The EU Emission Trading Scheme should not only be applied to industrial producers of CO2, but also to their consumers, proposes Karsten Neuhoff, Head of the Climate Policy Department at the German Institute for Economic Research (DIW Berlin). This would provide sufficient incentives to all market players to reduce their emissions and would do a lot to clarify the structure of free allowance allocation, providing long-term certainty for investments and innovation. New research findings from 17 international institutions, jointly led by Climate Strategies and DIW Berlin, show the viability of this approach.
European policymakers are currently debating how to reform the ETS. One crucial issue in the debate is the free allocation of CO2 allowances to industry. Unlike the power sector, much of the industrial sector, which accounts for some 43% of total emissions in the ETS, receives its allowances for free. The reason for this is that industrial manufacturers have to compete internationally (with industry outside of the EU). Particular focus is on producers of carbon intensive basic materials – steel and cement alone account for 40% of industrial emissions. If European industry faces higher carbon costs than its non-EU competitors, there is a risk that it may move production outside of the EU (“carbon leakage”). This would hurt the European economy and not result in reduced emissions globally.
The discussion around free allowance allocation has dominated EU ETS debates for the last decade and is at the core of the current debate around the structural reform of the system. Some studies show that industrial firms have received too many allowances and have been able to pass carbon costs on to product prices and thus have made windfall profits. Hence it is in principle agreed that the level of free allowance allocation needs to be reduced and more tailored to sector specific needs.
Industry lobbying in the past may have been an important factor behind the insufficient stringency of the EU ETS and the weak carbon price observed so far
However, both a political and an economic challenge remain. The political challenge is that while many studies investigate how many allowances need to be allocated to industry, their results do not converge. This means that the decision on the volume of free allowance allocation will remain inherently political. It will be very difficult to find the “right” allocation.
To date, it is clear that industry has always received more than enough allowances, but industry players fear that this may change in future. Consequently, they are continuing to lobby for continued free allocation, but also for weak EU ETS reduction targets, lenient rules for off-setting (i.e. the ability to use international carbon credits), and a delayed introduction of the Market Stability Reserve (a mechanism that would postpone the auctioning of some emission allowances to a later date). This lobbying could well be effective, given the high stakes involved. Indeed, industry lobbying in the past may have been an important factor behind the insufficient stringency of the EU ETS and the weak carbon price observed so far.
The economic challenge is that a carbon cost that can only partially be passed through in the price will not provide an incentive for producers of basic materials like steel, cement or aluminium to take measures to reduce emissions. This is because most mitigation potential resides either with incremental cost technologies like Carbon Capture and Use or with a move to more tailored, higher value materials, substitutes, or more efficient material use. The carbon price can only create incentives to realise these mitigation potentials if it is passed on to intermediate and final users of materials. A lower profit margin in and of itself will not induce companies to develop new technologies. They lack the resources to do so.
So what can be done? A team of researchers from 17 institutions, led by think tank Climate Strategies and the German Institute for Economic Research (DIW) in Berlin, has investigated the possibility of including consumers of carbon-intensive materials such as steel and cement into the ETS. They have worked out a new approach, based on the example of the Korean and Chinese emission trading mechanisms, which include power consumption in the system, and have adapted this to the industrial sector.
In both countries the power sector is not liberalised, power generators cannot pass carbon costs on to the power price, and allowances are allocated for free. To compensate for this, power consumption is integrated into the systems, both in China and Korea. Industrial and commercial power consumers have to surrender CO2 allowances proportional to their electricity consumption. Thus both power generators (supply side) and consumers (demand side) face incentives to reduce carbon intensity, the former by producing power with fewer emissions and the latter by reducing power consumption.
The main change would involve a shift from “historical allocation” to “dynamic allocation”
The researchers found that this approach of including the consumption side into an Emission Trading System could also be applied to the basic materials sector in Europe. Benchmarks would be used to split the responsibility for carbon emissions between material producers and users. Such benchmarks already exist in the EU ETS and define the carbon emissions of producing one tonne of steel, cement or aluminium with best available technology.
Material producers would receive allowances at the full benchmark level, for example for each tonne of steel produced in the previous year. This ensures continued incentives for steel producers to improve carbon efficiency. The main change would involve a shift from “historical allocation” to “dynamic allocation”. That is to say, the volume of free allocation would no longer be proportional to steel production in a historical reference period but would be proportional to steel production in the previous year. For every additional tonne of production the producer receives additional free allowances at benchmark level. These allowances suffice to cover most emissions from the additional production.
Consumers bear the cost of using carbon intensive materials… This will create incentives for them to use higher value, lower carbon materials and more efficient material design
With dynamic allocation producers do not need to pass on carbon costs anymore if they increase production, since they get extra allowances for this. This is precisely the reason why this approach has so far been rejected by policymakers, because it would remove incentives for users of materials to use these materials more efficiently and shift to lower-carbon materials. The Korean and Chinese example shows, however, that the elimination of carbon price pass-through does not need to be of concern but can instead even be desired, if it is combined with the inclusion of consumption in emission trading. The lost incentives from carbon price pass-through are regained by making consumers directly responsible for the emissions caused by their material use.
To simplify administration, consumers do not have to surrender CO2 allowances, but could be subject to a consumption charge. The charge would be levied per tonne of material used in the EU at the EU ETS emission benchmark and the recent EU ETS allowance price. Thus consumers bear the cost of using carbon intensive materials. As they would anticipate the charge levied on their products, this will create incentives for them to use higher value, lower carbon materials and more efficient material design. The revenues from the charges could go into a national trust fund to support climate action and thus replace the government revenues from auctioning allowances that are lost with free allowance allocation.
The research findings have confirmed the viability of this approach. Administrative costs for both public and private actors are limited, as only a few selected materials that dominate industrial emissions need to be covered. These are also the material producers and users that most depend on the carbon price signal for innovation and modernisation investment.
The approach could be implemented as part of the EU ETS to restore the carbon price signal lost with the free allowance allocation, and thus as an environmental regulation. As the charge does not discriminate by production process or location, it is fully compatible with WTO rules. Carbon leakage risk is also avoided, because the charge is not levied on materials or products exported to third parties.
Extending the carbon price incentives to intermediate and final consumers is a promising way for Europe to increase its efforts to combat climate change
The Paris Agreement on climate change – which governments agreed to in December 2015 – emphasises the role of National Determined Contributions to stabilise global temperature increase at or below 2°C. Industrial emissions are a dominant share of the emissions that need to be addressed. Emission trading systems to date have focused on coverage of the material producers.
Many of the opportunities to reduce these emissions create incremental costs or do not reside with primary material producers, but with the use of materials in industry and construction. With a limited carbon price pass-through regional emission trading systems create insufficient incentives to reduce these emissions. Extending the carbon price incentives to intermediate and final material consumers is a promising way for Europe to increase its efforts to combat climate change.
Prof Karsten Neuhoff is Head of the Climate Policy department at the German Institute for Economic Research (DIW Berlin). He is also a board member of Climate Strategies, an international network of senior climate change policy researchers. On 24 May, Climate Strategies presented the results of its study into the “inclusion of consumption” at a meeting in the European Parliament. The full report can be found here. A summary here.