Should carbon leakage stifle EU climate goals?

Conventional wisdom holds that even the EU’s current unilateral 20% greenhouse gas emissions reduction target by 2020 risks the loss of key heavy industries to cheaper high-carbon economies unless these sectors are compensated. But how true is this and what should be done? Paul Hatchwell sifts the evidence.

Port Talbot steelworks’ blas furnace: steel is one of the most vulnerable sectors to carbon leakage, courtesy of CorusSince the advent of the EU emissions trading scheme (EU ETS) in 2005, the world’s first and so far only mandatory carbon cap-and-trade scheme, carbon leakage has become an ever more politically loaded issue.

The fear is that energy-intensive heavy industries, facing higher costs because of the EU ETS, will lose out to overseas competitors. And instead of carbon dioxide emissions being cut, they will ‘leak’ out of Europe to the developing world.

The issue has long threatened to undermine the EU’s global climate leadership position, and has held up passage of parallel cap-and-trade legislation in the US (ENDS Report 424, pp 44-45).

The EU’s ambitious 20/20/20 energy and climate package adopted in December 2008 (ENDS Report 408, pp 38-41) laid down the broad ground rules for phase III of the EU ETS from 2013 to 2020. The European Commission and member states agreed there should be far more auctioning of carbon allowances to emitters, instead of giving them away free of charge.

Why? Because auctioning could raise large sums of money for governments, which they might choose to invest in help to decarbonise their economies. And because, in the earlier phases, some electricity generators were passing on the market value of their allowances as costs to customers, even though they were given them free – and thereby making big windfall profits.

But as part of 20/20/20 it was agreed that free allocations of carbon allowances to carbon-intensive industries would continue on a massive scale, to protect them from overseas competition and to tackle climate leakage.

And so began a complex, protracted process of working out exactly which industrial installations should get free allowances, and how many and for how long.

It is a process far from being settled. Meanwhile, the possibility of the EU moving from its target of cutting greenhouse gas emissions by 20% by 2020 relative to 1990 to a tougher target of 30% adds a further layer of uncertainty.

Moving target

Moving to 30% – long an EU aspiration – would require significant changes to the EU ETS, with implications for the anti-leakage policies. But whether the EU makes that move depends on politics within the bloc and how international negotiations towards an effective global deal, as opposed to last December’s Copenhagen Accord (ENDS Report 422, pp 15-16), are going.

Carbon-intensive industries have huge interests at stake and continue to put plenty of effort into lobbying. But globalisation has muddied the waters; this is not a simple matter of developed world industries struggling to stave off their low-wage, dirty rivals in the developing world. For instance, British and Dutch steelmaker Corus is owned by India’s Tata Steel.

Phase III of the EU ETS will see manufacturing – as opposed to power generation – receiving 80% of its allocations free initially, declining to 30% in 2020, and phased out by 2027. But the directive underpinning this phase allows for up to 100% free allocation to continue in sectors considered vulnerable to carbon leakage, to be reviewed every five years.

The top 10% of installations with the lowest CO2 emissions per unit of product will get up to 100% of their allowances free, while weaker performers will get a correspondingly lower share and have to buy the remainder (ENDS Report 414, p 12).

In December 2009, the commission confirmed that 164 industrial sectors and subsectors had been listed as vulnerable to leakage (ENDS Report 417, p 15). The list covered most categories of industry, and the companies it embraced were responsible for 77% of the EU’s industrial emissions.

Industries were listed as ‘vulnerable’ if the EU ETS would increase their costs by more than 5% and if they faced a defined high level of imports – and therefore competition – from rival industries outside the EU. This is referred to as the sector’s trade intensity.

While carbon leakage is a potential threat, the evidence base for quantifying it is patchy. This casts doubt on the commission’s very long list of allegedly vulnerable industries. The lack of evidence makes it harder to develop consensus on remedial policies, and has strengthened the hands of larger industrial interest groups calling for concessions.

Susanne Dröge, head of the global issues division at the ­German Institute for International and Security Affairs, works with the Climate Strategies policy thinktank. “The political decision [early in 2008] came before there was any knowledge on the sectors,” she says.

She says the trade intensity thresholds generated an inflated list of sectors. She also believes last month’s European Commission document analysing the case for increasing the EU’s carbon cutting target to 30% exaggerates the leakage threat, assuming “a very generous calculation of cost impacts”, and higher, pre-recessionary carbon prices.

