The EU Emission Trading Scheme - centre-cired.fr · The EU ETS: A tool to cap EU CO2 emissions EU ETS Directive in 2003 when no KP ratification 2 compliance periods (now 3) 25 then

The EU Emission Trading Scheme

Philippe Quirion

CIRED, www.centre-cired.fr/perso/quirion [email protected]

Ponts-ParisTech, 1 December 2011

Part 1 – Outline

1. Origins of the EU ETS2. Description and market developments3. Emissions and price dynamics4. Overallocation or abatement?5. From phase 2 to phase 3:

the December 2008 revision6. The windfall profits issue7. Conclusion

1. Origins of the EU ETS

A brief history of emission trading

• Before 1990: environmental policies in practice=regulations, earmarked taxes and subsidies

• Emission trading is an economist’ idea– Crocker, T.D., 1966. The Structuring of Atmospheric Pollution Control

Systems. In H. Wolozin ed. The Economics of Air Pollution. New York, W. W.Norton & Co.: 61-86

– Dales, J.H., 1968. Land, Water and Ownership. Canadian Journal of Economics 1: 791-804

• 1st implementation in the US for air pollution in the 1970s: offsets for existing regulations

• First full scale experiment: the SO2 emission trading system in the US since 1995 (amendments to the Clean Air Act in 1990)

– AD Ellerman, PL Joskow, R Schmalensee, 2000. Markets for clean air: The US acid rain program. Cambridge University Press

• Applications to CO2 : – BP, Shell, Denmark, UK: systems terminated– The EU ETS: started on January 1st, 2005

The Kyoto Protocol (1)

• 1988: UN general assembly and G8 first discuss climate change

• 1990: Intergovernmental Panel on Climate Change (IPCC) first report

• 1992: UN Framework convention on climate change (UNFCCC)

• 1994: UNFCCC enters into force• 1997: Adoption of the Kyoto Protocol• 2001: the US (G.W. Bush & Senate) decide not to ratify Kyoto• 2005: the Kyoto Protocol enters into force• 2008-2012: Kyoto Protocol first commitment period• Now: 194 parties to the UNFCCC, 193 to the Kyoto Protocol

The Kyoto Protocol (2)

• Emission caps for industrialized countries• Flexibility mechanisms• No obligation for parties to set a domestic emission

trading system• Banking of allowances… if there is a second

commitment period• Inclusion of 6 gases: CO2, N2O, CH4, PFC, HCF, SF6

• Inclusion of CO2 emissions from land-use, land-use change and forestry (LULUCF)

• Weak compliance provisions (de facto borrowing of allowances)

Allowance allocation & 2008 emissions

Kyoto Protocol flexibility mechanisms

Mechanism Bubble Emission trading

Joint implemen

tation(JI)

Clean development mechanism

(CDM)

Geographical scope

Between Annex I countriesBetween an

Annex I and a Non-Annex I

country

Nature

Common ratification

and commitment

Trade in allowance

Project-based

The EU ETS, consequence of two failures of the EU

• Kyoto, 1997: – The EU against emission trading– Emission trading imposed by the US and allies

• European Commission proposed an EU carbon-energy tax in 1992. Failure:– Unanimity decision rule– Competitiveness concerns– Carbon or energy? France vs. anti-nuclear countries

• Officially abandoned in 1997 • Replaced by non-ambitious minimum taxation levels on energy

products• 1998: 1st European Commission report to mention an EU ETS• 2000: Green paper• 2001: Directive proposal• 2003: Directive adoption

• Key role of uncertainty (Weitzman, Prices vs. Quantities, 1974)• Tax better if slope of marginal cost curve > slope of marginal

environmental benefits curve • All studies applied to climate change conclude in favor of the tax• But more difficult to implement internationally

Taxes vs. Tradable permits

tax

Quota

marginal cost ex ante

marginal environnemental benefits

marginal cost ex post

Emission abatement

Optimum ex post

2. Description of the EU ETS

13

The EU ETS: A tool to cap EU CO 2 emissions

■ EU ETS Directive in 2003 when no KP ratification

■ 2 compliance periods (now 3)

