What price the cost of carbon?

Industry is worried that European moves to take a lead on climate change will damage competitiveness and encourage carbon-intensive industries to quit the continent. Keith Tyrell finds out whether their concerns are justified.

Last month the European Commission ordered Bulgaria to reduce the emission limits in its national allocation plan (NAP) for the second phase of the EU emissions trading scheme (EUETS) which is due to begin in January. Bulgaria’s was the final NAP for greenhouse gas emissions to be assessed, and the twenty-third to be tightened by the Commission (ENDS Report 383, pp 46-47).

In total, the Commission has cut the amount of carbon dioxide EU heavy industry can emit in the trading scheme’s second phase by over 200 million tonnes per year. The new combined EU cap is nearly 7% below the average annual emissions for 2005-07, and 10% below the caps proposed by the 27 EU member states.

"The Commission’s strict-but-fair approach in assessing allocation plans for 2008-12 puts the European carbon market on a solid basis for the future," said Environment Commissioner Stavros Dimas. "It underlines once again Europe’s leadership role in combating climate change and in driving the development of a robust global carbon market as a key instrument for cutting worldwide emissions cost-effectively."

And the Commission’s latest round of cap tightening is only the start. The EU is committed to cutting emissions by at least 20% by 2020 and a tough EUETS is key to delivering these reductions.

During the scheme’s second phase, most of the major CO2-emitting installations it covers will continue to receive free allowances to cover most of their emissions. But this could change from the third phase beginning in 2012.

The Commission is expected to propose reforms to reduce the amount of free allowances. Current rules permit member states to auction up to 10% of allowances in the second phase, but only a handful of states are using the facility. One option on the table is to require member states to auction a minimum amount of allowances.

The UK government says that in the long term it wants to make firms buy all their carbon allowances. But some member states and industries have reacted angrily to moves to strengthen the scheme and have launched legal challenges to reverse the decisions (ENDS Report 389, p 48).

At the heart of their opposition is concern that a high cost of carbon will make European industry less competitive and damage their economies. They also argue that it will do little to reduce global emissions because production will shift to regions not subject to a carbon price, where emissions will then rise. This relocation of carbon-intensive industries out of the EU is known as ‘carbon leakage’.

In October, consultants Oxford Economics predicted that moving to 100% auctioning of allowances, with a carbon price of €25/tCO2, would cut EU GDP by 0.5% in the medium to long term.1 About a fifth of this predicted GDP fall is attributed to EU industry becoming less competitive.

The study, conducted for the Business and Enterprise Department (BERR), predicted that the basic metals sector, including the steel industry, would be hardest hit by full auctioning which would shrink output by nearly 5%. Competitiveness impacts - production shifting elsewhere - would be responsible for a fifth of this drop.

But the impact would not be restricted to installations covered by the EUETS. Higher energy costs resulting from the trading scheme would cascade through the economy, raising prices and reducing output so that the economy would shrink by 0.1% for every 1% increase in energy prices.

"Although the non-EUETS sectors tend to be less energy intensive than the EUETS sectors, they also account for a much larger share of GDP," says the study. "A small shock to a large proportion of energy usage can have a similar impact as a large shock to a small proportion of energy usage."

Oxford Economics assumes auctioning would be revenue-neutral, but does not explain how the money raised is recycled. This is a critical point which will influence the final figures. If the money is used to offset general taxation, it will simply be a cost to industry and will reduce competitiveness. But if it is returned to industry through grants or tax rebates, it could stimulate growth. However, this approach could run in to trouble with European state aid rules.

Dave Goodger of Oxford Economics said the study’s findings represented the "upper band" of the possible impacts. "This is all based on the assumption that the cost of carbon is fully priced in and passed on," he said. In fact, many firms may choose to absorb some or all of the costs rather than pass them on to customers. This is likely where energy costs represent a small proportion of overall costs.

Another key assumption is that Europe alone faces a cost for carbon: "A large part of the impact is because the model assumes a unilateral cost in the EU and no action anywhere else in the world," he said. He noted that many other countries already have carbon taxes in place and others are considering emissions trading schemes.

Professor Paul Ekins of the Policy Studies Institute said the report’s findings should not undermine the principle of carbon pricing. "The differences in the US exchange rate in the last couple of weeks will have a much greater impact on EU competitiveness than a €25/tCO2 cost of carbon," he said.

But he acknowledged some industries particularly exposed to international competition could be harmed if they faced an additional price of carbon.

Michael Grubb, chief economist at the Carbon Trust, said Oxford Economics’ finding should be treated with caution. "Specific insights can be useful, but other modelling approaches can generate the opposite results to this one in terms of overall GDP impacts."

Oxford Economics’ conclusions run counter to the opinion of the Intergovernmental Panel on Climate Change (IPCC) which has concluded that "energy efficiency policies intended for greenhouse gas mitigation will tend to improve competitiveness".

In November the panel published the full report of its working group on mitigation that examined competitiveness.2 It pointed to research that concluded: "In practice carbon leakage is unlikely to be substantial because transport costs, local market conditions, product variety and incomplete information all favour local production."

