Commission Services Paper on Energy Intensive Industries Exposed to Significant Risk Of

Commission services paper on Energy Intensive Industries exposed to significant risk of carbon leakage

- Approach used and state of play[1] –

1.This non-paper reports on progress achieved with the assessment of the position of Energy Intensive Industries (EII) in the context of the Commission proposal on a revised ETS. It aims at providing further information onthe development and road-testing of a methodology to assess which (sub)sectors and activities would be exposed to significant risk of carbon leakage, assuming full auctioning of allowances. It is important to point out that full auctioning is proposed only in 2020, and that in 2013 all energy-intensive industries would still receive a significant amount of free allowances.

The economic effects of ETS in the period 2013-2020 will obviously depend on the details of the international agreements which could crucially influence the list of sectors and activities at significant risk of carbon leakage.

The methodology proposed here will allow identifying the (sub)sectors and activitiesand group them into different categories and will offer more clarity on how to deal with the estimated impact during the allocation process.

IThe methodology

2.On the basis of the elements of the proposed directive, aprecise methodology is being developed by the Commission services, which can be summarised as follows:

First stage: measuring the impact on Community industry

Defining the (sub)sectors where problems may occur: energy intensive industries must be defined at a high level of disaggregation to ensure that the specificities of production processes having an impact on emission intensities are well covered, as these can vary significantly within sectors. Account needs to be taken of both direct and indirect emissions (i.e. those related to the consumption of electricity used in the production process).

Measuring the impact in terms of potential product price increase: using a standardised electricity input fuel mix and assuming full pass through of allowance costs in electricity prices, the additional costs induced by ETS can be calculated. These can subsequently be expressed in terms of the price increase required to offset the cost increase.

Measuring the exposure to international trade: the proposed Directive requires an assessment of the possibility of passing through higher costs into prices. While a refined analysis, including the estimation of price elasticities, would be desirable, an approximation based on the exposure to non-EU trade seems a more practical way forward offering sufficiently robust results.

3.Based on a simple cross-classification of opennessto non-EU trade and the cost increase due to full auctioning, activities can be classified into four groups, as in Figure 1.

Figure 1: Assessment based on cost increase and openness to non-EU trade

4.The analysed energy intensive (sub)sectors and activities could then be classified into four categories:

Iexposed to low or zero risk of carbon leakage

IIexposed to low-to-moderate risk of carbon leakage

IIIexposed to moderate-to-high risk of carbon leakage

IVexposed to high risk of carbon leakage.

The classification into four categories provides a balance which reflects both the data available and the need for an operational system, in accordance with the provisions of draft article 10. The particular weight given to trade openness and cost increase in the middle categories reflects the importance of trade openness in the carbon leakage debate.

Second stage: Taking into account other market factors

5.The level of competition from non-EU trade and the level of the cost increase would be the starting point to assess the risk of the carbon leakage problem and the "pass through" possibility. This would be complemented by a second step in which a certain number of other factors would be taken into account, such astransportation costs, tightness of the market, its geographical scope and concentration. These additional factors would be considered in a qualitative manner which will help refining the assessment. As a conclusion of this second stage, the assignment of (sub)sectors and activities to the four groups are then subject to the following modifications:

–Activities where the other market features were assessed to have little or no impact onability to pass through costs would stay in the same group.

–Activities where the other market features were assessed to have a sufficiently negative impact on ability to pass through costs could be moved up.

–Activities where the other market features were assessed to have a sufficiently positive impact on ability to pass through costscould be moved down.

Third stage: assessing the result of the international negotiations

6.Finally, according to the results of the international negotiations[2], the typology would allow for a further refinement in modifying the outcome of categories II, III and IV according to commitments at the level of the Parties of the UNFCCC and/or in the form of sectoral agreements. The resulting final classification will be the basis for drawing up the formallist of (sub)sectors and activities exposed to a significant risk of carbon leakage, which shall be entitled to up to 100% free allocation of allowances, as foreseen by the draft Directive[3].

The way ahead

7.In view of creating sufficient certainty for relevant (sub)sectors, the final Directive could specify that category I (sub)sectors would be subject to the full phase-in of auctioning by 2020, while category IV (sub)sectorswould be eligible for 100% free allocation, whilecategories II and III could be subject to a percentage of free allocation lower than 100%, de facto leading to a phase-out of free allocation at a slower pace), in accordance with the provisions of the draft Directive.

IIFirst results of the data analysis by the Commission services

8.To test the methodology for stage one, the Commission services have appliedthis approach for sub-sectors from three sectors (primary and secondary aluminium, steel and iron, and cement), using data available in the public domain andthose provided by industry associations following the launch of the Commission's data collection exercise in March 2008. Illustrative results are available inAnnex 1. These sub-sectors have been chosen for indicative purposes on the basis of the data available at this point, and should not be taken to prejudge the final results.

