Karsten Neuhoff is a Research Associate at the Department of Applied Economics at the University of Cambridge in the UK. He specialises in energy economics (electricity, gas, CO2 emissions), market design and regulation (investment in generation, new technologies), and network industries (market power in networks, network access).
In a recent paper for Climate Strategies (CS), you called for a full use of auctioning from the very start of the third phase of the ETS from 2013. Does that mean you support 100% auctioning for all industrial sectors from day one?
Yes and No. For the power sector, certainly yes. For the other sectors, it is different although I would also personally favour that option.
In our analysis, we looked at how viable was the Commission’s approach which still envisages quite a lot of free allocations in 2013 and then envisages to phase them out gradually until 2020. I think that by doing that, the Commission places itself on the conservative side, just to make sure that nothing goes wrong.
So you are advocating more use of auctioning, also for sectors other than electricity?
I think right now it is too late to address this point. Given where we are with the proposals on the table right now, the issue is more about trying to see how we can make sure that the free allocation that is being proposed is done in the least distorting manner, and making sure that other policy instruments are delivered to address leakage concerns, if necessary.
On the issue of carbon leakage, a number of industries, such as cement, steel and chemicals, are claiming that they are heavily exposed to international competition and that they would be forced to move their activities outside of Europe if too stringent regulations on CO2 emissions are imposed on them. Do you see any evidence today to actually back those claims?
Evidence today, not. I think it is a bit too early for sectors other than the power sector to make strong empirical assessments of the direct operational response of the sector.
On the strategic decisions, in terms of where companies do their investment choices, where do they go, again I think there is no evidence so far that I am aware of that they responded to a more ambitious European climate policy by thinking about moving somewhere else.
Let me formulate it another way: whether the more stringent European climate policy currently being discussed gives them a reason for moving somewhere else, I haven’t seen that in any explicit formulation so far.
Those sectors are essentially claiming that they are very much exposed to international trade. Are they typically trading a lot as far as you can tell?
It differs very much. If you look at the cement sector, so far we have only had in Europe imports where there was a domestic shortage. When there was the building boom in Spain, they imported first from Turkey, then from Egypt and eventually from China. They had to meet their excess demand which could not be satisfied locally.
So I think from that perspective, historically there is not really evidence for that. But at the same time, for a sector like cement, I think it’s probably the one where the carbon costs are highest relative to what you do when you produce clinker. For this first production stage, you then have to look in terms of what would happen if you had a long time of high carbon prices in Europe and not in other parts. In that case, I think there could be some influence on plant location, of course.
What about other industries such as steel, for example, which has been claiming the same. Is the situation different for the steel factor? There has been a boom in demand on steel mainly due to the fact that China and India are growing at an incredibly fast pace. Are they more exposed than other sectors?
As long as we continue to have the booming demand, relocation will not be an issue. The problem could come once we move to a situation - perhaps in a few years’ time - when there is a global excess supply of steel. What would happen then? Or what happens if steel plants are moving somewhere else because there is a better resource base. Will the climate package be blamed for that?
In the short term, I think there is not much reason for concern for the operation of an existing plant. I think potentially there could be concern if you think about new investment decisions and for these new investment decisions, again, I think we need more careful quantitative analysis, which is not yet on the table, before we can make a clear statement.
But if there is a concern, then probably free allowance allocation might not be the best way to address it and we might think of other approaches to do that.
What other approaches are you thinking about which are more efficient?
In the steel sector, for example, you could think of using state aid to support investment into energy efficiency to help the company deal with some of the higher carbon prices if you think there is a leakage concern. Otherwise, I think that they should rather increase product prices and get the revenue from that.
The other option is a border adjustment tax but I am really happy that we don’t have an explicit discussion right now for specific sectors about using it because I think we cannot use it as a European-only approach.
I hear the global business community is starting to warm up to the idea of a ‘carbon inclusion mechanism’ as they prefer to call it rather than a CO2 border adjustment tax…
Conceptually, I think it is a good idea. From the WTO perspective, I’m not very concerned about it. But we would have to find a way of aligning it with our international efforts on climate policy.
