Download Issues behind Competitiveness and Carbon Leakage

EXECUTIVE SUMMARY
When climate change mitigation policy introduces a cost for some but not others within
the same sector, competition among companies is distorted. The implementation of the
Kyoto Protocol potentially creates such a situation as some developed country Parties to
the Kyoto Protocol have binding emission reduction targets (36 countries), while
developing country Parties as well as other non-Parties, have no quantified emission
reduction binding targets. The introduction of domestic or regional emissions trading
schemes (ETS) that cap GHG emissions for sectors whose products compete internationally
(e.g. the European ETS) can also trigger such conditions. Competitiveness concerns arise
when this distortion becomes significant. For some industrial activities, this could be the
case, but by no means for all.
The question for those designing policy today is how to ensure that the transition towards
a low-carbon economy occurs with only limited carbon leakage - namely the movement of
production away from jurisdictions where carbon constraints exist to jurisdictions where
they do not. Nonetheless, the prevention of carbon leakage should not occur without
consideration of cost (to other sectors and the economy more generally). As a start,
policy-makers‘ priority should be: careful measurement and analysis of the issue, along
the lines of what is presented in this report.
This paper explores heavy industry‘s vulnerability to carbon leakage and provides a
statistical method to indicate possible carbon leakage. It also assesses a number of
proposed policy measures to mitigate carbon leakage based on a selection of economic
and environmental criteria.
This paper is not about how to maintain today‘s status quo: it is about ensuring that the
transition towards a low-carbon economy occurs with only limited carbon leakage (defined
below) and is not hampered by the ‗noises‘ made by a handful of sectors about
competitiveness losses.

What is carbon leakage?
Carbon leakage can be defined as the ratio of emissions increase from a specific sector
outside the country (as a result of a policy affecting that sector in the country) over the
emission reductions in the sector (again, as a result of the environmental policy). When
handling this issue, the aim is to address environmental effectiveness, not industrial
policy.

What causes carbon leakage?
There are several channels of sector-led carbon leakage initiated by uneven carbon
constraints, the three most important include: i) the short-term competitiveness channel,
where carbon-constrained industrial products lose international market shares to the
benefit of unconstrained competitors; ii) the investment channel, where differences in
returns on capital associated with unilateral mitigation action provide incentives for firms
to relocate capital to countries with less stringent climate policies; and iii) the fossil fuel
price channel, where reduction in global energy prices due to reduced energy demand in
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climate-constrained countries triggers higher energy demand and CO2 emissions
elsewhere, all things being equal.
This report focuses on the first two channels of carbon leakage for manufacturing sectors,
immediate loss of market share for carbon-constrained industrial products, to the benefit
of non carbon constrained countries (i.e. decreases of exports and increases of imports)
and location of energy-intensive industries to countries with a more favourable climate
policy. These leakage routes are also called the ‗competitiveness leakage channel‘
(Demailly and Quirion, 2007). These qualify as ‗competitiveness-driven‘ carbon leakage.

What can be concluded about the seriousness of competitiveness-driven carbon
leakage for industry sectors?
The sectors subject to loss of competitiveness under uneven carbon constraints and
potentially to carbon leakage are internationally trade-exposed, GHG-intensive industries.
These industrial activities would support a high mitigation cost and can see their products‘
market challenged by foreign competitors as a result of stringent emission objectives.
Case studies of industries whose products are widely traded globally and whose production
displays a relatively high degree of standardisation bring important elements to this
discussion. Primary aluminium, refineries, cement, pulp and paper, iron and steel and
chemicals fit in this category, although to varying degrees. The inclusion of intra-sectoral
discrepancies shows different leakage rates within these sectors.
Within the existing research on sectoral carbon leakage, none of the simulations focusing
on sectoral leakage indicate a leakage rate near 100%: in other words, it is highly unlikely
that carbon leakage would wipe out entirely an effort to reduce emissions in an industry.
The general notion that a cap in a country or region will result in even more emissions
globally is contradicted by all quantitative studies. However, as it is, we only have
imprecise and highly uncertain ranges of leakage estimates for some sectors (iron and
steel, aluminium and cement) but not for all sectors potentially exposed to such a risk
(e.g. paper and pulp, chemicals, etc.).
Higher leakage rates would be expected in the steel and primary aluminium sectors than
in the cement or electricity sectors – mainly because the latter are much less traded.
Some of the modelling studies are based on the introduction of taxes due to the modelling
frameworks applied: at a USD21/tCO2 tax applied in Japan and the EU-15, the leakage rate
reaches 55% in the iron and steel sector. Other studies manage to model the impacts of an
emissions trading scheme: at a EUR20/tCO2 price applied to the European Union (EU-27),
leakage rates range between 0.5% to 25% in the iron and steel sector and between 40-70%
in the cement sector, depending on how allowances are distributed among other
parameters.
Yet modelling the impacts of an ETS with a carbon tax may be misleading, especially if the
ETS regime provides gratis allowances to installations. In addition, under a free allocation
scenario based on an absolute cap, free allowances are valued at their opportunity cost,
and hence overestimate the negative impacts on companies‘ profit margins. Finally,
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models are essentially limited by their reliance on quantifiable factors, and cannot
incorporate other drivers of industrial decisions.

