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.
New approach
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.
Feasibility
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.
Editor’s Note
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.
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rom says
“include consumers in the EU Emission Trading Scheme”
Well, in substance, despite the fancy wording, they “just” recommmend to replace / supplement allowances with taxes. Old debate. I tend to agree with the idea, but why not call a spade a spade?
karsten says
The charm of EU ETS – it directly reflects the Emission Target that policy makers decide based on science and reflecting the public interest. The ET system gives targets credibilty and hence focuses public and private decision makers on achieving the target. If you use a tax – what price level to you want to chose, how do you give credibilty to a pathway, and do you want to sart an entire process of a new EU regulation? Lets rather make the Emission Trading System fully effective.
Emil Dimantchev says
Hi Karsten,
A thought provoking article and report. A couple of questions remain insufficiently addressed I think and I wonder what your thoughts are.
First, I suppose the charge imposed on consumers has to take into account the percent of the cost pass through by producers. If a producer passes 50% of the opportunity cost of surrendered free allowances, the additional charge on consumers then has to correspond only to 50% of the carbon cost (roughly, the CO2 intensity times production times the carbon price). But your paper suggests the consumer charge should reflect the full carbon costs. Is it because you are assuming that a dynamic allocation system where free allowances are based on recent production would eliminate cost pass-through? If so where is the evidence for this?
Furthermore, why would producers still need free allowances at all if imports are also priced for their CO2 content? Wouldn’t that alleviate competitiveness concerns?
Emil
karsten says
Good questions – on price pass through: Yes, the idea would be to move to dynamic allocation at full benchmark level. So for every tone of steel produced, the firm would obtain next year for example 1.8 allowances and would require perhaps 1.9 allowances to cover the resulting emissions. So it only needs to buy 0.1 allowances to pay for the inefficiency, and would thus only pass-through the corresponding costs. This is different from today. Today firms get an allocation based on historic steel production volumes which is in first approximation fixed. So if a steel firm produces an extra ton of steel it needs to buy 1.9 additional allowances (or cannot sell 1.9 surplus allowances). It will try to pass this (opportunity) cost to product prices. Thus today some, albeit uncertain, price pass-through creates some, albeit limited, incentives in the value chain. It is more effective to avoid this uncertain price pass through by using dynamic allocation and then reinstate the full price signal by inclusion of consumption.
On continuation of free allocation: with inclusion of consumption all steel consumed in Europe would be covered, irrespective how or where produced. The inclusion of consumption thus does not differentiate between foreign and domestic producers. It therefore also does – by itself –not provide any carbon leakage protection for steel producers covered by EU ETS in Europe. Where such protection is necessary, free allocation is therefore needs to continue. For sectors without carbon leakage risk free allowance allocation is not necessary. Firms pass the carbon price signal to consumers. In these sectors it is therefore also not necessary to include consumption in EU ETS.
Tilleul says
I think you’re overthinking all of this (or not thinking enough). CO2 market discussions would gain a lot by using a socio-technical approach which relies on the reality of the decision process inside companies.
Truth is, CO2 price and allowances have strictly no impact on the consumption market. If you look at how the ETS is managed in every companies they are centrally managed by a team which have no contact with the teams who are dealing with the process (or not dealt at all for SMEs). ETS is nothing more than a toy for economists and traders.
Industries are making their investments based on Best Available Technology choosen under CAPEX constraints. CO2 prices don’t have any effect on the budget a corporation will give to modernize a factory. The thing is Best Available Technology are always reducing CO2 as they are more efficient, so you see a fundemental flaw in the theory behind carbon market : it relies on the fact that it’s costly to bring CO2 down while it is actually the opposite.
The way CO2 is managed in every large companies is that CO2 will be something totally exterior to the decision process. This is just a way to bring your value to your assets : as business as usual means you’re bringing your CO2 emission downs it’s just a question of taking an additional value for something you would have done otherwise.
And for SMEs who don’t have the necessary capital to modernize their equipments and don’t have the ressources to devote a carbon team looking at every loopholes of the legislation and lobbying the EU for free allowance, this hands up being a transfer of funds from SME to large companies which reduce their investment capabilities (at least if it was a tax they could get their money back through government aids!).
Creating a market for a problem don’t create any solutions.
