Select Committee on European Union Thirty-Third Report

CHAPTER 5: Carbon Leakage

The issue

117.  Carbon leakage, as explained in Box 6, is one of the most controversial aspects of the EU ETS. In this chapter we consider how and when the sectors or sub-sectors affected should be identified, and the policy measures that should be adopted to tackle the problem.


Carbon Leakage
"Carbon leakage" refers to an increase in carbon emissions in one country or region as an indirect and unintended consequence of emission reduction measures in another country or region. This may occur as a result of the relocation of greenhouse gas emitting installations away from countries/regions where emissions are penalised (because certain businesses are particularly mobile), or it may occur as a result of producers in the "cleaner" country losing market share to producers in the "dirtier" country/region.

The prospect of carbon leakage is of particular concern in industries that—due to their exposure to intense international competition—are not able to pass on through product prices their increased operating costs, for example the additional cost of purchasing ETS allowances or the cost of higher energy prices resulting from the impact of the ETS on the power sector.

A number of policy options are available to address carbon leakage:

  • installations could receive some or all of their emission allowances free of charge rather than having to purchase them at auction;
  • the inclusion of importers of carbon-intensive products in the ETS;
  • global sectoral deals on emissions reductions in particular sectors could be pursued;
  • border adjustment measures, such as direct import tariffs or the imposition of taxes on carbon intensive imports, could be applied.

Content of the proposal

118.  The Commission proposes to identify by 30 June 2010, and every three years thereafter, those sectors deemed to be exposed to a significant risk of carbon leakage. In determining which sectors are at risk, the Commission will take into account the extent to which it is possible for the sector or sub-sector concerned to pass on the cost of the required allowances in product prices without significant loss of market share to less carbon efficient installations outside the Community.

119.  Once the decision has been taken on which sectors or sub-sectors are in principle at risk from carbon leakage, the Commission proposes to submit (by June 2011) an in-depth assessment of the position of those industries and their exposure to the risk of carbon leakage following the possible conclusion of an international agreement and/or binding global sectoral agreements. The report would form the basis for proposals on the treatment to be afforded to those industries still deemed at risk of carbon leakage.

Sectors at risk from carbon leakage

120.  DEFRA indicated that reports it had commissioned suggest that "the risk of leakage and moving overseas exists but probably only for a limited number of sectors" (Q 83). Phil Woolas MP (Minister of State at DEFRA) identified particular sectors that may be at risk: aluminium, steel, cement and food processing (Q 179) and suggested that the best prospects of a sectoral deal were in the cement sector (Q 181).

121.  The European Commission's initial analysis suggested that, in some industries, only specific sub-sectors are at high risk of carbon leakage. The Commission would thus consider clinker, a carbon-intensive intermediate product involved in the cement industry, to be particularly trade exposed rather than the cement sector as a whole, and it would consider primary aluminium, but probably not secondary aluminium (recycled aluminium), to be at risk of carbon leakage (Q 371). This analysis was supported by Professor Buzek MEP on behalf of the Polish government, who made the point that aluminium was more at risk of carbon leakage than cement because it was lighter to transport, and therefore easier to import if production were to be displaced (Q 447).

122.  The British Lime Association (BLA), British Cement Association (BCA) and the Aluminium Federation (AlFed) all argued that their respective sectors would be subject to carbon leakage (BLA Memorandum, p.117; BCA Memorandum, para. 14.7; AlFed Memorandum, para.2). According to the Aluminium Federation, aluminium was at threat "due to the global nature of the aluminium market" while the BCA argued that cement was vulnerable due to the large number of ports, easy access by sea and proximity of major conurbations to maritime distribution centres. The BCA estimated that 20 per cent auctioning in 2013 rising to 100 per cent by 2020 would cost the UK cement industry around €1.9 billion, to which a further €0.5 billion of electricity costs should be added.

123.  Brunner Mond, a UK producer of soda ash and sodium bicarbonate, claimed that its business too would be susceptible to carbon leakage. According to its calculations[59], the cost of emission permits would represent a 13 per cent increase in its production costs which would have to be passed on in full to their customers if the business were to remain viable. Brunner Mond warned, however, that its ability to pass on that cost would be highly constrained by its international competitors, most notably in Russia and the USA (Brunner Mond Memorandum, pp119-132).