Monitoring sectoral carbon leakage through pass-through of climate policy-induced
cost
The cost pass-through capacity of a sector is its ability to recover the cost of the carbon
constraint on product prices, without significantly undermining international
competitiveness, i.e. without inducing carbon leakage. As such, it is an indicator of the
carbon leakage exposure of a sector and is at the centre of discussions on how to deal with
trade-exposed sectors under domestic and international climate policies.
If climate policy entails a substantial increase in costs for a sector in one region, two
situations could occur – at the heart of both is the pass-through of those additional costs.
In the first situation, no sign of international competition allows the pass-through of costs
into product prices – at least in an initial phase. As a result, profit margins are maintained.
In the second situation, a sector is vulnerable to international competition, and as a result
does not pass-through cost increases onto its prices, hence eroding its profit margin.
Whether a sector is in the first or second situation is of paramount importance in the
debate on whether auctioning ought to be preferred to free allowances: the latter triggers
mostly an opportunity cost, whereas the former has a directly visible cost impact.
Over the medium to long run, if the cost differences remain and are significant, this may
affect the use of existing capacity, the return on investments in new capacity in the
region, and, following, the location of the next investment in favour of less stringent
climate jurisdictions. This medium- to long-term leakage route may be of more concern
than the more subtle immediate effects.
Cost pass-through is a result of several factors, including the competitive nature of the
market, the amount of production cost increase, and product substitutability. Further, a
domestic sector‘s ability to pass-through additional costs that foreign competitors do not
bear is dynamic as elements driving competition change with time (e.g. transport costs,
production costs, production availability, product specifications, etc.). The existing
literature has demonstrated a higher cost pass-through capacity in the refinery and
cement sectors than in the aluminium sector – the iron and steel, and the paper and pulp
sectors fall in between.

What would give us evidence of leakage?
If competitive distortions are significantly different between constrained regions and
unconstrained regions, carbon leakage should be apparent in the trade flows to and from
the constrained region. These trade flows should then be matched with other economic
parameters to evaluate whether carbon policy played a role. This requires understanding
the sector-specific parameters that need to be taken into account for each sector to single
out any leakage.
There cannot be leakage without a change in trade of related products or commodities. In
the short term, an indicator of carbon leakage is a change in international trade flows
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of carbon constrained products. In the case where the CO2 price triggers cost
differentiation, differences in cost levels vis-à-vis non carbon constrained producers could
trigger changes in trade flows as companies shift to the sourcing of emissions-intensive
products from abroad. This shift can be triggered both by the demand side (i.e.
consumers purchase goods made abroad, which are cheaper than carbon constrained
products) and the supply side (i.e. producers source semi-finished emission-intensive
goods from non-carbon constrained countries).
Over the long run, the main indicators of carbon leakage are changes in investment
patterns. The CO2 cost will affect investment decisions – mostly because profit margins
erode in the case where a sector cannot pass-through its cost increase. Yet drivers of
investment are multiple. Changes in exchange rates, energy prices, labour and capital
costs are, in many cases, far more significant in a company‘s decision about where to
source supply or locate production than the existence of a carbon price. A slow down of
the booming commodity market would certainly accelerate closures – and yet one would
surely not attribute them to climate policy. As such, properly defining the counterfactual
scenario (i.e. what would have happened in the absence of the climate policy) is critical
for finding evidence of leakage.

Experience with the European emissions trading scheme (EU-ETS)
While emissions trading is one of several policy instruments to reduce CO2 emissions, the
EU ETS has provided a full-size experiment to identify the magnitude of competitiveness
and carbon leakage. Experience to date with the EU-ETS does not reveal leakage for the
sectors concerned – analysis of steel, cement, aluminium and refineries sectors reveal that
no significant changes in trade flows and production patterns were evident during the first
phase (2005-2007) of the EU-ETS. This is mostly due to the free allocation of allowances,
sometimes in generous quantities, and to the still functioning long-term electricity
contracts, which softened the blow of rising electricity prices. Further, the general boom
in prices for most traded products subject to carbon costs – whether direct or indirect –
has blurred any effects of the latter. Finally, the relatively short time span of these
policies does not allow observation of the full potential effects on industry via changes in
investment location decisions.