Emil Dimantchev says
Tilleul, you have some good points. I do agree that there is an element of bounded rationality and organizational dynamics such as the ones you described that make carbon a minor consideration in far-reaching investment decisions.
Nonetheless, free allocation of allowances does have an impact on company behavior. For instance, the current system has caused some companies to pass through CO2 costs to their product prices. I’ve written about the issue here: https://energypost.eu/end-windfall-profits-eu-limit-free-allocation-co2-allowances-industry/
I wonder why you say the CO2 has no impact on the consumption market. What exactly do you mean by that? You go on to talk about CAPEX decisions, but not about how consumers of industrial products are affected by the price.
-Emil
Tilleul says
Sorry I was using the term “consumption market” for the energy solutions aimed at the consumer of energy like energy efficiency, fuel switching, onsite renewable and everything which is behind the meter… So it would be how factories are making decisions that affects their CO2 production and not how their consumers are behaving after these decisions. Point is it’s incredibly hard to make an industrial change its process because the energy bill is such a small part of the added value and CO2 is such a small part in the energy bill. So you just have to look at the investment cycle in modernization of factories : they did not change… So factory owners don’t react to the market price they react to a need of modernization and their ability to invest into these new equipment which are always more efficient because that’s what innovation in industrial Ă©quipements is aiming for.
So what you need is not something to punish people who don’t invest into more efficient equipment and reward people who are investing into modern equipment because their decision had nothing to do with the CO2 price… It’s only based on the fact that wealthy companies can borrow cheap money to modernize their equipments and this modernization gives them reduction of CO2 which are business as usual. If we would take the same methodology we use for CDM these reductions would have been qualified as non additional and would not have been counted.
With a CO2 market, large companies are being paid by small companies for something they would have done anyway…
What you need is the exact opposite : a mechanism which helps companies who can’t afford to modernize their equipment to be able to finance them…
Emil Dimantchev says
Thanks Karsten, understood. What do you think would happen if EU implemented dynamic allocation without the consumption charge? I suppose that would largely eliminate the carbon price incentive for consumers to substitute between products or become more efficient, in theory, because there would be (almost no) cost pass through. But, in practice, will that be a significant loss of policy effectiveness? I guess my question pertains to whether the current system is having or could have an impact on consumers (even if we assume prices increase in the future).
On your second point, I still don’t see why EU producers would need protection. If there is no incentive for their consumers to switch to foreign producers (because the carbon charge will not differentiate as you said) then EU producers won’t be harmed by the carbon price, no?
-Emil
karsten says
I do not expect the biggest impact at the level of final consumer. Even a 30 Euro/t CO2 carbon price if passed through to consumers translates in a car price increase of ‘only’ 90 Euro. This will hardly change demand for cars. But first, manufacturers and construction industry are very price sensitive when deciding on the use of components. Therefore it is important for EU ETS to impact the decision on the type/quality and design of materials to be used (allowing for lower carbon or weight options with lower emissions). This will happen if consumers are included in EU ETS. Second, many innovative processes to produce materials have incremental costs. Why would a company innovate let alone use such a technology? It requires a clear business case that ultimately involves consumers paying a bit more for carbon intensive materials.
Emily – on continued free allocation: EU material producers remain within EU ETS, e.g. have to surrender allowances for their emissions. This creates incentives for efficient and low-carbon material production and ensures the overall cap is not violated. Foreign producers are subject to their national systems that may have different carbon price levels. This may create carbon leakage risk. This carbon leakage risk does not change with the inclusion of consumption. Hence the continued free allowance allocation for selected sectors.
Agree with both of you that a carbon price signal is not sufficient (but necessary and focus of this discussion). Also a coherent innovation strategy is required to go beyond best available technologies. In addition regulations need to be adjusted, for example building codes to allow for different use of materials.
Emil Dimantchev says
It seems like regulators in California were less concerned about the incentive on industrial consumers when they decided to go with output-based allocation in their carbon market. Have you quantified the difference in emissions between the two cases – i.e. full cost pass through to industrial consumers and zero cost pass through to industrial consumers? I suppose your argument is that in the second case, emissions would be higher because industrial consumers would have no incentive to consume less of a CO2-intensive product. But do you know how much?