■ 25 then 27 MS with different economic and social ba ckgrounds

■ Referee: the European Commission

2008 2012

1 Jan: Beginning of EU ETS phase I

1 Jan: Beginning ofEU ETS phase II

2005 2007

1 Jan: Beginning of first Kyoto Protocol period

Feb: Kyoto Protocol comes into force

2020

Dec: End of EU ETS phase II

Dec: End of first Kyoto Protocol period

European 3x20 Objectives

2013

Intra -period borrowing :The UK example

■Borrowing and imports of allowances in the UK in phase 1 (2005-2007)

15

EU ETS installations’ timeline

30 Mar. 30 Apr.

Beginning of Year N of the EU ETS

Installations submit their verified emissions for Year N-1 to the national authority

28 Feb.

Year N allocationon installations’

accounts in their national registry

31 Dec.

End of Year N of the EU ETS

Installations surrender the allowances covering their Year N-1 emissions in the national registry

1st Jan. 15 May

Double-allocation periodPublication of Year N-1 emissions by the EC

11000 installations, but how many firms?

• In phase 1:• RWE

received 6% of the allowances.

• The "top 10" firms received 33%

• The "top 100" firms received 74%

In phase 2:

- Aviation (in 2012)- New countries- Some new installations (opt-in)

The ETS covers around 42% of EU GHG emissions

Perimeter change between phases 1 and 2

Allocation in phases 1 & 2

• Mostly free allocation– Mostly grandfathering

(share of historical emissions)

– Sometimes benchmarking (share of historical emissions) especially for new entrants

• Some auctioning in some Member States but less than the Directive limit (5% in phase 1, 10% in phase 2)

3. Emissions and price dynamics

Allocation - emissions, in % of emissions

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

2005 2006 2007 2008 2009 2010

FranceItalieEU 27EU 15Royaume-UniAllemagne

Allowance trades in 1 st period

Top 20 emitting companies 2008 position

0

20 000 000

40 000 000

60 000 000

80 000 000

100 000 000

120 000 000

140 000 000

160 000 000

allocated allowances 2008

verified emissions 2008

EU allocation and emissions for the biggest emitters in France

Source: Sandbag, www.sandbag.org.uk

ArcelorMittal

LafargeEDF

Total

4. Overallocation or abatement?

Could the excess of allowances be forecasted at the EU level?

Source: Michael Grubb, The EU Emissions Trading Scheme – present lessons, future evolution. Presentation to Annual Forum on Energy & Sustainability, Madrid, 15 Nov 2006

In France, over-allocation was obvious in NAP 1

95

100

105

110

115

120

125

130

Historical emissions

Government "BAU"scenarioNAP emission cap

Continuation of lineartrend 1990-2002

Government scenario: +3,6%/yr between 2002 & 06

trend 90-2002 :-0,5%/yr

+15%

-2,43%

Surplus = over-allocation or abatement?

• Ellerman & Buchner (2008): between 50 & 100 Mt of emission abatement per year in 2005 and 2006 (2,5 - 5% of emissions)

• Delarue, Ellerman & D’haeseleer (Short-term CO2 Abatement in the European Power Sector, MIT CEEPR, 08-008): "at least" 35 Mt in 2005, 19 Mt in 2006 (2 - 4% of power generation emissions)

• Only through substitution of existing power stations

Most recent estimation for phase 1: ~200 Mt CO2 for 3 years , i.e. 3%

5. From phase 2 to phase 3:the December 2008 revision

industry

Benchmarking principle

6. The windfall profits issue

Windfall profits in the power sector

• Allowances are freely allocated but can be sold: they have an "opportunity cost“

• The allowance cost is passed on to electricity consumers (60% to 100% on deregulated markets)– Sijm, J., Neuhoff, K., Chen, Y., 2006. CO2 cost pass-through and

windfall profits in the power sector Climate Policy 6 49–72• M. Grubb: windfall profits ~ 5 billion euros in 2005

– The EU Emissions Trading Scheme – present lessons, future evolution. Presentation to Annual Forum on Energy & Sustainability, Madrid, 15 Nov 2006

• Profit-maximizing behavior, even under pure competition• Cash transfer from electricity consumers to shareholders

of power generation firms• Allowances value: 2 Gt * 20 euros = 1/3 of EU budget

Windfall profits in other sectors?