It also noted that even where there was potential for firms to relocate to areas with weaker climate policies, "the investment climate in many developing countries may be such that they are not ready yet to take advantage of such leakage."

Potential for leakage
But the report did find some potential for leakage in specific sectors including chemicals and iron and steel, with the highest bilateral leakage between the EU and China. Most was attributed to a reduction in world energy prices leading to a rise in production rather than cheaper imports substituting for European production.

"The evidence is that carbon leakage is likely to have only a small effect," said Dr Terry Barker, of Cambridge University, coordinating lead author of the report. International trade would only counteract climate policies under certain assumptions and conditions but in practice governments introduce complementary policies to prevent this.

"The biggest effects are found by studies that treat sectors as being on the edge of competitiveness, so that any little thing will push them off the edge," he said.

It may well be that in the short term, a carbon price could make energy more expensive and lead to a loss of competitiveness in energy intensive industries, but in the long run, exchange rates will adjust to offset a persistent loss of competitiveness.

In contrast to studies which model the theoretical impact of climate measures, Dr Barker has examined the actual effect of six unilateral economic measures aimed at reducing CO2 emissions.3 He found carbon leakage was very small in all six cases; indeed, in some years there was negative carbon leakage.

He believes effective climate policies will improve competitiveness. "It’s possible that the EUETS could give rise to accelerated development of low-carbon technologies," he said. "In that instance, the EU would be able to enhance its competitiveness." This effect could be enhanced if the revenue from auctioning helped industries make the transition.

Sensitive sectors
While carbon leakage is likely to be small for the economy as a whole, competitiveness impacts are certainly of concern to some sectors. A report to be published shortly by the Carbon Trust, drawing on analysis from the European research organisation Climate Strategies, sets out the potential cost impact of the EUETS on manufacturing activities.4 It’s first basic screening uncovered 20 or so subsectors where competitiveness could be an issue.

Aluminium, the sector where competitiveness issues are of most concern, is not in the scheme (ENDS Report 389, pp 30-33).

Professor Grubb said: "Two sectors stand out like a sore thumb: cement and steel production. There’s a plausible case for concern over competitiveness in both, but it’s stronger in steel."

For cement, competitiveness impacts are softened by it being a heavy, bulky commodity which is expensive to transport, giving local producers a strong advantage. Professor Grubb said adding a €20-30/tCO2 carbon cost, if passed through fully, would outweigh these transport cost advantages.

If, said Professor Grubb, carbon costs did outweigh transport costs, cement makers would cut back their European operations and potentially increase imports from areas like North Africa.

But steel is slightly different. "The price impacts are less for steel but the trade sensitivities are greater," he said. Unlike cement, transport costs do not give local producers such a strong advantage. The problem for steel, he explained, is that the added costs overlay more fundamental cost differentials already driving the industry to globalise and look at foreign relocation.

This view is borne out by a recent study of the impact of the EUETS on the steel sector prepared for steel giant Corus. The study concluded that moving to full auctioning of allowances under the EUETS could add €50 to the cost of each tonne of EU steel, based on a carbon price of €25-30/tCO2.

The EU is already an expensive location for making steel. The report estimates that steel slab costs $504/t to produce in western Europe, compared with just $239/t in India. Even with these high costs, current high demand allows European producers to turn profit margins of about 15%. Imposing an extra carbon cost of €50/t of steel would shrink these margins to 1% says the report.

The report predicts that if European producers passed on all of these EUETS costs to their customers, they would see foreign steel imports rise by up to 5% and lose market share equivalent to 7.5 million tonnes of steel worth about €5.6 billion.

European blast furnaces typically emit about 1.8t CO2 per tonne of steel compared to about 2.5t CO2 in China, so any increase in foreign imports will not only result in carbon leakage overseas, but could also lead to an overall increase in global emissions.

"Something like 75% of steel production in China is coming from what we would consider to be sub-sized kit compared with a typical EU producer and therefore with an emissions penalty," said Ian Goldsmith of Corus.

But European producers should be able to pass on some of any increased carbon costs they face to their customers without losing market share. They have a well-developed sales and logistics system which can meet the needs of customers rapidly. Chinese or Indian producers would struggle to offer the same service.

The report says existing customers would be willing to pay a premium to maintain their original suppliers. It estimates this could account for as much as $31.5/t of the $50/t carbon cost. Even so, steel companies would still have to absorb $18.5/t, which would equate to $2.6 billion a year.

Corus’s Ian Goldsmith questioned the study’s home advantage assumption. "I’m not sure there is the degree of protection we might have had three or four years ago. Importers are starting to build relations with clients and as a result, the piece of market we can protect is shrinking."

Another factor limiting the impact of any extra carbon cost on competitiveness is the high global demand for steel. Most production is destined for home markets with little spare for export. But this could change as capacity grows in China and India.

"China is in the situation where there is a structural surplus, and is able to service export markets," said Mr Goldsmith.

