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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 3 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, 4 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 5 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. 6 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 7 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). 1 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. 8