Industrial winners and losers in the carbon tax game

Major energy users are campaigning fiercely against the European Commission's proposals for a carbon/energy tax - and have persuaded a parliamentary inquiry to back their case. But much of the evidence suggests that even energy-intensive sectors would experience little increase in production costs or serious reductions in competitiveness - while other industries, and consumers in general, may even benefit. The ways in which the tax revenues are recycled will also be crucial in determining its economic and industrial impacts.

Despite the controversy which greeted their publication in September, the Commission was given the go-ahead by EC Ministers in December to work up its ideas in more detail. The debate will enter a crucial phase when these are discussed by Environment Ministers on 26 May, just a few days before the Earth Summit begins in Brazil.

To recap, last September's proposals envisaged the imposition of a tax split 50:50 between the carbon and energy content of fossil fuels and other energy sources except the renewables. The tax would begin in January 1993 at an equivalent of $1 per barrel of oil - the current price is about $18 per barrel - and would rise to $10 per barrel by 2000. A January 1993 start date now appears to be out of the question.

A key component of the package would be a requirement on Member States to ensure that the tax was "fiscally neutral". In addition, exemptions for energy-intensive sectors - iron and steel, non-ferrous metals, paper, glass, chemicals and cement - would be considered, possibly in exchange for agreements to meet specific energy efficiency targets, but perhaps lasting only until the EC's main competitors enacted similar measures.

Industrial lobbying
The proposals have been greeted with undisguised hostility by industry. Energy-intensive sectors, together with coal, oil and electricity producers, have sounded dire warnings of a slide in the EC's international competitiveness and a flight of investment out of the EC, a collapse in its coal industry, and a growing dependence on gas supplies from politically unstable regions. At the same time, it has been claimed that the tax would be too small to promote any significant reductions in CO2 emissions within the EC, and - if imposed unilaterally - would reduce global energy prices and hence promote higher CO2 emissions outside the Community.

The same forecasts of an impending economic and industrial cataclysm were presented to an inquiry into the Commission's proposals by the House of Lords Select Committee on the European Communities. Its report, due to be published on 1 May, broadly accepts industry's arguments, and comes down firmly against a carbon/energy tax.1Lords' objections
The Committee says it has two principal reservations about the tax. Firstly, since demand for energy is "highly inelastic", a tax of $10 per barrel of oil would be too small to have an impact on the behaviour of most consumers. Secondly, a unilateral tax would damage the competitiveness of Community industry to an unacceptable degree for a poor environmental return.

The Committee reached these conclusions, however, along a rather crooked path. It accepted, for example, that the tax would not hit overall output. And it noted that "the impact of a unilateral tax on the average competitiveness of Community industry would depend on other policies, on how the revenues were used and the response of non-EC countries."

These observations and qualifications are absolutely crucial, but in the final analysis the Committee concluded that they should not deflect it from opposing the Commission's proposals. Other commentators, some of whom submitted evidence to the inquiry, have come to quite different conclusions.

Elasticity of energy demand
A central issue in weighing the potential effects of the tax is the price elasticity of demand for energy. One member of the Committee who was particularly exercised by this point was Lord Gregson. During a hearing in February, he commented that a tax as high as $50 per barrel would be needed to promote a shift to a less carbon-intensive economy, and then went on: "Oil prices went from two dollars to 35 dollars a barrel and all sorts of predictions were made - it was the end of the motor car, in five years it would be obsolete. You need an enormous price change to change structures. Everybody was going to go by railway, and in ten years there would be no motor cars and it would be all rail. And nothing happened."

This was a remarkably perverse account of events in the energy market since the first oil shock of 1973. Evidence submitted to the Committee by the Science Policy Research Unit (SPRU) at Sussex University showed that the cost of fossil fuels to UK industry - expressed in £/tonne of carbon at constant prices - rose on an almost unbroken trend from their 1973 value of £60 per tonne to £200 in 1984/5, since when they have fallen back to about £120 per tonne.

The impacts of this price trend are evident in a memorandum submitted to the inquiry by British Steel, of which Lord Gregson is a board member. The energy used to produce a tonne of rolled steel in western Europe declined by 40% between 1970 and 1989, according to the company.

Statistics such as these are being used by the energy-intensive industries to buttress their claims that they are already committed to energy efficiency and do not need the incentive of a tax to continue cutting their energy consumption. However, trends over long periods do not tell the full story.

Energy saving in chemicals
The picture was filled in in April when the Chemical Industries Association (CIA) published its annual survey of its members' investment intentions. The figures for energy-saving investments display a close correlation with energy prices. In 1984, when the post-1973 upward trend in fossil fuel costs reached its peak, chemical companies were planning to devote 17% of their capital budgets to energy saving. The figure then declined gradually to 11% in 1991 - and this year's survey shows a sharp fall to just 6%. More compelling evidence that some sectors of industry are responsive to fine changes in energy prices would be difficult to find.