So you think it could be compliant with a wider international climate agreement?
I think it could be if there is sufficient trust, especially among developing countries, that we use it not as a stick, that we use it not in a discriminatory way, and that we use it very, very narrowly and focused on specific very carbon intensive products to make sure we increase the domestic price for this carbon intensive product.
But I think to really create that confidence with developing countries, we have to work together on an understanding of how it would work and go into discussion in an open manner. Saying for example that we are exploring the instrument and we would like to discuss with developing nations how we could do that in a way that is acceptable to everyone. I think that is why it was very important not to commit to using it now. If you are going to first say “we are going to use it, let’s talk about it”, it is a different framing of the discussion and I think that it would have a rather bad impact on the international cooperation on climate policy.
Do you mean more as a last resort measure?
No, I think it’s an option to explore but we have to explore it as an option with other countries rather than saying we are going to use it and impose it on other countries.
You were mentioning not using it as a stick. Is there a way that it can be used as well as carrot?
Likewise, if we come back to this leakage concern, and the analysis that we have been doing shows that only for 1, maximum 2% of economic activity, the carbon costs really are significant and only for a fraction of these we are probably really concerned about leakage.
How much would that fraction be?
1 or 2% of economic activity are associated with products or production processes which are very carbon intensive.
We looked at the UK and there was about 1% of production outside of the power sector that have either higher direct emissions or indirect emissions from power. If you look at Germany, it’s about 2%. The average is lower than that again. So it’s only a very small part of our GDP which is very carbon intensive.
Can we then conclude from that that the industry claims have been somewhat exaggerated?
I think the industry claim to the extent that they argue it has a big economic impact I think is exaggerated. I want to take leakage seriously from an environmental perspective because at the end if we drive relocation of emissions to other areas instead of reducing them, that doesn’t really help. And I think we need to take it seriously because we want to demonstrate that climate policy is something you can do with your industry and so you do not want to relocate specific production activities somewhere else as a response to the climate policy.
You said carbon leakage concerns mainly new investments. But what about existing plants, will they be less hit?
I think that would be the case if you look at the steel sector where they have a lot of investments already in Europe. So once you’ve got the plant there, you have a strong incentive to continue to operate it. Here, the question of where to invest arises when you need to reinvest on a large scale.
If you take other sectors like cement for example the, their capital investments are rather small relative to operational, energy and CO2 costs. And there it is more often an issue of operation.
So for sectors such as cement, they will be more inclined to go somewhere else?
To reduce output, perhaps even temporarily, and replace it, yes.
You were mentioning possible solutions, like state aid and the carbon inclusion mechanism. Are there other mechanisms which you think can be further explored?
Carbon inclusion schemes and free allowance allocation need to be reassessed in the circumstances of every specific sector to see which solution will be most suitable and where you are likely to get support from other countries.
North America, Australia and New Zealand - all of these countries are struggling with the same problem than Europe. And if we could find a way of dealing with it together, I think we will be in a far better position to find a good solution.
But if we pre-empt it, that is what I am worried about in Europe right now - that we make a pre-emptive decision a bit too early on a on mechanisms to address leakage and therefore pre-empt any discussion or any opportunity to discuss it with other countries or to really find the best solution for a sector.
The European Commission has had a very bad experience in the first phase of the scheme where the over-allocation problem made the price collapse. Do you think that there is a risk that this could happen again?
I do not think that the price is going to collapse entirely because now there is “banking” between the periods, which was explicitly not the case between the first and the second trading periods because it was an experimental phase of the first period.
To what extent we will have a very high carbon price after 2012, I am less confident right now. After all, this 20% emission reduction targets that we are committing to right now is not really ambitious. So in the end, I think that it might be a lot easier to achieve this 20% target than some people argue right now.
You mean the 20% reduction target for 2020 is not a strong enough commitment to actually guarantee a sufficiently high carbon price?
