Energy Intensive Industries

Written evidence submitted by the Government

Introduction

1. The UK Government is committed to pursuing its ambitious approach to tackling global climate change. The UK has a range of policies in place, underpinned by the Climate Change Act which includes our legally binding target to reduce greenhouse gas emissions by 80% by 2050. In addition to tackling climate change, our energy and climate change policies can help UK businesses to manage risks, such as those from increasing and fluctuating fossil fuel prices; increase resilience, such as to the impacts of climate change and seize the opportunities from new and emerging markets, both nationally and internationally.

2. Industrial energy efficiency is also an important part of the Government’s approach, being good for growth and good for competitiveness. It aids energy security and will enable us to meet our targets for reducing carbon emissions, in particular our target for 2050, more cheaply. Because a number of barriers exist to the take-up of cost-effective energy efficiency measures, the UK Government has therefore targeted policies to encourage industrial energy efficiency and carbon reduction.

3. However, in addition to the benefits and new market opportunities which will emerge from the move towards a lower carbon economy, for some sectors there will be transitional costs and risks. In particular, the Government considers that it is important to ensure that the competitiveness of UK-based electricity intensive industries is not compromised. These industries are critical to growth of the economy and, in many cases, will be providing the components for renewable energy generation or the materials required to lower the carbon intensity of consumer products.

4. For this reason, in the 2011 Autumn Statement, the Chancellor announced that the Government would compensate those electricity-intensive industries most at risk of carbon leakage to help offset the indirect [1] cost of the Carbon Price Support Mechanism (CPS) and the EU Emissions Trading System (EU ETS), subject to state aid approval from the European Commission. The Government also announced that it will explore options for reducing the impact of electricity costs on electricity-intensive industries as a result of electricity market reform policies where this has a significant impact on their competitiveness.

Background

5. The Department for Business, Innovation and Skills (BIS) has been allocated £210m for the rest of the spending review period to cover indirect CPS and EU ETS compensation. These will compensate for costs which businesses will start to face from next year (electricity generators will face ETS costs from January 2013 and CPS costs from April 2013). With a finite amount of money to distribute, we have sought to develop appropriate criteria to identify who should be eligible.

6. In March, the Government published a call for evidence. The purpose of this was to improve the evidence we have regarding electricity usage in industry across the UK. In particular, we sought information and data concerning the electricity and trade intensity of companies, the effects of increased electricity prices on investment decisions, and views on how criteria might be applied. We received 48 responses, which provided strong evidence from a few respondents on the need to take action on the risk of carbon leakage and deliver compensation to companies at risk. However, the responses provided no clear consensus on which metrics should be used to assess eligibility for compensation or the level at which eligibility should be assessed (i.e. at sector, company, site or process level).

7. The Call for Evidence and the Commission’s work on eligibility for indirect EU ETS compensation has informed our proposed approach which is set out in the consultation published in October.

8. A number of energy and climate change policies will increase the price of electricity for industrial consumers in the short and medium term (see Chart 1). In particular, the costs from the EU ETS, the CPS, and low carbon generation subsidies (Electricity Market Reform and the Renewables Obligation) place costs on energy companies. These costs are subsequently passed on to consumers through increased electricity bills.

Chart 1 – Estimated impact of energy and climate change policies on average retail gas and electricity prices faced by large energy intensive users [2]

9. This additional increase in electricity price can create a competitiveness issue for the most electricity intensive sectors with sites in the UK, many of whom will face a significant increase in costs when compared to sites in other countries. While electricity is a key input to many industrial processes in the UK, other energy intensive users are more gas intensive. The issues facing gas-intensive industries are somewhat different, with energy and climate change policies having very little effect on the price of gas

10. BIS commissioned a study into the effect of Government policy costs on the price of electricity faced by different industrial sites across the world – see below.

Chart 2 - Impacts on electricity price (£/MWh) of energy and climate change policies [3] in selected years [4]

11. Based on countries’ current policies, the study highlights that, for the most electricity intensive industrial users in the UK, policy costs affecting the price of electricity may be higher over the medium term when compared with other countries existing plans, without Government intervention to alleviate some of these costs. It should be noted that the above graph focuses on the estimated policy costs impact on retail electricity prices. The wholesale cost component is not included – current UK ‘base’ electricity prices (i.e. excluding policy costs) for energy intensive industries are within the range of the other countries. The chart also takes into account the various cost exemptions that exist for the industrial sector in other countries and assumes no cost exemptions for industry in the UK. As such, the existence of compensation for the costs of EU ETS and Carbon Price Support would improve the outlook for the UK-based EIIs, as would any future policies which may reduce the exposure to other policy costs. It is worth noting, however, that a number of energy intensive users source a significant amount of their electricity through on-site generation, the cost of which will not be subject to many of these other policy costs. In addition, there remain significant uncertainties as to the future policy cost impacts in other countries.