The commission has now moved on to benchmarking – the technical assessment and consultation exercise aimed at identifying the top 10% of most carbon-efficient performers in each sector. The exercise is in full swing, but measures will not be approved until December 2010 under state aid provisions (see timeline), and allocations will only be determined in 2011.

In Britain, the climate and energy department (DECC) is in charge of presenting the UK’s views on exactly how the anti-carbon leakage rules should work. But it declined to reveal anything about its thinking, or what research it has commissioned. This reflects the change of government, with new ministers not yet fully briefed on the issues.

The Environment Agency is tasked with collecting verified emissions data which will form the basis of UK proposals for free allocation to UK carbon-intensive industries. Some of these industries contacted by ENDS said they wanted to focus on the overall impact of both national and EU climate policy instruments on industrial costs and carbon leakage.

The task at EU level is huge, and frequently contentious, with detailed assessment and consultation needed for all 164 sectors. So far, 53 product benchmarks have been developed for 20 sectors. But there are still intensive negotiations with member states over several sectoral concerns, and over use of ‘fallback options’ based on fuel use, efficiency criteria or historical emissions in cases where benchmarking is impractical. Data are also still incomplete.

Draft benchmark methodology proposals are due out in summer 2010, but ENDS understands these could be delayed.

Meanwhile, detailed drafts on the principles for free allocation of allowances have also been circulated for discussion.

But here, too, major issues remain to be resolved. These include how to gradually reduce existing, or ‘grandfathered’, allocations of allowances to individual industrial sites, how to treat heat generated onsite, exported or bought in, and how to deal with new entrants and the mothballing or closure of plants.

Arching over the emissions trading scheme is the limit on the total number of allowances – after all, what use is a cap-and-trade scheme if it does not cap, or limit, total emissions? However, the more that allowances are granted to some emitters free of charge, the fewer that remain available for auction to others.

To add to the complexities, the cap is going to shrink year after year through phase III as the EU brings down its greenhouse gas emissions. It must contract by 21% between 2005 and 2020 given the current 20% EU target, or by 34% if the EU ever opts for the tougher 30% target.

To cope with this shrinking cap and avoid a shortage of allowances for auction, the European Commission may find itself having to reduce the number of free allowances on offer through phase III.

An alternative way of dealing with this problem would be to set tougher carbon efficiency benchmarks, so that fewer plants qualify for 100% free allowances. ENDS understands this is favoured by the commission. One such proposal is to tighten them annually. Either way, even state-of-the-art installations will find it increasingly hard to avoid having to buy in extra allowances – unless they become even more carbon-efficient or cut production.

Given all this complexity, carbon leakage must create its own bureaucracy in member states and the commission, with masses of data collection, rule-setting, monitoring and auditing. But how strong are the arguments for protection of these carbon- and energy-intensive industries?

The commission’s May analysis looked at negative impacts on production in energy-intensive sectors vulnerable to leakage under both the current 20% and the conditional 30% target.

In each case it assumed that the range of anti-leakage measures in the 20/20/20 package were deployed and only the least ambitious end of the range of pledges offered by the globe’s biggest economies through the Copenhagen Accord are implemented internationally (ENDS Report 421, pp 53-55).

It concluded that the 20% target would displace less than 1% of manufacturing overall, with organic and inorganic chemicals and fertiliser production reducing by 0.5-0.7%, but some chemical products declining by up to 2.4%. It found other sectors would either suffer no loss or even benefit.

With a 30% target, there would be additional production loss of 1% for ferrous and non-ferrous metals, chemical products and other energy-intensive industries. Chemical industry leakage could increase to between 1% and 3.5%.

The analysis found that so long as current anti-leakage measures for phase III are maintained, including access to international offset credits outside Europe and banking of allowances as well as free allocation, carbon leakage should be restrained to these minimal levels. And if, as part of a global climate deal, other manufacturing nations agreed to stronger carbon-cutting pledges, even these risks would reduce greatly, it says.

Poor timing

Yet despite this analysis, the European Commission concluded in May that the time was not right to move to 30%, amid strong opposition from industry, France and Germany, largely due to fears over carbon leakage and job losses.

Several recent independent studies have also questioned the earlier assumptions about how vulnerable European manufacturing is to carbon leakage. This more recent work mostly suggests far fewer sectors are at imminent risk, highlighting steel, cement, aluminium, paper and pulp, some chemical subsectors and refineries as being most vulnerable.

These have been seized on by NGOs as evidence that industry is dragging its feet despite potential for much larger emissions cuts by the EU.