9.This preliminary analysis indicatesfor example that primary aluminium, hot rolled steel and slabs through the BOF route,and clinker would be likely to be strongly affected and would therefore be amongst the subsectors likely to benefit from partial to totally free allocations (see paragraph 7), depending on the final analysis to follow international negotiations.

Next steps

10.This approach is now being applied to other industries and activities(Annex 2). Given the available data, thisapproach seems to constitute a practical way forward while remaining analytically robust, without prejudging further analytical development that may be required for other sectors.

11.Pursuing the data analysis – depending on delivery of outstanding data for some (sub)sectors – is a priority for the coming months. This will lead to an initial assignment of activities and subsectors into the four groups. This will require setting thresholds for cost increase and non-EU trade exposure.

12.The outcome of the international negotiations will enable drawing up the formal list of (sub)sectors and activities exposed to a significant risk of carbon leakage, as described under the third stage above.

Annex 1

1.In order to be able to comply with the first sentence of Article 10a (9)[4] Commission services[5] have launched a data-gathering exercise so as to be able to estimate (i) the extent to which auctioning would lead to a (substantial) increase in production cost [Article 10a (9), letter (a)] and (ii) the extent to which it would be possible for installations covered by the EU ETS to pass through these cost increases to their clients, taking into account their exposure to international (non-EU) competition and other market characteristics influencing this pass-through potential [Article 10a (9), letter (c)].

2.This exercise was launched in March 2008 and should deliver first operational results in December 2008. In line with Article 10b, it is limited to all business outside the power-generation sector falling under the EU ETS and being considered to be energy intensive. In line with the "Energy Products Tax" directive (Directive 2003/96 EC), a business is considered as being energy intensive where the purchases of energy products and electricity amount to at least 3.0% of its production value.

3.The data-gathering exercise is undertaken in close collaboration with concerned industry stakeholders providing crucial information not otherwise available. All facts and figures used are based on empirical evidence (as compared to model simulations or stakeholders' concerns only), and are verifiable and replicable so as to allow for a maximum of transparency and of empirical backing. Accordingly, all data and information used is cross-checked by industry stakeholders, and Commission services.

4.The level of disaggregation is typically at the NACE 4-digit level, further broken down to PRODCOM 8-digit level where necessary, i.e. when the 4-digit level aggregation would risk to mask (i) significant differences in energy- or emission intensities of different production processes (such as primary and secondary aluminium, BOF and EAF steel), or different products with different market characteristics (such as clinker and cement) and/or (ii) significant differences in the profit-neutral price increase needed to pass through the costs of the carbon constraint (such as the production of iron ingots or stainless steel or bricks and roof tiles or sanitary ware).

5.When calculating emission intensities (expressed in tons of CO2eq per ton of production) both direct emissions (process emissions e.g. from the production of cement and emissions from the burning of fossil fuels in the production process) and indirect emissions (emissions generated in the process of producing an upstream product, namely electricity) are taken into account. Estimations are based on the most recent so-called "BREFs" adopted by the Commission in the context of the Integrated Pollution Prevention and Control Directive (Directive 1996/61/EC), cross-checked with most recent information provided by stakeholders.[6]

6.Also, for the analysis the fact is taken into account that emission intensities are to a large extent influenced by the carbon content of (i) the fuel mix used in the production process[7], (ii) the fuel mix used to produce the electricity purchased[8] and (iii) the carbon intensity of alternative production processes[9]. Where appropriate and possible, the resulting different emission intensities are taken into consideration, and a range of estimations is provided. The central approach, however, could be basedon the sector-specific fuel mix in the relevant EU industry, and providing estimations of upper and lower ends where relevant.

7.When calculating the increase in production cost, a carbon price of €30/t of CO2eq is applied to the sum of direct and indirect emissions, giving then the increase in production cost for different production processes and products (sectors).It is assumed that the cost of allowances will be fully passed through in electricity prices. With these assumptions, the cost of producing one ton of primary aluminium out of bauxite would increase by between about [€234/t and €553/t], depending on assumptions on the fuel mix needed for producing electricity.The estimate based on the EU average fuel mix would be[€300].The contribution of direct emissions in this cost increase would be about [26%] for this case.In contrast, the cost of producing one ton of secondary aluminium would increase by about [€15] only. In the case of cement production, the emission costs would range from [€16 to €33] per ton of cement, varying with the production process and the fuel mix used. The central estimate for the EU fuel mix would hover at around [€24].