12. Relatively high electricity costs will make it difficult for UK-based energy intensive industries to compete at international prices, thereby exposing them to the risk of carbon leakage – i.e. the prospect of an increase in global greenhouse gas emissions when a company shifts production outside a country because they cannot pass on the cost increases induced by climate change policies to their customers without significant loss of market share.

Characteristics of Energy Intensive Industries

13. Energy Intensive Industries [5] employ around 2% of the UK’s workforce (around 600,000), contributing around 4% of the UK’s GVA [6] . Many of industrial sites in the UK are based in regions of relatively high underemployment and low standards of living. As such, their continued operations are vital to the economies of those regions, with foregone jobs often difficult to replace.

14. Energy intensive industries are frequently owned by international companies and are sometimes vertically integrated. The companies often also own energy intensive business sites outside the UK. This can mean that UK management has to compete internally over a limited pot of available capital for new or additional investments. The ability to raise the capital to invest depends on projects being able to deliver risk adjusted rates of return above those from other investment opportunities available to the firm.

15. Businesses will often use hurdle rates of return and defined pay-back periods in making their investment decisions. For example, projects relating to different internal sites of a multi-national business will need to meet a particular ‘hurdle rate’ to enable them to successfully bid for finance. Energy costs will be one factor influencing hurdle rates and investment decisions. Of course, firms will also take into account issues such as labour costs, stability of the tax regime – including corporation tax – and proximity to markets and planning processes/systems. Where UK costs rise relative to other countries, and this cannot be passed on to customers, the business’ required hurdle rate of return becomes more difficult to reach for UK-based projects relative to the sites based in other countries.

European Commission & State Aid

16. The UK’s intention to compensate energy intensive industries for the indirect costs of both the EU ETS and the carbon price support mechanism is subject to state aid approval from the European Commission. Under EU law, a Member State must notify the European Commission of its plans to grant new aid and must not put the aid into effect before the Commission has authorised it. The European Commission has sole competence to decide whether state aid is permissible and they will consider whether it is necessary to achieve a particular objective, limited to the minimum amount to realise that objective and that overall distortions to competition are minimised and outweighed by the positive effects the aid will have.

17. However, the EU ETS Directive states that from 2013 Member States may choose to compensate sectors at significant risk of carbon leakage as a result of indirect EU ETS costs, providing schemes are designed within the framework set by the European Commission. The Commission adopted state aid guidelines [7] for this purpose in May 2012. The guidelines list the sectors deemed to be exposed to significant risk of carbon leakage due to indirect emissions costs and provide details of the maximum levels of compensation that can be made available to them.

18. The UK Government has submitted two pre-notifications - for compensation of the indirect cost of the EU ETS and Carbon Price Support mechanism. It is likely that the Commission will approve indirect EU ETS compensation, provided we can demonstrate that our approach falls within the requirements in the Commission’s published guidelines. However, CPS does not have an approval framework of this type, so it is more difficult to assess the likelihood of the Commission approving compensation for the costs of the CPS. Nevertheless, we consider that the UK has a reasonable case for this compensation scheme, which is analogous to the Commission-backed scheme for EU ETS compensation.

19. The process is usually that any doubts that the Commission have about the scheme will need to be resolved during pre-notification discussions ahead of final notification being submitted which can then quickly be approved. Whilst we cannot be certain about timing of the state aid clearance process, we are working towards a final decision by the Commission by the summer of 2013 – shortly after businesses begin to face the indirect costs from ETS and CPS.

The proposed approach

20. Energy and Climate change policies impact mostly on the price of electricity rather than the price of gas. The Government’s focus is on mitigating some of the cumulative costs of Government policy faced by these industries. EIIs will face many other issues as a result of operating in internationally competitive markets, or as a result of recession / reduced demand, or even the price of gas-generated heat. This package is not intended to address any of these issues.

21. As such, the EU ETS and Carbon Price Support compensation package is focused on sectors which are electricity intensive and trade intensive – i.e. operate in internationally competitive markets. The table below sets out the top 20 electro-intensive sectors in the UK based on information collected by the Office of National Statistics. It ranks sectors according to the size of their electricity costs as a percentage of gross value added (GVA) [8] .