• CE Delft, 2010. Does the energy intensive industry obtain windfall profits through the EU ETS? An econometric analysis for products from the refineries, iron and steel and chemical sectors. Delft, April

– […] for most products a significant influence of the EUA prices on the European product prices can be found. […] The cost-pass-through rates from the econometric estimations show that for products of the refineries sector full cost-pass-through rates are likely. […] For both steel varieties, the cost-pass-through was close to 100%. The same value was found for polyvinylchloride and polyethylene.

• Alexeeva-Talebi, V. (2010). "Cost Pass-Through of the EU Emissions Allowances: Examining the European Petroleum Markets." ZEW Discussion Paper No. 10-086, Nov 2010. ftp://ftp.zew.de/pub/zew-docs/dp/dp10086.pdf

– "Our econometric analysis shows that refineries were capable to pass-through prices of EUAs to consumers during the first trading period 2005–2007.""the full pass-through (100%) is rather likely"

7. Conclusions on the EU ETS• Limited abatement• Distortionary allocation• Price volatility• Massive windfall profits in electricity (& in industry?)

• Corrected after 2012 by the Dec. 2008 revision?• Over-allocation? Not sure:

– Banking of CERs and ERUs– Banking of unused allowances from phase 2 to phase 3

• Distortionary allocation? Yes• Price volatility? No• Windfall profits? Partly in power generation and not in

manufacturing industry

Part 2

Climate Change Policies,

Competitiveness and Leakage

45

Outline

1. Competitiveness and carbon leakage: definitions

2. How to measure industrial sectors exposure to climate policies

3. A focus on cement

4. Ex post analyses

5. Two solutions to reduce carbon leakage: border adjustments and output/capacity-based allocation

46

1. Competitiveness and carbon leakage:

definitions (1)

• Carbon leakage: increase in emissions in the rest of the world following a climate policy in a part of the world (e.g. the EU), compared to a reference situation without climate policy

• Leakage ratio or (better) leakage-to-reduction ratio:

• Literature review by Gerlagh and Kuik (2007): 2 to 21%, plus one outlier: 115%

• Sometimes, carbon leakage refers to carbon embedded in international trade of goods (Peters and Herwitch, 2008)

RoW UEE E∆ −∆

47

In France, accounting for CO2 embedded in

international trade increases emissions by 20%

Source J.-L. Pasquier, Revue du CGDD, janvier 2010

Source : Yamano (2009)


definitions (2)

• For a sector or a firm, “competitiveness” has 2 main meanings (Alexeeva-Talebi et al., 2007) :

– ability to sell � net imports (imports – exports) or variants (revealed comparative advantage…) � problem for workers

– ability to earn � profits, firm value � problem for shareholders

Approbation of Rhodia

CDM project in Korea

"Provisional estimates by PCI Nylon forecast

operating rates for the last three months of

2008 will fall by between 30 and 50 per cent in

the US and Europe compared with the first nine

months of the year.

Meanwhile, factories in Asia and Brazil, four of

which will earn carbon credits, will keep

production rates of above 80 per cent of

capacity. "

Andrew Allan, "Carbon credits linked to product

dumping", Point Carbon, 20 Nov 2008

50


definitions (3)

• Another illustration that ability to sell differ from ability to earn

– "European factories are cashing in on an unexpected benefit from wilting output, selling surplus carbon emissions permits worth about 1 billion euros to raise funds on the carbon market."