A study by independent, Cambridge-based thinktank Climate Strategies published on 20 May for Green MEPs, whittled the number of sectors at risk down to just 13, based on a carbon price of €30/tonne CO2e in phase III.1

It noted that decisions on where to locate manufacturing plants are complex and that even free allowances do not guarantee firms will stay put. At its launch, French Green MEP Yannick Jadot accused EU industry of building up an exaggerated threat as a smokescreen against tougher emissions mitigation.

A key argument for carbon leakage protection – supported by most studies – is that, unlike the power sector, some energy-intensive industries cannot pass through the added costs they face from having to buy emission allowances to their customers without losing market share.

But here too the case has been challenged head-on by Dutch consultant CE Delft in its controversial April 2010 report, funded by the European Climate Foundation, which itself is largely funded by green NGOs.2

The report cites statistical evidence for 100% cost pass-through in iron and steel, petroleum products, PVC, polyethylene, and to a significant extent in polystyrene, during phase I and the early part of phase II of the EU ETS. Delft claims these industries were able to do what the power generators did: charge customers for carbon allowances which the manufacturers were given free.

Lead author, environmental economist Sander de Bruyn, told ENDS: “On average, it proved more worthwhile to pass on costs fully [based on the prevailing carbon price] than retain full market share.” As a result it estimated €14bn in windfall profits may have been made from free allocation between 2005 and 2008 alone.

Not surprisingly, carbon-intensive industries do not agree with those downplaying the leakage threat. Gareth Stace, head of environment at the Engineering Employers Federation (EEF), says there is too little history of carbon trading schemes to reveal what damage leakage can do.

Ian Goldsmith, head of public affairs at steel giant Corus, adds that the effects of carbon leakage can be subtle and take time, as ageing plants lose out on new investment going to less-regulated countries outside the EU.

But this view runs counter to the commission’s analysis, which concluded that “investment in low-carbon technology in energy-intensive sectors has strengthened their overall productivity”.

Industry’s concerns about carbon leakage go wider than the EU ETS. EEF’s Mr Stace stresses: “Our biggest fear is that there’s a creepage of additional costs through [overall] climate policy”.

He cites other EU and UK measures such as ambitious renewables targets, the Carbon Reduction Commitment Energy Efficiency Scheme, and the forthcoming carbon capture and storage levy on electricity sales, as well as electricity generators passing on their own EU ETS costs to customers.

Nicholas Sturgeon, head of energy and climate at the UK’s Chemical Industries Association, believes the cumulative impact of current and planned climate policies could boost electricity prices by 70% in 2020 and gas by 40%. “We’re going to see a step-change in carbon cost [and electricity prices] as we go into phase III despite leakage criteria,” he says.

All three rejected CE Delft’s conclusion that the key vulnerable sectors of steel, chemicals and cement will be able to pass through costs to customers and even made windfall profits from earlier free allowances.

Low thresholds

But one thing EEF, Corus, the CBI and the latest independent studies do agree on is that European Commission thresholds resulting in 164 sectors being designated as potentially vulnerable have been set too low: “That list is too long and it detracts from those sectors that are exposed to carbon leakage,” says Mr Stace, arguing the commission should have focused resources on understanding the key sectors and how to benchmark them better.

Corus’s Mr Goldsmith has worked closely with Climate Strategies to ensure a realistic analysis in its earlier report (ENDS Report 422, pp 15-16). This suggested targeted measures for different sectors rather than a blanket free allocation which could undermine incentives to decarbonise.

The report proposed free allocation for steel, under serious competitive pressure with little imminent chance of technological breakthrough, measures to reduce electricity costs for aluminium and compelling cement importers to buy carbon allowances to cover the CO2 emissions embedded in their imports. “We broadly agreed with that conclusion,” says Mr Goldsmith.

But on benchmarking for free allocation there are still serious disagreements over criteria and complexity, notably in the steel industry. “The benchmarking measures being proposed by the commission are unrecognisable by the industry”, says Mr Goldsmith. “The data being asked for [including energy flows around sites] we don’t even collect”.

Another major problem for steel is in its use of process waste gases. ‘Waste’ process gases from steelmaking, which could be flared off, are increasingly used for heating and electricity generation on-site (ENDS Report 424, p 13).

Even though CO2 emissions from power generation using waste gases should arguably receive 100% free allocation of carbon allowances, the commission proposals would only give allowances for the difference between emissions from high-efficiency natural gas generation and more carbon-intensive waste gas generation. The industry says this fails to reward on-site resource efficiency.