Limitations of current analyses
Empirical analysis of relatively recent climate mitigation policies reveals lower leakage
rates than models projected. However, past observation of carbon leakage does not mean
that there will not be any in the future as countries move towards more ambitious
mitigation commitments. Further, past estimates may also be limited because
globalisation has profoundly changed the business environment of many manufacturing
industries. This phenomenon may be a factor in accelerating the leakage. It could raise
limitations to a sector‘s ability to pass-through carbon asymmetric carbon costs as firms
will fear loss of market share - pending production capacity is available for the export
market. To this effect and as pass-through capacities are dynamic, continuous analysis of
pass-through capacity is needed if governments wish to assess the reality of carbon
leakage.
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The sea change in commodity markets (e.g. globalisation, growth of production, etc.) also
calls for a continuous monitoring of trade flows and investment decisions as indicators of
carbon leakage. Moreover, it requires the establishment of a counterfactual scenario of
industry developments in the absence of climate policy to identify which factors may have
caused what changes in industrial operations on a global basis and the exact role of a
carbon policy cost. A slowdown of the booming commodity market would certainly
accelerate closures – and yet it would be overreacting to attribute movements of industry
cycles to the CO2 price alone. And here is the most difficult challenge of the report: how
to single out the effects of climate policy (i.e. to define the counterfactual scenario). In
the specific case of the European Union, how does one detect, in the rapid industrial
production growth outside the EU, the actual effect of the ambitious EU climate policy
and the resulting loss of competitiveness and industrial relocation? Disentangling its
particular role – and the role of climate policy therein – from other factors (such as
economic growth, etc.) proves analytically difficult and so does the design of policies to
deal with the possible effects on competitiveness.

What measures are proposed today to address competitiveness-driven carbon
leakage?
If full auctioning of CO2 allowances to industry sources became the general rule for
allocation, for some of the most carbon-intensive industries such as cement, blast-furnace
steel and some basic chemicals, the carbon leakage impact could be significant enough to
warrant countervailing policy intervention. Nonetheless, such policy measures should be
targeted to specific sectors (or sub-sectors) rather than being comprehensive.
A range of policy responses proposed or discussed in current legislation is reviewed in this
report: free allocation to existing and new facilities; financial compensation for loss of
competitiveness; schemes that adjust the carbon cost at the border; and instruments that
encourage sector-based actions in developing countries. Each of these policies has its
merits and demerits (see Table 12 and Table 13), and implementation in a specific sector
requires adapting the measures to each sector‘s characteristics.
A structured sectoral evaluation of each measure in addressing carbon leakage could
highlight valuable information for choosing and designing measures. Namely, a measure
geared to mitigate trade movements in favour of developing countries in an electricintensive sector (e.g. aluminium) could mobilise a different form of compensation from
that required for process emission-intensive sectors (e.g. cement or integrated steel).
Three challenges lie ahead for the development of measures aimed to address carbon
leakage:

First, the debate on carbon leakage reflects the ―second-best‖ situation of climate
policy today. The ―first-best‖ policy option is the pursuit of a global international
agreement that imposes a similar marginal cost to all emitters. As a result, the
effectiveness of measures that guard against emissions leakage must be carefully
assessed against any risk of undermining a broader international climate agreement in
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the future.1 Ideally, measures to deal with competitiveness distortions should
encourage broader participation of sectors in global GHG mitigation, and not create
entrenched market positions.

Second, measures would need to maintain a carbon price signal in the carbon
constrained economy, and lead sectors to a necessary low-CO2 path. A carbon price
could reveal technical solutions of limited interest up to now to industry and
equipment providers. Any measures that obviate a visible CO2 price signal in the
economy, one way or another, would significantly undermine the effectiveness of the
climate policy. Understanding how much effectiveness could be lost as a result of their
implementation must be a prerequisite – not to mention the additional cost that may
be borne by the rest of the economy, if measures imply a lower environmental
constraint on industry.

Last, policy makers should consider designing measures as flexibly as possible to avoid
the lock-in of less efficient policies (e.g. free allocation vis-à-vis auctioned
allowances). Governments need to be able to react to progress made within the
international negotiations.
The sensitive aspects of some of the measures discussed to counter leakage highlight the
importance of a careful assessment of the reality of this issue. Policy-makers need to
seriously consider today‘s trends in industrial development to understand how large or
small an impact carbon policy may have on it. Without such analysis, policy-makers will
not be in a position to balance the cost of leakage-mitigating measures against the
benefits (i.e. avoiding competitive loss and higher emissions elsewhere).
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The global nature of the climate change problem makes this element central in all discussions that aim to
alleviate the negative aspects of CO2 price signals in the economies.
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