The Government appears to be well aware of this. A Department of Energy official told the Lords' inquiry that an official study covering a five-year period in the 1980s had shown that the elasticity of demand for energy is "actually somewhat larger in the United Kingdom than we had previously thought." The analysis, she added, had influenced the revised projections issued in December which suggest that the UK's emissions of CO2 will be lower at the end of the century and beyond than earlier projections had indicated (ENDS Report 203, p 20).

While it is evident that some sectors will respond to changes in energy prices induced by a carbon/energy tax, it would be wrong to suggest that this will be the universal rule. In many sectors of industry and commerce energy accounts for only a few per cent of operating costs. In industry as a whole, the costs of fuel, light and power fell by over 25% in real terms between 1986 and 1991 - a factor rarely mentioned in industrial presentations of the impacts of a tax.

Likewise, a large proportion of household energy bills consists of transmission and distribution costs which would be unaffected by a tax. In addition, fuel, light and power now account for only 4.5% of total household spending - the lowest figure since records began in 1957, indicating the difficulties of relying solely on price signals to influence consumer behaviour.

The difficulty is also acute in road transport, the sector whose CO2 emissions are rising most sharply. Because vehicle fuel is already relatively highly taxed, a $10 per barrel tax would raise the price of petrol by just 6% and of diesel by 11%.

Evidence submitted to the Lords' inquiry by Commission officials suggests that it may be considering fine-tuning its earlier proposals to address these problems (ENDS Report 205, pp 23-4 ). But in any event, according to Simon Roberts (Energy Campaigner, Friends of the Earth), "it is quite wrong to treat the price elasticity of demand for energy as a God-given factor which can't be altered by policy."

Lubricating the market
It is common ground between all participants in the carbon tax debate that great scope exists for cost-effective investments in energy efficiency - perhaps by 15-20% over the next few years. There is also a consensus that the market needs to be lubricated - or that the price elasticity of demand for energy could be increased - by information campaigns, new incentives for energy saving and other policy measures. The consensus tends to break down as far as the energy utilities are concerned when environmentalists propose that they should be obliged to engage in "least-cost planning" - or invest in energy conservation measures when these are cheaper than supply-side investments - and as far as consumer durable producers are concerned when statutory energy efficiency standards are mooted.

Various combinations of price signals and regulatory measures are also now under discussion in the Commission's expert advisory group on vehicle pollution. It appears to be generally accepted that a fuel tax alone will not deliver adequate improvements in fuel efficiency, but the debate on the precise mix of instruments to be incorporated in forthcoming EC legislation is still at an early stage (see p 29 ).

The interests of the energy-intensive sectors also bulk large in the debate about the impact of a carbon/energy tax on the competitiveness of EC industry. Yet the evidence suggests that it is by no means inevitable that major energy users would be seriously disadvantaged if they were not exempted from the tax, while other industries, and national economies as a whole, may actually benefit or at least not lose out.

First, the impact of a tax on energy costs needs to be seen in perspective. According to International Energy Agency figures cited in a Friends of the Earth (FoE) briefing on the Commission's proposals, the price of most fuels to industry already varies by a factor of two in different EC countries. Several competitors, notably Japan, Norway, Sweden and Switzerland, have prices for key fuels towards or above the higher end of the existing EC price range.

The Commission's proposals would push up the 1990 prices of coal by 58%, of heavy fuel oil by 45%, and of gas by 34%. Superimposed on present energy prices, this would still leave industry in some EC countries paying less for fuel than some of their main competitors - though not those in the USA.

Secondly, another recent Commission proposal has opened up the prospect of compensation for a tax in the form of cheaper energy supplies for many major industries. The legislation would provide for third party access to the international electricity and gas distribution systems within the EC, and is specifically intended to provide cheaper power and gas to the 400-500 industrial groups with a high energy intensity.

Thirdly, it is highly unlikely that all the energy-intensive sectors would face a severe competitive threat if an EC tax was imposed unilaterally. Cement, in which there is little international trade because transport costs are a major factor in the product price, is well insulated against a threat of this kind.

Impact on industry costs
Fourthly, the results of modelling work carried out by Shell UK and submitted to the Lords' inquiry indicate that the proposed tax would have little impact on production costs in the vast majority of industries. The results, it should be noted, assume a worst case scenario in which no energy conservation or fuel switching takes place in response to the tax, and apparently no recycling of any of the tax revenues to industry.

In the three countries - Germany, France and the UK - for which Shell gave data, the full tax increases production costs by less than or just over 1% in the mining, food and drinks, textiles, paper, wood and engineering sectors. The impact is slightly larger in the chemical industry at 0.7-2.2% - assuming feedstocks are not taxed. Production costs in the non-metal minerals sector - mostly cement - rise by 3-4%. The biggest impact would fall on metals, where costs would rise by 4-10%.

The variations in impact across industries and countries are "surprisingly small", according to Shell. And "vis-a-vis non-European competitors who would not be subject to the tax, a cost difference of 1-2% is well within the range of normal variations in exchange rates, corporate tax rates, and other government policies that affect inter-country competitiveness."

