Avoiding incentives for CCS projects to make more CO2

Paying CCS projects per tonne of CO2 captured tends to create incentives to make more CO2.  Basing payments on emissions savings, with actual emissions compared with what they would be without CCS, provides much better incentives.

There is a story that a city was over-run by snakes (or rats in some versions of the story).  The authorities put a bounty on snakes, with a reward for every dead snake presented.  This worked for a while. But when many of the snakes had been killed, the people began to miss the income.  So they started breeding snakes to earn the bounty.  When the bounty was removed people released the snakes they had been breeding, and the town was over-run again.  I don’t know if this story is true, but apparently there is real example of something very similar from Georgia in the USA in 2007 with a bounty on wild pigs[i].

This story illustrates how perverse outcomes can arise if you target something that looks like what you want to achieve (fewer live snakes) but is actually something different (more dead snakes).

Payments for tonnes of CO2 captured by a CCS project can lead to exactly this sort of problem.  The atmosphere is over-run with CO2 and you want to reduce emissions.  But if you put a “bounty” on CO2, in the form of a contract payment for each tonne of CO2 captured, you provide incentives to make more CO2, just as there was an incentive to breed more snakes.

The current proposals by the UK Government run into exactly this problem, because CCS support contracts include payments based on the number of tonnes of CO2 captured[ii].  This makes captured CO2 a valuable product, and thus creates incentives for more production of CO2 (a CO2 factory), while disincentivising energy efficiency.  It could also potentially make less efficient projects appear cheaper than others on a cost per tCO2 basis, because they will be producing more CO2 for the same manufacturing output, and so may benefit from economies of scale in capture, and thus reduced costs per tonne. 

The incentive to produce more CO2 is seen in its clearest form when energy is cheap. This may be, for example, due to a fall in market energy prices, or access to low costs energy, for example at a refinery.  If a factory reduces output of its main product, it may continue to burn fuel and run it through the capture process anyway, because the capture payments make this profitable.  It will essentially get into the CO2 production and capture business.

A less extreme form of this type of distortion is the reduction in incentives for energy efficiency, either in the factory or the capture unit.  An energy efficiency project may be profitable without the capture incentives, but the loss of contract payments for tonnes captured may make this uneconomic. 

Illustrative worked examples of both these issues are included at the end of this post.

Improved incentives by estimating tonnes avoided

A better choice is to base payments on the amount by which emissions are reduced by the operation of the CCS plant.  This represents the actual environmental benefit of the project.  It gives better incentives and a better basis for comparing projects. 

The emissions reduction is the difference between:

  • what would have been efficiently emitted without the capture plant operating; and
  • what is actually emitted with the plant operating.

That is:

Emissions without capture (tonnes) – emission with capture (tonnes)

This calculation approximates the environmental benefit of the capture project (though is not on a full lifecycle analysis in this form). 

It is not dependent directly on tonnes captured, so gives no incentive for additional CO2 to be produced.  However, it still does give incentives for increased capture rates of other changes that reduce residual emissions (the 5% or so not captured).  

This incentive extends to choosing the appropriate size of capture unit and efficiently operating the plant, including optimising the capture rate. 

This approach requires the emissions that would have happened without the capture plant to be estimated (the counterfactual).  This can, for example, be based on the following.

  • Benchmark emissions per tonne of product.  This may be based on those under the ETS, which already exist for most producers at risk of carbon leakage.
  • Historical emissions per tonne of product from that particular plant.
  • Some other metric fixed in advance.

Something like this is already envisaged for power projects, with payments based on  MWh produced. 

Under this approach there is no incentive to burn energy to generate capture revenue, because the payment does not vary with tonnes captured. It is only affected by the benchmark and residual emissions.  However, the costs are still incurred in making extra CO2, so it becomes highly unprofitable.

Similarly, no net revenue is lost by an energy efficiency project.  Indeed some may be gained due to reductions in residual emissions.  Incentives are thus maintained or strengthened.  The incentive to reduce residual emissions is created by the carbon price, and possibly by additional contractual payments (see note at the end of this post). 

There are some challenges to implementing this approach, but it is broadly in line with the benchmarking approach for free allocation of allowances under an ETS.  As such, it should prove entirely practical, although, like free allocation, not entirely uncontentious.