The steel sector could, of course, reduce its exposure to increased carbon costs by curbing CO2 emissions. According to Mr Goldsmith, the scope for this is limited. "We’re getting towards the technical limits of what we can do," he said. "We are cutting emissions by around 1% per annum, and could probably carry on whittling away like that for a number of years, but it will be difficult to get below 1.6t CO2 per tonne of steel."

The industry is seeking technologies to reduce emissions with a research and development budget of over €50 million. It has a goal to cut primary emissions by 50% by 2050. But with the life of a blast furnace averaging 25 years, major technological advances that cut emissions will not have an impact for many years.

There are measures EU steel producers could use now to cut emissions. They could use partly processed pellets instead of iron ore to make their steel, or they could buy in coke instead of making it themselves. These options would dramatically reduce a plant’s emissions. Even though they would increase raw material costs, this would be more than offset by reduced carbon costs.

But CO2 emissions from processing the pellets and making the coke would still occur - outside of the EU.

Plugging the leaks
The difficult challenge for European policy-makers is to strengthen the EUETS to deliver real emission reductions without crippling industries and shifting emissions elsewhere. If carbon costs continue to rise governments will have to introduce new policies to moderate the competitiveness impacts.

The Carbon Trust’s Michael Grubb thinks there are three basic options: border tax adjustments, intensity-based emission allowances, or global sectoral agreements.

Border tax adjustments would involve applying a tariff equivalent to the cost of carbon under the EUETS to goods entering the EU from areas with no measures to limit emissions, thereby levelling the playing field. But the idea is problematic and unpopular with industry.

"The legal hurdles to border tax adjustments are formidable and should not be underestimated," said Ian Goldsmith of Corus. "We still export material from the EU and importers might impose their own tariffs in response. You would get a trade war - you just don’t want to go there."

Professor Paul Ekins said "Border tariff adjustments would almost certainly be challenged at the World Trade Organization. The jury is out over whether it would be successful."

He also flagged up the practical problem of deciding what goods and exporting nations have no carbon controls: "Lots of countries have climate change policies. It’s difficult to know how much of a tax to impose and on whom."

California and other US states are well on the way to introducing their own emissions trading schemes. China could well argue that it has carbon constraints in place.

But these technical and legal problems could be overcome if there was political will to put the tariffs in place.

"Worries about the WTO or US opposition didn’t stop the EU keeping GMOs out. If the political will is there, governments will act," said Professor Ekins.

The second option, intensity-based allocations, would shrink emissions per unit of production but still allow absolute emissions to grow as overall

production increased. It would favour the most efficient producers and weed out the dirtiest plants. This option is favoured by the steel industry, keen to see a system of benchmarking that rewards the cleanest producers.

But one big problem with this approach is that it removes, at a stroke, the real attraction of a cap-and-trade system such as EUETS: certainty about limiting greenhouse gas emissions. By setting a hard cap for any sector, governments can be sure it will emit that amount of CO2 and no more.

Ian Goldsmith is not convinced by this objection. "There is no certainty [about cap and trade] because it is a leaky system," he said. "Things like carbon rich resource substitution and foreign emissions credits all mean you don’t know the true level of emissions savings. In practice you don’t have certainty and anybody who believes you do is kidding themselves."

But others in the carbon leakage debate resist intensity-based targets. The problem with this option is that it dilutes the carbon cost for these products, explained Professor Grubb.

"If the objective is to decarbonise the economy over the next few decades, you don’t want to start down that road," he said.

The final option, a global sectoral agreements on cutting emissions, is widely seen as the best, but also potentially the most difficult. Getting different companies and governments to agree on emissions reductions for the sector as a whole is a daunting task, but Ian Goldsmith thinks it is possible.

"For the first time we will have data being gathered on a common basis" for

the steel industry globally, he said. "That’s a major step forward." But it will take time: "Realistically you’re going to need five years to gather data and probably at least another five years to negotiate a deal." He thinks foreign producers will sign up to the idea to fend off carbon tariffs on exports to the EU.

Whatever route is considered, Professor Grubb is keen to see the debate move from how to protect EU industry, to how to protect business in a multilateral deal with targets and trading post-2012.

"Any option driven fundamentally by pressure to protect industry within a single trade jurisdiction - whatever the EU or North American Free Trade Area is potentially explosive.

"Negotiations on the second period of the Kyoto commitment is the right place to do this," he said. He wants the EU to make clear that it will ensure its industrial sectors are not disadvantaged and that it has a strong preference for a multilateral agreement to deal with the problem.

Ensuring real reductions
Carbon trading is gaining ground with governments and industry worldwide thanks to the EUETS. But while the system is now established, its success at cutting emissions is still questionable.

The European Commission has acted to make cap-setting more rigorous to ensure a market for curbing carbon. But it will also need to act to plug carbon leaks if the scheme is to remain credible and achieve real emission reductions.

A handful of sectors like steel and cement have real cause for concern over the scheme’s competitiveness impacts, and governments will have to act to protect them from harm, but the threat to the wider economy appears limited.

"Cement and steel together comprise 0.2% of value added to the economy," said Professor Grubb. "To say the EUETS is of serious threat to the economy is wrong. The policy message here is that protection measures need to be confined to a limited number of specific sectors."

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