eye on domestic and international policy trends all the time.

∙ Establishing GHG Reduction Target and Action Plan

At a point where it finished comparing effects and costs of internal and external reduction options, a company now can decide on specific strategies for each option; to illustrate, which technologies to apply, how much investment to make for which offset projects, and how to combine banking and borrowing. A set of specific strategies are better to be drawn up in the mid-term, covering at least one trading period.

Once strategies and action plans finalized, the next step is to distribute them on a time line. Since there is too large uncertainty laying in permit price and offset projects, rigorous economic analysis is needed to mitigate economic and financial uncertainty of internal carbon-cutting efforts. After economic analysis, tasks with lower cost and bigger achievement should be prioritized. Along this order, a company lays out action plans.

∙ Building Infrastructure Needed to Trade Emissions and Mapping Out Risk Mitigating Strategies

ETS participating companies are advised to build infrastructure that will facilitate emissions trading in the future, such as an internal trading platform. The key role of this trading platform is to link with the emissions market. And this platform should be designed to receive real-time information from energy and GHG information system so



that platform users can get a glance of the company's emissions balance, compare reduction options in financial terms, and decide on optimal trading points.

There is one more thing to keep in mind when designing a trading platform: risk management. Chapter Ⅴ�already discussed that profit margin hedging was the optimal strategy to minimize financial risks. This paper suggests that a trading platform adopt profit margin hedging as an important derivative trading rule.

Most financial institutions or corporations take a set of measures to prevent trading managers from committing mistakes or moral hazard. This should be applied the same in emissions trading as well. Preventive regulations, including basic trading guidelines and ban on electronic trading, should be set out.

∙ Enhancing External Communication

Finally, companies should make efforts to help people recognize them as eco-friendly business through consistent communication with external stakeholders, for example, by promoting actively their activities to combat climate change. Now at a time when consumers are increasingly aware of green products, companies which try to turn themselves greener would inevitably get into the limelight and be exposed to broader opportunities to make profits. Therefore, sharing information of international climate change policy and scientific trends, emissions trading, GHG reduction technology, offset projects, and domestic and international best practices would boost companies' long-term prosperity.

One good example is Bayer. This German health care company has


created Bayer Climate Award, which has been recognizing outstanding achievements in fundamental research in the area of climate science. Also, it supports young talented researchers in the area through Bayer Climate Fellow Program and works with the United Nations Environmental Program to support International Children's Painting Competition. All of these efforts help Bayer more closely connected to international civil society and enhance its brand power.

Building partnership and strategic alliance with other companies of the kind provide more cost-saving opportunities. By sharing international trends, market conditions, new technologies, offset opportunities, and best practices, companies will be able to manage risks and make more economical choices. There is no doubt that the more available information the more chances to save costs.

To illustrate this point, MRV(measuring, reporting and verification) costs go down when working together. Normally, training constitutes a substantial part of MRV costs. However, if multiple companies hold training sessions together, they will be able to save some of the training costs. Knowledge exchange and networking come as bonuses.

We can confirm that there is a limitation of this study. Although the present study has yielded some preliminary findings, its design is not without flaws.

Our work failed to reflect each industry's nature in mapping out strategies. For example, power generation business might have a different approach from what we suggested in this paper, because the business requires an enormous initial investment to reduce GHG and energy saving projects that often last longer than other businesses. Future research would be more convincing if researcher will take this aspect into account.



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• Sung-Hee Shim Research Fellow <Major Books and papers>

“An optimal design for costs minimization of Korea Emission Trading System”, Korea Energy Economics Institute, 2012. “Pro-competitive Measures for ‘Top-runner’ System in Korea”, Korea Energy Economics Institute, 2010.“A Study on Strategies for Green Growth in Energy Sector in relation to the Response to Climate Change：Policy Instruments to Promote Green Energy Industry in Korea”, Korea Energy Economics Institute, 2010.“A Study on Strategies for Low Carbon Green Growth and Growth Potentials of the Green Energy Industry in Korea”, Korea Energy Economics Institute, 2009.


Study on Firm’s Carbon Management Strategy under Emission Trading Scheme

Printed on August 31, 2015Issued on August 31, 2015

Author Sung-Hee Shim Publisher Joo-Heon Park

Published by Korea Energy Economics Institute, (Address) 405-11, Jongga-ro, Jung-gu, Ulsan, 44543, Korea, (Phone) +82-52-714-2114, (Fax) +82-52-714-2028

Registered on December 7, 1992Korea Energy Economics Institute, 2015

authors - keei

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