Carbon trading and industrial competitiveness

The potential impact of emissions trading schemes on the competitiveness of individual companies, industrial sectors and the economy as a whole is an enduring focus of debate. Since the contribution of carbon/ energy costs to industrial competitiveness depends upon a host of fac-tors4, the impacts of introducing a trading scheme are hard to predict, may be greater in the short term than in the long term, and may easily be overstated by well organised and influential lobby groups. This can lead to policies that reduce incomes in the economy as a whole and shift the costs of national compliance with the Kyoto targets to less well organised groups such as taxpayers. Two notable examples are the failure of most member states to use even the minimal provisions for allowance auctioning provided in Phases 1 and 2 of the EU ETS, and the use of inflated projections of business as usual emissions as a means to secure relatively weak emission targets.

The economic case for allowance auctioning, with the revenues used to reduce income and business taxation, is overwhelming. As an illustration, Smith and Ross (2002) used a model of the US economy to show that the economic costs of an economy-wide trading scheme were 80 per cent higher with free allocation than with auctioning. Similarly, Bovenberg and Goulder (2000) show that only a small fraction (less that 15 per cent) of the auction revenues need to be sacrificed in such a scheme to fully compensate the most vulnerable firms for adverse impacts on their competitiveness. However, it has taken a long time for policymakers to recognise the benefits of auctioning and much of business remains opposed.

Claims regarding the potential impact of emissions trading schemes on industrial competitiveness frequently lack a sound analytical basis. Recent studies by the IEA (Reinaud, 2005), the Carbon Trust (Carbon Trust, 2005a, 2005b) and Climate Strategies (Hourcarde et al., 2008) have provided a better understanding of the competitive impacts of the EU ETS, and have suggested that (at least for Phase 1 and 2) these may be less than many industrial groups predicted. Indeed, with free allocation and carbon prices around €l0-20/tC02, almost all sectors have the potential to profit from EU ETS and the anticipated increase in production costs is unlikely to lead to significant imports from outside the EU. A notable exception is the aluminium sector, as a result of its electricity intensity and its exposure to international competition. Impacts on most other sectors (although not necessarily on individual firms) are likely to be relatively small.

Most industrial sectors participating in the EU ETS have been given all the allowances they were projected to need in both Phase 1 and Phase 2 (HCEAC, 2007). In many cases this represents a significant increase on historical emissions. The result has been limited incentives to reduce emissions and an unhealthy focus on negotiating over emission projections rather than identifying abatement opportunities (Grubb and Neuhoff, 2006). Electricity generators were given more stringent targets, but nevertheless were able to make substantial profits in Phase 1 (Martinez and Neuhoff, 2005; Sijm, 2005). While generators receive the bulk of their allowances for free, they are able to pass on a large fraction of the opportunity cost of these allowances in wholesale electricity prices (Harrison et al., 2005). As a result, the impact of the EU ETS on electricity prices is the same whether the allowances are allocated for free or auctioned. This has meant that UK electricity generators, for example, have been able to increase their profits by as much as UK£800 million/year following the introduction of the scheme (IPA Energy Consulting, 2006). Indeed, higher electricity prices may have had a more significant impact on industrial competitiveness in Phase 1 than direct participation in the EU ETS, but the affected industrial consumers could not be compensated for these higher prices because the freely allocated allowances did not raise any revenue. Fortunately, the Commission now recognises this and proposes full auctioning of allowances to electricity generators from the beginning of Phase 3.

If both allowance auctioning and more stringent carbon targets are adopted in Phase 3 and beyond, high allowance prices could damage the competitiveness of some energy intensive sectors, although the macro-economic impacts are still likely to be small (Stern, 2006b). The effects will be less if carbon pricing is relatively uniform within trade blocs, if major competitors (both inside and outside Kyoto) impose comparable regulatory constraints, if progress is made on international agreements within energy intensive sectors (Bodansky, 2007), if compensation is provided to the affected sectors through additional allowance allocations or the recycling of auction revenues, or if measures such as border tax adjustments are pursued (Grubb and Neuhoff, 2006). Given this range of options, it would be very unfortunate if concerns over competitiveness lead to any weakening of the Phase 3 proposals from the Commission.

The majority of companies outside the EU ETS are less energy intensive and hence less affected by carbon pricing. But concerns over industrial competitiveness can still undermine the environmental effectiveness and economic efficiency of climate policy. For example, a total of 6000 UK companies from 54 industrial sectors are currently signatories to Climate Change Agreements (CCAs) that provide them with exemption from 80 per cent of the Climate Change

Levy (CCL) - an energy tax for organisations in the public and private sectors. This special treatment is only justified for a subset of these companies, since in many cases energy forms a very small proportion of their total costs. Moreover, exemptions from carbon taxes and trading schemes are best justified as a transitional arrangement, to avoid high adjustment costs. Since the CCL has been in place for nearly a decade, the grounds for such exemptions are now much weaker. Instruments such as the CCAs therefore need to be progressively phased out.

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