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This week, Sandbag presented its ‘tiering’ proposal to the Environment Committee shadow rapporteurs meeting on reforming the Emission Trading Scheme. The proposal recommends a way to improve ‘carbon leakage’ protections, with a nifty boost for ambition at the same time.

The issue in play was how to separate out or tier the free allocation of allowances awarded for ‘carbon leakage’ protection. Hundreds of millions of free allowances and billions of Euros in unearned industry profits are at stake.

Currently, almost all industries get some free allowances to protect them from becoming uncompetitive internationally because of the carbon price. However, many businesses can easily just pass the cost of CO2 in their products onto their customers. With existing free allocation rules, this has led to enormous windfall profits from selling these free allowances.

Windfall profits are unsurprisingly popular so many businesses apply for the free allowances (read: free money). A limited number of allowances are available and each year that there simply haven’t been enough to go round. The Commission then has to give an equal ‘haircut’ to everyone’s applications (the Cross Sectoral Correction Factor) so businesses that might actually need full protection from the carbon price don’t get enough.

The proposals on the table, in brief:

  • The European Commission’s proposal is typically conservative, and the Commission itself estimates it would take the percentage of emissions covered by free allocation from 97% to....(drumroll)...94%! 
    A stunning reform, we can all agree.
  • France and UK have a much better proposal, but our calculations show it will still trigger the Cross Sectoral Correction Factor (CSCF), which will make everyone very unhappy.
  • Sandbag’s proposal (PDF) fixes all this. It reduces un-needed free allocation substantially and fairly, avoids the dreaded CSCF, and should free up ~650m allowances. These could be cancelled for more ambition, or added to the Innovation Fund to help industry install low-carbon technology.

 

A Commission in stasis

The Commission’s binary tiering will make very little difference to free allocation, and risks continuing to boost the surplus which has long dogged Europe’s carbon market.

Fig. 1: All industrial sectors have developed surpluses in previous phases of the ETS, leading to windfall profits. Many, such as the Cement Sector, continue to grow these surpluses.

The Commission also proposes a "Qualitative Assessment" for borderline cases, so even the small number of industrials that fell outside the high risk category could still argue for free allocation.

The Phase 4 carbon leakage list would last for 10 years, to give industry "certainty".

Phase 4 would also see more encouragement for indirect cost compensation. There are technical impediments to harmonising this across the EU, so it's likely to still vary wildly between Member States. This is because:

  • The EU doesn't have enough money/allowances
  • The EC lacks info on power prices
  • There's no single electricity market

On cost-pass through, the Commission reassure that we shouldn't be too worried; it's a “natural phenomenon” and evidence shows all sectors do it to varying degrees. Carbon price is far less important than changes to wholesale price from renewables / gas price change.

 

Balance in all things

The UK and France have experimented with a number of tiering options and settled on a "balanced" tiering proposal. Four tiers of 100% free allocation, 75%, 50%, 9%, would depend on exposure to carbon leakage.

The representatives admitted they had great difficulty in tweaking tiers to use all the allowances, but not to trigger the CSCF

Sandbag think you should build in 'insurance' in the form of a buffer of many spare allowances to avoid triggering CSCF. This is especially important because the predicted demand for free allowances assumes a certain level of industrial growth, and nobody has shown themselves to be particularly successful at predicting such things more than a decade ahead.

 

Sandbag’s tiering insurance proposal

Special adviser for Sandbag, Damien Morris, gave this presentation (PPT), pointing out that a similar proposal was made in the Commission's Impact Assessment, it was ranked most highly, but was ignored.

Why is Sandbag’s proposal so damn useful?

  1. It avoids windfall profits (from un-needed free allocation).
  2. It protects the best performers in highly exposed sectors – giving them the free allocation they need.
  3. It tightens supply and so boosts the carbon price thereby increasing the value of the Innovation and Modernisation Funds while driving faster emission cuts.

Fig 2. Trade intensity with emissions intensity, mapped with tiers

Our calculations show this tiering system leaves ~650m spare allowances, if industrial growth is 1% a year (quite ambitious). These could be cancelled to boost ambition, added to the Innovation Fund, or kept as insurance for increased industrial growth in future. In fact, the Commission could wait until mid-Phase, and make a decision then (after we know the benchmarks and growth more accurately).

The representative from the aluminium industry closed the meeting by pointing out it was difficult for them to invest because businesses just don't know where the carbon price will be in 5 years. Is there a way to give certainty?

*cough*...price corridor...*cough*[1]

 

View Sandbag’s full presentation proposal here (PPT), and watch out soon for our full ETS reform recommendations.

NB: Ian Duncan MEP, the rapporteur on the Environment Committee tasked with guiding the reform proposal through parliament, has indicated support for some form of tiering, and strong support for avoiding triggering the CSCF.

Creative commons tiered cake photo used with thanks to Nonpareils Boutique Bakery

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