Top 20 electro-intensive sectors

Rank

Sector

Electricity costs as a percentage of GVA (average 2004-7)

1

Aluminium

55

2

Electric arc steel [1]

37

3

Fertilisers and nitrogen compounds

36

4

Paper and paperboard

35

5

Throwing and preparation of silk

32

6

Industrial gases

31

7

Inorganic basic chemicals

30

8

Non-wovens and articles made from nonwovens

22

9

Household and sanitary goods

20

10

Preparation and spinning of worsted-typefibres

18

11

Clays and kaolin

17

12

Veneer sheets, plywood, fibreboard etc

17

13

Cement

16

14

Hollow glass

15

15

Iron and steel [1]

15

16

Copper

15

17

Synthetic rubber in primary forms

14

18

Refineries

14

19

Man-made fibres

14

20

Sewing threads

13

22. In line with the Commission’s guidance, we propose that, in order to be considered for indirect EU ETS compensation a company must be in one of the above sectors. However, we are aware that within electricity intensive sectors, there will be some processes which use much less electricity and, as such, will be much less exposed to electricity price increases. In order to ensure that compensation is appropriately targeted, we propose to apply an additional filter – that companies applying for compensation must demonstrate that their carbon cost (EU ETS and CPF) in 2020 will amount to 5% of their GVA. This is based on the quantitative test which the Commission applied when developing the eligibility list.

23. With regard to eligibility for CPS compensation, it has been difficult to draw strong conclusions from the call for evidence regarding where the risk of carbon leakage impacts is greatest - i.e. we understand that it is those industrial sites which are both electricity intensive and trade intensive which are placed at risk of carbon leakage from increases in electricity prices, but at what levels of electricity intensity and trade intensity will indirect costs represent a serious carbon leakage risk?

24. Given this, we consider that it makes sense for the UK to base its approach to CPS compensation on the Commission’s approach to indirect EU ETS compensation for the following reasons:

· The Commission has undertaken considerable analysis in assessing which sectors are at significant risk of carbon leakage from indirect EU ETS costs;

· The CPS effect is analogous to indirect EU ETS costs, largely affecting the same sectors in the same way;

· Administering the two schemes – CPS and EU ETS compensation – in broadly the same way will minimise burdens and cost for businesses and Government.

The recently published consultation document [9] sets out the Government’s proposal for eligibility and administration of the scheme. A summary of the eligibility and methodology for assessing compensation is available in the consultation document.

Energy efficiency

25. In designing compensation for the indirect costs of EU ETS and CPF, Government has been keen to ensure that environmental objectives are fully considered.

26. The incentives for greater energy efficiency are already strong for many energy intensive industries, as energy costs represent a significant element of their overall costs. The presence of an aid intensity which is at a level of less than 100% and which reduces over time will mean that eligible companies will continue to pay a proportion of the additional passed-through costs from EU ETS and CPF. As such, there remains a further incentive for firms to continue to examine ways to become more energy efficient. For EU ETS compensation, we will also be applying efficiency benchmarks. The benchmarks have been developed by the Commission and are based on the top 10% most efficient process for manufacturing that specific product. Companies with processes below the very best level of energy efficiency will, as a result, find that their compensation is further reduced.

27. Many Energy Intensive Industries also sign up to voluntary Climate Change Agreements, which set out stretching energy efficiency targets in return for relief from the Climate Change Levy. DECC is currently engaged in the target setting process with the 54 eligible sectors for the new CCA period which runs from April 2013 to 2023.

27 November 2012


[1] Indirect costs arise when electricity prices increase as a result of fossil fuel based electricity generators passing on policy cost s to their customers.

[1]

[2] Taken from the Government’s 2011 report Estimated Impacts of Energy and Climate Change Policies on Energy Prices and Bills . Available online at: http://www.decc.gov.uk/en/content/cms/meeting_energy/aes/impacts/impacts.aspx .

[3] GHG – GHG policy measures e.g. EU ETS and CPF; EE - energy efficiency policy measures; RE – renewable energy policy e.g. RO and EMR; ET – energy taxes

[4] Source: ICF, An international comparison of energy and climate change policies impacting energy intensive industries in selected countries - Figure 1-b , available at: http://www.bis.gov.uk/assets/BISCore/business-sectors/docs/i/12-527-international-policies-impacting-energy-intensive-industries.pdf

[5] D efined as those industries where energy costs are greater than or equal to 10% of gross value added

[6] Energy Intensive Industries data 2009-10

[7] http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2012:158:0004:0022:EN:PDF

[8] Data comes from DECC’s Energy Consumption UK and the Annual Business Inquiry. 2007 is the most recent year for which a detailed sectoral breakdown of energy consumption is available.

[1] 2005-2007 data

[1] Total iron & steel sector.

[9] Energy intensive industries compensation scheme - available at: http://www.bis.gov.uk/Consultations/energy-intensive-industries-compensation-scheme?cat=open

[9]

Prepared 4th December 2012