8.In order to allow for a cross-industry comparison and to get an idea of the price increase needed to recover this additional cost, the increase in production cost is then put in relation to the product price, as the size of the price increase would eventually give an important indication in how far it might be worth for the client to enter into substitution activities. Based on first findings, such a (profit neutral) price increase would have to correspond to less than [2%] in the case of secondary aluminium and SEMIs[10], [17.5% to 40.3%] in the case of primary aluminium, and [23% to 50%] in the case of cement.[11] The product prices used are those observable on the market; to cater for price volatility, an average over the most recent three years has been calculated.[12]

9.For the purpose of analysing the potential consequences of efforts of producers to pass on this cost increase key market features for the different sectors and subsectors are in the process of being analysed, namely the degree of exposure to international competition, the relevant geographic and product market, the concentration on and tightness of the market, and the potential cost implications for clients to switch to non-EU suppliers as e.g. reflected in transportation costs and other barriers to trade.

10.In a quantitative manner, exposure to international competitionis approximated by the level of non-EU-trade competition ("trade intensity"), as measured by the sum of non-EU exports and imports in relation to the total market size for the Community as expressed by the sum of annual EU production and non-EU imports[13]. A first analysis shows that the non-EU trade intensity amounts to about [45 to 47%] in the case of primary aluminium as compared to [23%] in the case of secondary aluminium. In the iron and steel industry, the trade intensity varies very much with individual products. It is very high for some of the BOF-route products such as hot rolled coil [30%] and slabs [54%], or stainless steel cold rolled in the EAF process [30%]. Also in the cement and lime industry the trade intensity differs very much depending on the product analysed: while it amounts to as little as [6.3%] for cement, it reaches up to [56%] for clinker.Moreover, trade exposure has proven to not be stable,e.g. over the last ten years it has increased for clinker, slabs and primary aluminium, decreased for cement, while remained rather stable for recycled aluminium, rebar, and hot dipped metallic coated iron.

11.In a second step with a view to possible qualifying these data, additional information on exposure to international competition and the cost-pass-through potential could potentially be gained by analysing other market features such as the geographical scope of a market, the concentration on the market or the absence or presence of excess capacities (tightness of the market). This analysis is undertaken by the Commission in a qualitative manner, as e.g. the degree of concentration (rather high in primary aluminium and BOF steel production and rather low in secondary aluminium and EAF steel production) does not automatically determine the degree of competition between non-EU and EU installations. As important is the tightness of the market, the latter both determined by supply-side and demand-side dynamics, with the latter being much more volatile than the first. Thus, additional information such as capacity utilization rates, the development of (global) stocks etc must be taken into account. Over the last economic boom with soaring commodity prices, the markets have been relatively tight for both aluminium and steel products (less so for cement and lime, although some regions in the EU were characterized by a shortness in the supply of cement), and it was rather easy to pass through potential cost increases.

12.However, in a cyclical downturn or at times of massive capacity increases the picture might reverse. As regards a proper delimitation of the relevant geographical market, the existence of global stocks of global markets might serve as an indication of the existence of global markets, while the absence of such features or the existence of significant price differences at the (inter)national level or the presence of high transportation costs might indicate that markets are at most national or European. In the short run, the pass-through potential is determined by the tightness of the market, in the longer run by more structural features such as the value added of producing close to the market, other trade barriers, and technical substitution possibilities of clients. The degree of vertical integration and regional clustering of value chains (e.g. of aluminium or steel production and of its processing or the importance of transportation cost in relation to the carbon cost can provide useful information in this context. These indicators are used for a qualitative analysis.

Annex 2: Tentative list of sectors and status of the information provided

Sectors currently being analysed / Sectors that have provided Information / Sectors that have announced that they will provide information
Aluminium / Ceramics / Man-made fibres
Steel and Iron / Chemicals / Starch
Cement / Pulp and paper / Boards
Magnesite and graphite / Manganese
Potassium / Nickel
Refineries / Expanded clay
Zinc / Textiles
Tyres
Copper
Glass
Aviation

1

[1]For illustrative purposes, first findings are given for aluminium, iron and steel and cement and lime. As figures quoted are not yet considered as being final, they are shown in square brackets only. This work is carried out in the context of Article 10a (9), especially with respect to the letters (a) – increase in production costs and (c) – market structure and exposure to international competition).

[2] Including any international sectoral agreements.

[3] cf article 10a(8). This is without prejudice to other measures under article 10b

[4]At latest by 30 June 2010 (…) the Commission shall determine the sectors [which are exposed to a significant risk of carbon leakage].

[5]Key Commission services involved in this exercise are DG ENTR, DG ENV, DG ECFIN, Eurostat and the JRC (IPTS Sevilla), other services (SG, DG TREN, DG TRADE etc.) participate to this exercise through an interservice steering group.

[6]These Best Available Technologies "Reference Documents" (BREF) are adopted by the Commission after an extensive information exchange between Member States, stakeholders representing the industrial sectors concerned and the environmental NGOs. 31 BREFs have been adopted by the Commission covering all the IPPC industrial sectors. A process has also started to review and update the existing documents.