– "West European iron and steel output will fall by about 14 % this year compared to 2008 and EU cement production by 20-25 %, analysts estimate."

– Source : Gerard Wynn and Nina Chestney, EU Climate Cash Windfall For Industry In Downturn, Reuters, 22-Jan-09.

• Free allowances have protected ability to earn, not ability to sell


definitions (4)

Competitiveness

as ability to earn

Competitiveness

as ability to sell

Carbon leakage,

competitiveness

channel

Carbon leakage,

int’l fossil fuel

price channel

Carbon leakageCompetitiveness

Carbon leakage,

int’l clean goods

price channel

52

2. Industrial sectors exposure to

climate policies

53

A basic indicator: CO2 intensity

(direct et indirect)

Source : Hourcade et al., 2007, Differentiation and dynamics of EU ETS industrial

competitiveness impacts, Climate Strategies, November54

CO2 intensity along the value chain:

cement

Source: K. Neuhoff (2009)

Illustrative for UK

0%

10%

20%

30%

40%

50%

60%

70%

0 500 1000 1500 2000 2500 3000 3500Cumulative gross value added (million Euro)

Cos

t inc

reas

e re

lativ

e to

val

ue a

dded

(20

€/tC

O2)

Cost increase from higher electricity prices

Clin

ker

Cem

ent

Concrete products (concrete products for construction; mixed concrete etc)

Total cost increase

Cost increase passed on fromfirst production stage (clinker)

Illustrative for UK

0%

10%

20%

30%

40%

50%

60%

70%

0 500 1000 1500 2000 2500 3000 3500Cumulative gross value added (million Euro)

Cos

t inc

reas

e re

lativ

e to

val

ue a

dded

(20

€/tC

O2)

Cost increase from higher electricity prices

Clin

ker

Cem

ent

Concrete products (concrete products for construction; mixed concrete etc)

Total cost increase

Cost increase passed on fromfirst production stage (clinker)

55

The EU climate-energy package

approach• A sector or subsector shall be deemed to be exposed to

a significant risk of carbon leakage if one of the conditions below is met:– (direct + indirect costs) / VA > 5% and

(exports + imports) / EU market > 10%

– (direct + indirect costs) / VA > 30%

– (exports + imports) / EU market > 30%

• Assumptions: – 30€ / t CO2

– 0.465 t CO2 / MWh

• �164 sectors exposed (~ 75% of ETS industry emissions), 112 not exposed

56

Situation of key industrial sectors vis-

à-vis EU ETS criteria

57

cement

lime

steel

oil refining

flat glass

paper and boardhollow glass nitrogen fertilizers

aluminium

bricks & tiles

0

5

10

15

20

25

30

35

40

0 10 20 30 40 50 60 70 80

(direct + indirect costs) / VA

(exports + im

ports) / EU (tu

rnover + im

ports)

Source: author’s calculation based on European Commission (2009).

3. A focus on cement

58

What does the industry say?

• A very CO2 intensive sector

– True

• Many efforts have been made to reduce emissions

– To a certain extent only

• Few abatement potential left


• A sector exposed to international competition


• Auctioning allowances � Competitiveness losses and carbon leakage

– In theory yes but to what extent?

The value of CO2 allowances is close to

the variable cost

0

5

10

15

20

25

30

35

40

Jan-

95Ju

l-95

Jan-

96Ju

l-96

Jan-

97Ju

l-97

Jan-

98Ju

l-98

Jan-

99Ju

l-99

Jan-

00Ju

l-00

Jan-

01Ju

l-01

Jan-

02Ju

l-02

Jan-

03Ju

l-03

Jan-

04Ju

l-04

Jan-

05Ju

l-05

Jan-

06

Eur

o pe

r T

onne

of C

emen

t

EUAElectricityFuel

0.7 EUAs per Te cement

105 kWh electricity per Te cement

0.12 Te coal per Te cement

How cement is produced

To reduce emissions:

