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Sandbag’s recent report on the cement sector highlighted several key flaws in Emissions Trading Scheme (ETS) rules around free allocation of allowances. These rules give rise to perverse incentives to pollute: we estimate the ETS has increased cement sector emissions, at the same time as handing over billions of Euros worth of unneeded allowances to some of the world’s largest companies. Meanwhile, other industrial sectors have seen their share of allowances diminish. Here we examine these rules in further detail.

Phil MacDonald, Policy Analyst at Sandbag, commented:

The cement sector’s over-allocation is making life harder for other sectors covered by the ETS. Unless a tiered allocation system is adopted, this problem will only get worse as we expect the cement sector’s surplus to continue growing through to 2020.

Free allocation rules in the ETS are designed to prevent relocation of energy intensive industries away from Europe, an effect known as carbon leakage. Free allocation works by awarding sectors deemed ‘at-risk’ with emissions allowances (EUAs) in order to shield them from becoming uncompetitive because of the carbon price. In the current system, there is a binary distinction (either on or off the list) between sectors which are at risk of carbon leakage and those which are not.

To qualify for protection against carbon leakage in Phase 3 (2013-2020), sectors needed to meet both minimal carbon cost intensity and trade intensity criteria. Exceptions were made for cement, along with the related lime and plaster sector, which do not meet the minimum threshold for the trade intensity criterion but have still been made eligible to receive allowances to cover 100% of their benchmark allocation. These were the only two sectors on the carbon leakage list during Phase 3 due to their carbon cost intensity alone. It follows that, if the cement sector were awarded free allocation in accordance with the same principles as most other industrial sectors, the volume of EUAs it would receive would be considerably lower.

Expected development of allowance surpluses (cumulative) for major industrial sectors until the end of Phase 3. Future projections based on 2014 emission levels. Source: EUTL (Sandbag calculations).

The graph above shows the cumulative balance of free allowances relative to the yearly emissions of each sector. Unlike many other sectors, cement is expected to grow its surplus of allowances out to 2020 and will be insulated from the carbon price for around a decade afterwards. A finite number of allowances is available for free allocation so placing cement on the same footing as others in terms of leakage risk has direct consequences on free allocation for all industrial sectors. In Phase 3 the list of risk-exposed sectors was overcrowded so it was not possible to grant all installations their full application. That resulted in the introduction of a cross-sectoral correction factor (CSCF) – a uniform reduction in the amount of allowances across all sectors to fit the available ceiling on free allocation. Highly risk-exposed sectors are extremely critical of the CSCF as it results in them receiving less protection than their benchmarked entitlement.

There are significant differences in the risk exposure of each industrial sector to carbon pricing which are not reflected in the binary system of leakage risk classification. The European Commission has proposed moving from binary leakage provisions to an approach recognising that sectors fall into different tiers of progressively diminishing risk. Under this approach, each sector’s risk exposure would be assessed by combining its trade and emissions intensity into a single metric. Installations which fall into a less risk-exposed tier would see their free allocation reduced – with only the highest tier eligible to receive 100% of its application. Cement, being an industry with low trade exposure, would see its allocation fall.

A tiered system avoids penalising sectors at the highest risk of carbon leakage by the triggering of the CSCF. It would also reduce the free allowance given to industries which fall into a lower risk tier. For example, allowances which would otherwise be allocated to cement would become available to other sectors as shown in the table below.

Volumes re-channelled from cement to other sectors, as a function of cement’s risk exposure and overall industrial growth. Source: EUTL (Sandbag calculations). Note: Industrial growth is year-on-year, and continues uninterrupted from 2014 onwards

 

Since the number of EUAs is limited, over-allocation of free allowances to one or more sectors puts other industries at a competitive disadvantage. Questions remain about the reality of ‘carbon leakage’ with the carbon price at just €5 a tonne but there can be no doubt that adopting tiered allocation is necessary in order to prevent chronic over-allocation of EUAs to carbon fat cats. The advantages would be a fair apportioning of allowances to high leakage-risk installations while those that are less exposed to leakage will lose only their surplus.

Read the full report here: Cement – The Final Carbon Fatcat.