Payments based on reductions in emissions are a much better approach than payments based on tonnes captured, and need to be implemented for forthcoming capture projects.

 Adam Whitmore – 17th February 2021

Example: Incentives to make extra CO2.

The table shows and illustration of how this might arise.  The numbers are illustrative, but broadly realistic.  Natural gas costs around £10/MWh, so it costs just under £60 to make a tonne of CO2 for capture. (Historic natural gas wholesale prices have mainly in the range 9-26/MWh[iii]over the past decade, although they fell below this range in 2020.)   If incentive payment for capture are £80/tCO2 (excluding transport and storage), then making CO2 for capture is profitable, even allowing for some non-fuel operating costs for the capture process. This does not happen if payments are based on emissions savings.

Tonnes of CO2/MWh fuel (GCV)0.184
Fuel to produce 1 tonne CO2 (MWh)1/0.184 = 5.43
Fuel used per tonne CO2 captured assuming 95% capture efficiency (MWh)5.43/0.95 = 5.72 
Fuel cost (£/MWh GCV)10
Cost of fuel per tonne CO2 captured (£/tCO2)5.72*10 = 57.2
Non fuel opex per tonne captured (£/tCO2)12
Cost of uncaptured emissions at 95% capture and £40/tCO2 (£/tCO2)2
Total costs per tonne captured (£/tCO2)57.2 + 10 + 2 = 69.2
Revenue per tonne captured (£/tCO2)80  THIS REVENUE DOES NOT EXIST WITH ALTERNATIVE APPROACHES, SO COSTS ARE NOT RECOVERED
Profit per tonne captured (£/tCO2)10.8

 Assumptions:  Natural gas cost £10.00 per MWh. No additional costs from producing energy to run the capture process, as equipment is already in place and the energy from the additional fuel burn here is sufficient.  However there may be some additional electricity purchases costs is electricity to run compressors is bought from the grid. There are some incremental non-energy operating costs in running the capture unit.  These are £10/tonne.  The 5% not captured pays a carbon price of £40/tonne. Carbon captured receives a payment of £80 per tonne captured. 

Example: an energy efficiency project.

In the illustrative example shown below, improved energy efficiency is economic based on fuel cost savings alone, by £4/MWh. However there is a loss of revenue from incentive payments due to smaller volumes of CO2 being captured, which is only partly offset by savings in capture plant operating costs.  This loss of revenue leads to a financial loss on the efficiency project of £5/MWh. This makes the project uneconomic.  Again, this does not happen if payments are based on emissions saved.

Cost of energy efficiency per MWh saved (£/MWh)6
Fuel cost saving (£/MWh)10
Profit per MWh saved4
Reduction in tonnes captured per MWh saved0.175 
Loss of incentive payment at £80/tCO2  (£/t)14.0 NO PAYMENTS ARE LOST UNDER ALTERNATIVE APPROACHES SO ENERGY EFFICIENTY REMAINS PROFITABLE
Savings in capture plant operating costs5.0
Profit per MWh saved4 – 14 + 5 = -5 (now makes a loss)

What is the effective carbon price when payments are based on emissions reductions?

There is the risk off double penalty for additional emissions if payments under a contract are reduced and a carbon price is also payable on residual emissions. This can be addressed simply by paying only the difference between the carbon price and the strike price on the residual emissions.  Payment would be:

Benchmark emissions * strike price

– residual emissions * (strike price – carbon price) 

– residual emissions * carbon price     this is the payment under carbon pricing system

This would effectively charge a higher carbon price for residual emissions.  This would give stronger incentives, which may be appropriate for early demonstration projects.  An alternative would be to price any residual emissions at the carbon price only.  Payment would be:

Benchmark emissions * strike price

– residual emissions * carbon price   this is the payment under carbon pricing system


[i] This story is recounted in this podcast, which relates it to similar issues with other incentives.  https://www.bbc.co.uk/sounds/play/m000rln5

[ii] https://www.gov.uk/government/publications/carbon-capture-usage-and-storage-ccus-business-models

[iii] Approximately 25-75 p/th. See https://www.ofgem.gov.uk/data-portal/all-charts/policy-area/gas-wholesale-markets.

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