Carbon leakage in the European Unions power sector

Keisuke Inoue, Climate Change Unit

The EU Emissions Trading System (EU ETS) is an essential tool for the European Union to achieve its goal of reducing CO2 emissions from power generation. The EU ETS encourages fuel-switching away from fossil-based generation, with a cap on CO2 emissions, eventually resulting in higher electricity prices. The electricity sectors of countries that border on the European Union and do not apply such a policy may gain a competitive advantage and, transmission capacity allowing, gain shares in the European Union's electricity market and trigger so-called carbon leakage. This paper provides an introductory exploration of this issue and indicates how such leakage may be tracked and quantified if it were to become a concern for policy makers.

After heavy industry, now electricity? What exactly is carbon leakage?

Third-phase discussions of the EU emissions trading scheme have created much debate on the issue of so-called carbon leakage. If the cost added to electricity production from CO2 regulation within the European Union either a) enhances the competitiveness of producers from outside the regulated region by increasing the cost for those inside, or b) causes EU producers to relocate production to outside the European Union, so-called carbon leakage would occur. In both cases, part of the emissions avoided through CO2 regulation would simply shift elsewhere, undermining the effectiveness of the initial regulation.

The threat of carbon leakage has generally been associated with energy or CO2-intensive sectors whose products are traded on international markets (Reinaud, 2008). Electricity generation is largely local, with its trade limited by physical transmission capacities; little, if any, attention has been drawn to the issue of carbon leakage in the power sector. There could, of course, be cases of industrial relocation that would lower local electricity demand and related emissions, with higher electricity-related emissions elsewhere: this leakage would be associated with the competitive disadvantage of the industry, and be tracked through changes in trade of this industry's products.

In general, opportunities to trade electricity are well exploited, largely among countries with similar CO2 regulations. However, recent reports have raised the spectre of European companies installing electricity capacity outside the European Union with the intention of exporting their output back to Europe, hence evading the constraint imposed by the EU Emissions Trading System (EU ETS) (Ames, 2010).

Carbon leakage is measured as the ratio of emissions increase from a specific sector outside the constrained region (as the result of a policy affecting emissions of that sector in the region), over the emissions reduction in the sector (as a result of that same policy) (Reinaud, 2008). Carbon leakage in the power sector should therefore result from a change in the international trade of electricity to and from a carbon-constrained region after the introduction of CO2 regulation.

In practice, a generator faced with a carbon constraint would reflect its cost in its prices, therefore enhancing the competitiveness of clean generation sources - what is expected from the regulation - and of those generators that do not face such a constraint. The CO2 constraint would also lower expected returns on new investments in fossil-fuel-based generation; a decision to replace an old plant may be postponed or cancelled, and electricity imports may be substituted instead. Whenever CO2 is emitted to generate these electricity imports, carbon leakage would occur.

What EU electricity trade flows tell us at this stage

As a point of reference, the gross electricity trade of all EU-27 countries combined amounted to near 300 terawatt hours (TWh) in 2008, or some 8.9% of the region's total electricity generation. In most years, the European Union also imports electricity from outside countries. In 2008 these imports amounted to 0.5% of total supply, or 16 TWh.1

The level of such electricity trade is of course very much dependent on transmission capacity between EU and non-EU neighbouring countries.

1. In the last decade, net electricity trade varied between net exports of 7 TWh (2004) and net imports of 19 TWh (2000) (IEA Statistics, 2011).

Any significant change in this percentage can only happen with joint investments in transmission. However, transmission lines are rarely fully used at all times, and there may be opportunities for enhanced electricity trading across the two regions if economic signals were appropriate and excess generation capacity existed.

This analysis first considers net trade flows in electricity between the European Union and neighbouring countries. Carbon leakage occurs either when energy exports are lower from EU to non-EU countries or imports are higher from the latter, due to the additional cost that the CO2 constraint creates for generators in the European Union. Such observations would also need to take into account the other factors that can affect international electricity trade, including availability of generation capacity (hydro, based on variations in precipitation; nuclear, as a result of maintenance activities), and economic factors such as international fossil-fuel price variations. These factors are not studied in any depth in this analysis.

The statistical method that follows rules out those EU countries that do not border non-EU countries. However, Norway, not an EU country, is included in the group of countries facing a CO2 cap. In spite of its reliance on CO2-free hydro power, Norway's integration in the Scandinavian power market exposes its electricity sector to an electricity price which reflects the cost of EU CO2 allowances faced by generators in Denmark, Finland and Sweden. Electricity trade was observed for the following countries: Albania, Belarus, Macedonia, Russia, Serbia, Switzerland, and Ukraine. Russia and Ukraine are particularly interesting because of the relative importance of their electricity exports to EU countries.

Figure 1 illustrates net electricity trade between CO2-constrained countries and Russia between 1990 and 2008. The positive value indicates net imports from Russia by the indicated country. Figure 1 shows, for instance, Finland as a net importer from Russia, with amounts growing from around 5 TWh annually up to 2000 and around 11 TWh thereafter.

The increased imports did not begin in 2005. The growing imports seem to follow a general increase in electricity demand over the period, as shown in Figure 2. While there is a net increase in imports in 2005, it is largely due to excess hydro capacity in Norway and Sweden, which crowds out the more expensive coal- and peat-based generation in Finland. If this was accentuated by the price of CO2, it is a result of the intention of the EU ETS that cleaner generation in the European Union become more competitive than CO2-intensive sources. Imports from Russia were at roughly the same level between 2003 and 2008, showing no upward adjustment as a result of the CO2 constraint in Finland.

Figure 1 also shows growing imports of Russian electricity in Estonia in 2007. With only three years of observations (2006-2008), no conclusion can be inferred. In 2007, however, Estonian minister Juhan Parts complained about competitive distortions between Estonian and Russian power generators, as the latter face no restrictions on their emissions of CO2 and other pollutants (New Europe, 2007); the question is whether the existence of a carbon cost in the price of Estonia's electricity was the defining factor in the competitive advantage of the nearly 3 TWh of Russian electricity sold to Estonia. Only then could carbon leakage be a concern.

Figure 1

Russia net electricity trade with countries subject to the EU ETS (1990-2008)

Figure 1

Russia net electricity trade with countries subject to the EU ETS (1990-2008)

Source: ENTSO-E, 2007, 2008, 2009; IEA statistics. Unless otherwise indicated, material in figures derives from IEA data and analysis. uj

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