3E Intelligence

Europe’s energy-intensive industries surely have done a great job in the last six months convincing European policymakers that stringent CO2 measures for their sector would lead to relocations and thus “carbon leakage”. As a result of this successful lobbying, EU leaders last week felt obliged to make promises to protect these industries by possibly giving them free carbon allowances in the future emission trading scheme.

Here is the paragraph of the Council Presidency conclusions related to this carbon leakage issue:

The European Council recognizes that in a global context of competitive markets, the risk of carbon leakage is a concern in certain sectors such as energy intensive industries particularly exposed to international competition that needs to be analysed and addressed urgently in the new ETS Directive so that if international negotiations fail, appropriate measures can be taken. An international agreement remains the best way of addressing this issue.”

On which scientific evidence is this decision based? Is carbon leakage really happening as a result of the EU’s climate or environment policy?

It is surprising how little research has been done on this subject. The only really good study I found has been undertaken by four Dutch research institutes in the framework of the Netherlands Research Programme on Climate Change. The study “Spillovers of Climate Policy. An assessment of the incidence of carbon leakage and induced technological change due to CO2 abatement measures” dates from December 2004.

Here are a few extracts of the conclusions of this 251-pages report (my highlighting):

“Based on analysing the trends in regional production structures of energy-intensive bulk materials (steel, paper, aluminium, cement and fertilizers), it can be concluded that industrialised countries have been losing global market shares in the production of these materials over the past three decades. This loss in global market shares has been predominantly demand-driven, i.e. caused by the development of new markets and increasing demand in developing countries, rather than by an overall shift of competitive advantage from the industrialised countries towards the developing countries (and a consequent relocation of production structures in the actual, strict sense of the word).”

“1. In the past, environmental policy has generally not been a significant decision criterion for the location of investments in the energy-intensive industry and, hence, it does not represent a key explanatory factor for such investments in the developing world.

2. In general, compliance costs as a result of environmental policy are limited in pollution intensive industries, and other cost factors seem to be more decisive investment criteria, with the most important ones being market size and growth (regional demand) and the wage level. Hence, industries with increasing returns to scale will not relocate easily if the pollution abatement costs do not rise more than a high threshold level.

3. The limited effect of environmental policy seems plausible also in view of the companies’ pursuit of higher value added products and their concomitant relatively low interest in conventional energy intensive products. It is also supported by statements of industry representatives
who point out that all countries that are attractive for investment have rather stringent environmental legislation and that, secondly, multinational enterprises would risk their reputation by investing in pollution havens. Moreover, if income levels of developing countries increase, they will demand stricter environmental legislation and, hence, these countries should normally not be a long-term pole of relocating energy-intensive or other, highly polluting industries. Finally, some global players tend to use the most recent technology worldwide since this minimises planning and maintenance costs, particularly in energy-intensive industries producing typical products such as basic chemicals, cement, or pulp and paper.”

The study draws three policy implications from these empirical conclusions:

“The first-best policy to reduce carbon leakage is to increase the size of the group of abating countries. To reduce global carbon leakage, it is not important that additional countries to any international agreement are forced to substantial reductions; it is enough if they agree to any binding target (which might be a zero reduction target with respect to their baseline emissions, i.e. an allowed increase of emissions from, say, 1990 levels).

Without such broader participation, it might be worth considering whether domestic or regional (EU) reduction policies could be designed in a manner to reduce carbon leakage. The second-best policy would be to implement import and export taxes for the international trade of CO2-intensive products with non-abating countries. It is commonly believed that such a form of trade discrimination would not be allowed under the rules and disciplines of the WTO, but there are precedents by the way of multilateral environmental agreements with (discriminating) trade provisions that have not (yet) been challenged before the WTO. Nevertheless, it appears that the participating countries to the Kyoto protocol do not actively investigate this second-best policy.

A third-best policy would be to differentiate the stringency of domestic CO2 reduction policies among sectors. On the basis of their CO2-intensity and sensitivity to international trade, economic sectors can be classified into ‘exposed’ and ´sheltered’. In general, sheltered sectors may be less vulnerable to leakage than exposed sectors, although differences among sectors and even among firms within these broad classes may be significant. Any policy that would simply shift a part of the CO2 reduction burden from the exposed to the sheltered sectors could reduce leakage, but would probably increase aggregate national abatement costs. This increase in costs could be justified from a global cost-effectiveness perspective if the relative increase in costs would be less (in absolute terms) than the resulting reduction in leakage rate.

As most researchers argue, however, that leakage in the short to medium term is primarily caused by changes in relative prices of energy goods (the energy trade channel) and not by industrial relocation, an alternative option would be accept an ‘unavoidable’ rate of leakage in the short to medium term and concentrate on action to avoid leakage by industrial relocation in the longer term. The most obvious course of action would be to stimulate innovation to improve the CO2–efficiency of exposed sectors in order to remain or even enhance their competitiveness on the world market.”

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