124.  Other witnesses expressed scepticism about the prospect of carbon leakage. Greenpeace emphasised that there was little evidence to suggest that carbon leakage would be a problem (Q 33) and urged the Commission to scrutinise properly the claims in this regard (Q 42). The RSPB rejected this type of concern, noting that concerns about competitiveness were invariably offset by other factors[60] (Memorandum, para. 6.1).

Criteria for assessing carbon leakage

125.  As regards the criteria for assessing whether a sector was at risk from carbon leakage, the CBI considered that the key criterion should be whether additional costs could be passed through to customers without losing market share internationally or undermining the sector's ability to attract investment (Q 133). On behalf of the CBI, Mr Farrow explained that, in order to make this assessment, one would need to consider: the cost of carbon; what that represented as a proportion of profit margin; value added; trade exposure of the company; significant trade internationally; and the sensitivity of the market price. He concluded that "this needs to be as far as possible an evidence-based discussion".

126.  DEFRA agreed that it was crucial to "have a thorough evidence-based approach" to the assessment of carbon leakage as the analytical work undertaken thus far had demonstrated that the issue was very complex (Q 83). Commenting on that analytical work, Mr Demorais (Lafarge Cement) stressed that the modelling and analysis undertaken thus far had been historical, and that there was a need to look at what was likely to happen in the future (Q 134).


The Commission's carbon leakage assessment criteria[59a]
The Commission proposes to take into account the following considerations when assessing whether a sector is able to pass the cost of allowances through to product prices:
  • the extent to which auctioning would lead to a substantial increase in production costs;
  • the extent to which it is possible for individual installations in the sector concerned to reduce emissions levels;
  • market structure, relevant geographic and product markets, the exposure of the sectors to international competition;
  • the effect on the sector of climate change and energy policies implemented, or expected to be implemented, outside the EU.

This was further supplemented by a Commission "Non-Paper"[61]

127.  New Zealand government officials confirmed that the question of international competitiveness was also an issue in the New Zealand scheme and that New Zealand would base its assessment of the extent to which an industry was threatened by carbon leakage on trade intensity and on exposure to carbon costs, as defined by the proportion of ETS costs relative to other costs (Q 358).

128.  The British Cement Association (BCA), British Lime Association (BLA) and the Aluminium Federation explained that a problem in their respective industries was "cost pass-through" from the power sector, which could not then be passed on to the consumer. According to the Aluminium Federation this affected an energy-intensive industry such as aluminium, whose pricing was set at the global level on the London Metal Exchange (Memorandum, para.7). The BCA pointed out that energy prices represent 35-40 per cent of variable costs in the cement industry (Memorandum, paras. 3 and 14.6). The BLA explained that the manufacturing of lime was "an energy intensive process … with limited opportunities to pass the cost on to consumers" (Memorandum, p.117).

129.  In the BCA's view, key criteria to be used when assessing the threat of carbon leakage were: the ability to pass through to customers the cost of buying allowances at auction; vulnerability to imports; and the proportion of carbon dioxide emissions relative to product profitability (Memorandum, para. 14.3). The BLA queried the Commission's proposed criteria for assessing carbon leakage, particularly the use of GVA (gross value added) as an indicator (Memorandum, p.117).

Timing of the decision

130.  A number of witnesses expressed concern about the Commission's proposal to identify the sectors deemed at risk from carbon leakage by June 2010. The CBI took the view that the Commission's proposed timetable for identifying vulnerable sectors "does seem far too leisurely", creating undesirable uncertainty (Q 133). The British Cement Association (BCA) considered that the decision should be made much sooner than proposed (Memorandum, para. 14.10), and the British Lime Association (BLA) considered that certainty would be improved by bringing the decision forward to mid-2009 (Memorandum, p.117). The Centre for European Policy Studies took the view that the whole process[62] could be completed by mid-2010, giving certainty to industry on the rules applicable from 2013 over two years before the rules took effect (Memorandum, p.137). The Spanish Government agreed that the dates should be brought forward in order to provide industry with greater certainty (Memorandum, para. 8).