“dry process", heat recovery, renewable energies, clinker substitutes

The industry value chain –

leakage versus substitution effect

62

Clinker Cement Concrete Building

Other building materialsLeaner structures

Lower clinker content

Sub

stitu

tion

Clinkerimports

Cement imports

Leak

age

EfficiencyClinker Cement Concrete Building



Sub

stitu

tion



Sub

stitu

tion

Clinkerimports

Cement imports

Leak

age

Clinkerimports

Cement imports

Leak

age

EfficiencyEfficiency

Source: K. Neuhoff (2009)

France has lost its leadership as regards specific

emissions

Source WBCSD, GNR project, http://www.wbcsdcement.org/gnr-2008/index.html

550

600

650

700

750

800

850

900

950

1990 2000 2005 2006 2007 2008

kg CO2 / t cim

ent

Etats-Unis

ex-URSS

monde

Europe

Chine

France

Inde

Allemagne

Brésil

An important gap between the least and the

most CO2-efficient plants

Source : Methodology for the free allocation of emission allowances in the

EU ETS post 2012. Sector report for the cement industry

Huge price differences in cement price,

even between neighbouring countries

0

20

40

60

80

100

120

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Eur

o pa

r to

nne

FranceGermanyItalySpainUK

Calculation: Neil Walker, using Eurostat ProdCom & ComExt databases65

Two studies with contrasted results

• D. Demailly and P. Quirion, CO2 abatement, competitiveness and leakage in the European cement industry under the EU ETS, Climate Policy, 2006– Import ratio: 3% in BaU,

8% at €20/t CO2under full auctioning

• Boston Consulting Group, Assessment of the impact of the 2013-2020 ETS proposal on the European cement industry, 2008– Import ratio: 80% at €25/t CO2

under full auctioning

• Reasons for the difference:– Trade in cement or clinker?

– Capacity constraints?

– Pure or Cournot competition?66

Other estimation, same conclusion

Barriers to trade in cement

Source : Hourcade et al., 2007, Differentiation and dynamics of EU ETS industrial

competitiveness impacts, Climate Strategies, November 68

The exchange rate volatility,

a barrier to relocations

dollar en francs source http://fx.sauder.ubc.ca/dat a.html

0

2

4

6

8

10

12

janv

-71

juil-

72

janv

-74

juil-

75

janv

-77

juil-

78

janv

-80

juil-

81

janv

-83

juil-

84

janv

-86

juil-

87

janv

-89

juil-

90

janv

-92

juil-

93

janv

-95

juil-

96

janv

-98

juil-

99

janv

-01

juil-

02

janv

-04

juil-

05

janv

-07

Freight rate volatility,

another barrier to relocations

Conclusions about cement

• Many efforts made to reduce emissions?– Not everywhere (not in France) in recent years

• Few abatement potential left?– Debatable for clinker, clearly false for cement

• A sector exposed to international competition?– High barriers to trade exist

• Auctioning allowances � Competitiveness losses and carbon leakage– To what extent? Hard to say

• Short run: available production capacities explain international trade in cement and clinker, more than relative costs– The increase in European imports � 2007 was due to a transitory boom in the

construction market– Statistically, not influence of CO2 allowances on international trade

• In the long run, production capacities are endogenous, driven by expectations of relative costs and demand– The EU ETS may play a role, among other factors– In such a case, importance of EU ETS capacity-based allocation

5. Ex post analyses

72

World bank,

International trade and climate change, 2007

• Study imports and exports in energy-intensive industries, in countries with

and w/o carbon tax

• Carbon tax: impact < 0 on exports only in cement, > 0 in paper and steel

• No statistically significant impact on imports for any sector

• Competitiveness in energy-intensive products decreased in US, not in EU

73

Miltner and Salmons,

COMETR Report, 2007

• Study competitiveness indicators:– import intensity

– export intensity

– market share of domestic producers

• 1990 � 2002

• 8 GHG-intensive sectors

• 7 European countries with environmental tax reform: Germany, Denmark, Netherlands, Finland, Sweden, Slovenia, UK