Despite the pessimistic assumptions built into its model, Shell went on to caution against a unilateral EC tax. Such a tax, it said, would be "only one of a large and growing number of environmental overheads which European industry is being asked to support. The cumulative effect of these costs may damage competitiveness in ways that individual steps do not. This cumulative impact, as we see it, poses the greatest danger as regards Europe's competitiveness with the US and Japan."

Some participants in the Lords' inquiry took a rather different perspective on this question. As SPRU pointed out, industrialists' perception in the USA is that "US environmental overheads impose a larger burden than that borne by European industry." And the Fellowship of Engineering observed that, far from hampering industry, high energy prices have made Japanese companies the "most advanced in devising and bringing to market new energy efficient equipment and promoting, for example, fuel cells and photovoltaics."

Another assessment of the impacts of greenhouse gas controls on the UK's and other countries' competitiveness was completed recently for the Department of Trade and Industry by John Pezzey, a former Department of the Environment economist now at Bristol University.2His report applies proper caution in weighing the capabilities and shortcomings of the various models which have been used in this area. It also highlights the importance of distinguishing between sectoral competitiveness, national competitiveness, terms of trade and economic welfare because the impacts of carbon/energy taxes on these indicators can vary markedly.

Winners and losers
The results of Pezzey's own modelling work are broadly consistent with Shell's findings, but his study shows more clearly which industries and countries are likely to be winners and losers. The tax levels in his study are higher than those proposed by the Commission, and his model, like most others, did not incorporate input-output effects between sectors.

According to the report, a tax of $100 per tonne of carbon roughly double the level of a pure carbon tax of $10 per barrel - would make little impact on production costs in non-energy-intensive sectors in the EC, USA and Japan. The four energy-intensive sectors - iron and steel, non-ferrous metals, non-metal minerals and chemicals - would be hardest hit in the USA, where costs would rise by between 8-13%. Of the four EC states studied, Germany's heavy industry would be most affected.

The ranking changes, however, when the effects on sectoral competitiveness are considered because of the varying trade intensities of different countries. The USA, with a low trade intensity, would be second least affected by the tax after Japan, while Germany would be hardest hit. Again, the effects are hardly noticeable outside the energy-intensive sectors, so that national industrial competitiveness barely changes. In the UK, output from energy-intensive sectors is predicted to drop by 1-5%, with the steepest decline being in non-ferrous metals.

These calculations assume that the tax revenues are not recycled. If, however, the tax is offset by uniform subsidies per unit of value of industrial production, then the competitiveness of the transport equipment, machinery, food, paper, wood and textiles sectors improves a little in all countries. The biggest losers are iron and steel in most countries, all energy-intensive sectors in Germany, and non-ferrous metals in the UK - though their output generally declines by less than 3%.

In another part of the study, Pezzey used an existing general equilibrium model to assess the effects of unilateral action to curb CO2 emissions. With a 20% unilateral reduction in consumption of carbon-based fuels, the EC's production of energy-intensive goods is predicted to fall by 8.3%. Strikingly, however, a shift in consumption to less energy-intensive goods and improvements in the Community's terms of trade offset potential welfare losses to consumers.

One of the key points highlighted by the report is the effect of recycling the revenues from a carbon/energy tax. Fiscal neutrality is a central feature of the Commission's proposals, but industrial responses have either ignored it or treated it with scepticism - no doubt due to suspicions that treasuries may simply use the revenues to cut public expenditure deficits.

There is a consensus that the way in which revenues from the tax are recycled will be crucial in determining its impacts on industry, inflation, employment and other indicators. But there is less agreement on which of these should be given priority.

Cambridge Econometrics, for example, believes that using the revenues to reduce VAT would curb inflation and promote growth, while cuts in income taxes could boost inflation and interest rates. From a different perspective, a study sponsored by the CIA has concluded that cuts in income tax would be most helpful to the chemical industry, while cuts in its capital costs would be the least desirable option. On the other hand, there is pressure from environmental groups for the revenues to be used to promote energy-saving investments, while others want higher benefits for low-income households which would otherwise suffer inequitably from higher energy costs.

There are clearly issues raised by the Commission's proposals which would merit further analysis. Whether Brussels itself has carried out any such studies should emerge in May.

It is also apparent that uncertainties about the impact of the tax could be invoked to postpone it for years ahead. A counter-argument was put to the Lords' inquiry by consultants Environmental Resources Ltd. In view of the uncertainties surrounding all aspects of the global warming problem, it will be important, ERL proposed, "to accept the principle of a tax and to implement it in a way which is adjustable and responsive to new knowledge and circumstances. The exact and efficient level of the tax cannot be predicted."

ERL also supported the tough logic behind the Commission's proposals. The restructuring of industry and household incomes to induce a change to a less carbon-intensive economy, it said, is "the purpose of the policy, not an undesired side-effect." Exempting special interest groups from the tax would neutralise its effects, limit its effectiveness in promoting energy efficiency, and mean the loss of other environmental benefits such as reduced acid gas emissions.

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