131.  DEFRA considered that the criteria used to identify sectors at risk of carbon leakage should be settled as part of this year's political negotiations (2008). A decision on the sectors deemed to meet these criteria should then be reached by June 2009 and a decision on the appropriate protection measures should be taken once the outcome of the international negotiations at Copenhagen in December 2009 was known (Q 83). In this way, every industry would know where it stood and what measures would be put in place to protect them by the middle of 2010, a year earlier than proposed by the Commission (Q 107).

132.  Commenting on the uncertainty over which sectors would be designated as being at risk from carbon leakage Dwight Demorais of Lafarge Cement stressed that "from a business certainty point of view, there is no question … that it is affecting our investment decisions" such as the building of a new cement works in Kent (Q 131).

133.  The European Commission was adamant, however, that it would only be possible to establish a definitive list of affected sectors in 2010, once an international agreement had been secured (Q 370). It questioned what help it would be to produce a list in 2009 that then had to be changed in 2010 to reflect the international agreement (Q 399).

Measures to address carbon leakage

134.  Several of our witnesses recognised the need for policy measures to address carbon leakage, such as free allocation, the inclusion of importers in the scheme, global sectoral agreements or border adjustment measures. The CBI, Aluminium Federation (AlFed), British Cement Association (BCA) and British Lime Association (BLA) anticipated that any such policy measures (including free allocation) would only be necessary until a satisfactory international agreement that placed an equivalent burden on international competitors was in place (CBI Position Paper, p.4 and AlFed Memorandum, para.7). Neither the BCA nor the BLA rejected "border adjustment" measures relating to importers, such as the imposition of taxes on carbon intensive imports (BCA Memorandum, para. 14.8 and BLA Memorandum, p.118).

135.  The International Chamber of Commerce UK questioned the concept of border adjustment measures, noting that: the cost of inputs could be pushed up; there would be high administrative costs; there would be legal implications, notably in relation to the WTO; and there could be an impact on the EU's trade relations (Memorandum, para. 16). The CBI also rejected border adjustment for similar reasons (Position Paper, p.3).

136.  A European Commission representative explained that the measure that would take effect immediately was free allocation and that "the issue of border measures … would only come later" (Q 370). He explained that it would not be wise to float the prospect of border measures in the draft directive as "it is not helpful in reaching the right international agreement" (Q 372). Global sectoral agreements should be looked at very seriously as a potential solution to the threat of carbon leakage, but probably only after the December 2009 Copenhagen meeting.

Conclusions and Recommendations

137.  While the EU ETS remains a regional scheme, we believe that some sectors of industry may be at risk of carbon leakage. The evidence we received suggests that vulnerable firms are concentrated in a handful of sectors, and in some cases, sub-sectors, such as clinker and primary aluminium. We consider that it would be appropriate to award special treatment to the industries or sub-sectors at risk in the third phase of the ETS until an international agreement or a global sectoral agreement putting these industries on an even footing with their non-EU competitors can be reached.

138.  Identification of the sectors or sub-sectors at risk should be evidence-based. We support the Commission's proposed criteria for arriving at these judgments, but emphasise that the analysis should distinguish between potential competitiveness lost as a direct result of the ETS and other influences on competitiveness (e.g. regulatory standards more generally) that arise from trading in a global context. The extent to which cost savings are possible through energy efficiency measures should also be considered.

139.  In order to create a predictable policy environment, decisions on the sectors or sub-sectors at risk ought to be taken as soon as possible. We therefore believe that the decision-making process should be speeded up. Sectors potentially at risk of carbon leakage should be identified by 2009 so as to minimise uncertainty for all other sectors within the scope of the ETS. Decisions on the treatment to be afforded to sectors at risk of carbon leakage should be taken in 2010 after the December 2009 UN Climate Change Conference in Copenhagen, when the full extent of that risk (or lack of it) will become clear.

140.  Free allocation of emissions allowances should in our view be the preferred policy response to the threat of carbon leakage, but international sectoral agreements on emission reductions in particular sectors must be the eventual aim as there is a risk that free allocation could, in the long term, become a protectionist measure. Border adjustment measures should be avoided, due to their potential to breach WTO rules.

59   Based on an indicative carbon allowance price of €30 per tonne COBack

59a   Based on an indicative carbon allowance price of €30 per tonne COBack

60   Such as labour and transport considerations  Back

61 Back

62   Of determining both the "at risk sectors" (due by June 2010) and the measures to be taken to protect them (due by June 2011).  Back

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