• 16% of the cases: competitiveness ↘

• 4%: competitiveness ↗

• 80%: no change

• But often exemptions, lower tax rates and rebates

74

My own analysis: Cement and clinker

Source : P. Quirion, Mémoire d’Habilitation à diriger les recherches, EHESS, 2011

0

20

40

60

80

100

120

0

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9M

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9Ja

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2005

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euro

s/t C

O2

; Mt/

animportations ciment et clinker exportations ciment et clinker

prix CO2 construction

Steel


0

20

40

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80

100

120

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industrie manuf . construction

Aluminium


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importations alu exportations alu prix CO2 industrie manuf.

6. Two solutions to limit leakage:

output/capacity-based allocation and

border adjustments

78

Free allocation vs. free allocation

• US SO2 : allocation on a historic basis (or lump-sum or « « grandfathering » ») – Same impact on ability to sell as auctioning

– Protects ability to earn, often creates windfall profits

• Output-based allocation (US lead in gasoline, UK ETS for CO2…) – Protects ability to sell compared to auctioning

– Does not necessarily protect ability to earn compared to auctioning

• EU ETS: hybrid, capacity-based– New entrant reserve

– No allowance for installations closed (but mothballing often possible!)

79

Did the free allocation in the EU ETS protect

competitiveness and mitigate leakage?

• Another illustration of the difference between ability to sell and ability to earn

– "European factories are cashing in on an unexpected benefit from wilting output, selling surplus carbon emissions permits worth about 1 billion euro to raise funds on the carbon market."

– "West European iron and steel output will fall by about 14 percent this year compared to 2008 and EU cement production by 20-25 percent, analysts estimate."

– Source : Gerard Wynn and Nina Chestney, EU Climate Cash Windfall

For Industry In Downturn, Reuters, 22-Jan-09.

• Free EU ETS allowances did protect ability to earn but not ability to sell (in the short run)

• Distinction short & long-run (Ellerman, 2008)– Does not reduce “operational leakage” compared to auctioning

– Does reduce “investment leakage” compared to auctioning80

Output-based allocation

• Principle– In year n, free allowances = benchmark * output forecast

– In year n+1, correction for actual output

• Pros– Mitigates carbon leakage

– Less jobs losses in these industries

– No windfall profits

– Allowance price less sensitive to business cycle

• Cons– Little incentive to reduce the production of GHG-intensive goods

– Need for information on output level

– End of the insurance effect of historic allocation

– Risk of non-compliance for Member States and the EU

– WTO issue

• P. Quirion, Climate Policy, 200981

Border adjustments

• Mechanism– Importers of GHG-intensive goods would have to buy allowances

– No requirement to surrender allowances for emission entailed by the production of goods exported outside the EU

• Rationale– Mitigate carbon leakage

– Make the consumer pay, not the producer

– Induce reluctant countries to join a climate agreement

– Raise public funds for mitigation or adaptation in developing countries

• Risks– Block international negotiations on climate change

– WTO issue

– Trade war

– Administrative cost

– Transfer of leakage towards downstream products82

Conclusions

1. Competitiveness and carbon leakage are different things

2. Only a few sub-sectors are really exposed to climate policies

3. Ex ante studies results vary a lot; some clearly exaggerate the impacts

4. Observations so far indicate no or very little leakage from climate

policies

5. The EU ETS-style free allocation method

• Reduces « investment leakage » but not « operational leakage »

• Protects competitiveness as « ability to earn », not as « ability to sell » (in the

short run)

6. Two main solutions to limit leakage (from the competitiveness channel):

output-based allocation and border adjustment. Border adjustments

more cost-efficient but diplomatically dangerous

7. Leakage and competitiveness concerns should be balanced with

spillovers and first mover advantage

83

Documents

The EU Emission Trading Scheme - centre-cired.fr · The EU ETS: A tool to cap EU CO2 emissions EU ETS Directive in 2003 when no KP ratification 2 compliance periods (now 3) 25 then