But while some sectors are concerned they will get inadequate allowances, inappropriately allocated, the UK’s specialised ceramics sector, straddling both the EU ETS and the UK’s Climate Change Levy agreements, complains it has been left out of carbon leakage sectors altogether despite competition from imports and substitutes.

With the prospects for a strong global deal on climate change remaining uncertain, pressure for action on cheap, carbon-­intensive imports into the EU is growing.

A study by the Centre for European Policy Studies, released on 27 May, 2010, came out against the idea of using free allocation of allowances to preserve a level playing field against overseas competitors.3 It argued that this undermined incentives to invest in low-carbon technologies.

It focused instead on how tariffs imposed on the most carbon-intensive imports from countries failing to adopt adequate climate change policies, notably China, could in effect create a global shadow carbon price by proxy, even without a global climate agreement.

Anyone importing such products would have to buy carbon allowances or pay a levy to cover the CO2 emissions embedded in them, creating in affect a carbon tariff.

The study concludes that border measures, allowed for in the EU ETS and US proposals (ENDS Report 424, pp 44-45), need not violate World Trade Organization rules (ENDS Report 414, p 55). It notes that, in principle, assessment of embedded carbon in imports has many parallels with systems for assessing and regularly applying duty on embedded sugar in imported food products, and adds that development of a new ISO14067 international carbon footprint standard could help develop a globally acceptable EU carbon tariff system.

In any case, it suggests that initiating a long-running trade dispute could be more damaging to these high-carbon exporters than paying the tariffs, making conflict less likely.

The CEPS study notes that the most carbon-exposed sectors – cement, steel, aluminium, chemicals, pulp and paper – amount to just 5% of all trade in the EU and US. Unlike other studies it recognises that making them pay for their carbon emissions would impact indirectly on many other sectors. It also points out that embedded carbon in imports from major emerging economies ranges from twice to eight times the average for the same products made in OECD countries.

The EU analysis published in May noted that actual or threatened border carbon tariffs could increase pressure for a global climate deal… or make negotiations even more difficult. There would be serious issues of monitoring, reporting and verification in the exporting countries, and rewarding more efficient individual producers in these economies would be complex.

But it also warned of other unwanted possible side-effects. Emerging economies could simply divert ‘dirtier’ goods for domestic use or export them to other emerging economies, as can happen with rainforest-grown beef in Latin America. And carbon tariffs would also increase costs to wider EU industry.

So the European Commission sees such trade measures as a last resort. It prefers other measures, such as tightening up on use of international offset credits by cutting out those generated from easy wins in energy-intensive industries in major economies.

The commission points out that such Clean Development Mechanism (CDM) offset projects, allowed under the Kyoto ­Protocol, can result directly in carbon leakage. It says there is evidence that production of HCFC-22, and adipic acid for nylon and plastics, has shifted to developing countries to generate CDM credits, as these can yield more revenue than the products themselves.

Credits crackdown

In contrast, it believes much tougher thresholds for generating developing world carbon credits, based on agreements covering entire industrial sectors rather than individual factories, (ENDS Report 409, pp 49-50) would reduce these trade distortions while preparing the ground for comparable cap-and-trade regimes in emerging economies such as China and India.

Industry has mixed views on border measures. The steel sector does not dismiss them out of hand, but notes they could be divisive and would need to address steel in manufactured imports too – a big ask. They could potentially work for cement, but would surely be impossible in the chemicals sector with the carbon footprints of 30,000 different products having to be assessed.

Most stakeholders agree that significant carbon leakage is confined to a fraction of the 164 sectors listed by the commission, and that far more attention should be focused on these, whether through free allocation or other measures to level out costs.

While carbon leakage need not hold back the EU’s climate ambitions, even without a global climate deal, there is still little consensus on the intensity of the threat in these sectors, or how best to deal with it. Most attention is still focused on the costs imposed by only the EU ETS rather than overall climate policy measures.

And industries complain that benchmarking for carbon intensity is far removed from the real world profitability criteria that influence investment decisions. Benchmarks based on European practice also tend to ignore new, high-performance heavy industrial plant in India and China compared with often ageing EU and UK installations.

All sides of the debate look to a global climate agreement creating a level playing field as the ideal solution to the leakage problem. In the meantime, smarter, targeted anti-leakage measures will be needed. These must be based on better data and understanding of vulnerable sectors and what drives investment decisions in a global market.

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