Yes, I think that 20% by 2020 can maintain carbon prices at their current levels but it could also get them lower particularly if you think about increasing the CDM usage that is currently envisaged.
And the current economic slowdown is probably going to make that situation worse at least in the short term it seems…
Yes, indeed. I see two effects in the short term. First, when there is less economic activity, you tend to have lower emissions because there is less money to spend around. The second question is how we are going to react with our climate policy. Are we going to be more hesitant and therefore delay some of the actions that could reduce CO2 emissions? Or are we going to use the opportunity to stimulate the economy and make productive investments in energy efficiency, therefore accelerating CO2 emission reductions?
So you think there is an opportunity there to be seized?
I would think so. In a way, this is probably the one area where you really want to make investments that are paying off in the future.
On the issue of auctioning: Poland is making the case that power prices would rise by 100% because of its heavy reliance on coal, if the power sector was to be fully auctioned in the third phase of the ETS, after 2012. Do you think this is a realistic claim or is the figure grossly inflated in your view?
I think Poland and other countries with a lot of coal power stations will not suffer more in the third phase of the ETS than other countries because in the third phase we will have coal power stations setting the marginal electricity price across continental Europe.
It does not matter whether you have 20% or 80% coal power; in the system you have the same electricity price for your consumer and your industry. So up to 2020, the share of coal power in your power system in continental Europe does not matter.
Why is this?
With the liberalisation of the energy markets, the most expensive power stations are the ones which are setting the marginal price of electricity, and therefore the prices of CO2 as well. And these are the coal power stations that you have in Poland and Germany. So most continental European countries and many of the other new member states have similar carbon prices already.
Given that there is an electricity trade between those countries, power prices – even in countries like France which uses very little coal – are set at this level which is the level of the most expensive coal power station in neighbouring countries.
And we have seen over the last 3-4 years that it does not matter how you allocate the allowances - whether you give them for free or whether you auction them - the power price will have included the full cost of CO2 allowances already, and you already have that in Poland nowadays. So free allowance allocation does not really influence the power price.
Today, most of the allowances in the power sector are already allocated for free so continuing the system will have a very limited impact on power prices.
Whereas, if you go for an auction system, you can get revenues from the auction and that allows you to compensate poor households for the increase in power prices. Very poor households are the ones that proportionally pay the higher bill and they should be the ones you want to compensate.
What would be the situation after 2020?
Beyond 2020, I would expect that more and more countries to move away from coal. And as you go beyond 2020, some countries will see lower power prices as they manage to avoid coal power generation.
So in a way, the challenge I see is now is how we can use the period up to 2020 to work with countries to get away from their coal power stations and to shift their investment in other technologies - either carbon capture and sequestration or renewables or whatever low-carbon options.
We should use the opportunity of this discussion to think strategically about what we want to do and make sure we go on the right track for this longer term low carbon economy with lower power prices.
So you are saying that we have essentially until 2020 to make that transition?
Well 2020 is roughly the time where we start to see a lot of coal power stations having a difficult time. And giving the coal power stations free allowances won’t help anyone at all before 2020.
With an auction system, governments will get financial resources which I think they should be able to use in a clever way to support that transition. So I am very happy that Poland will get a lot more auction revenue than other countries because they have a lot of coal power stations which determines how many auction revenues they will receive. I hope that they are going to find some clever way of using these funds to support the transition to a more efficient and lower carbon system.
Some energy intensive industries are also proposing to use a benchmarking system where free CO2 allocations would be handed to the best performing sectors. And those which do not meet the benchmark would need to buy their allocation at auction. What is your view about such proposals? Are there advantages and drawbacks?
There are three aspects where benchmarks are still sub-optimal and where moving to auctions will be far more effective for environmental purposes.
The first one is that with the kind of benchmark approach that you just described, companies will only pay to the level at which they are inefficient. For example, cement, steel or other energy intensive industries will not pay for the costs associated with their carbon emissions up to the benchmark.
So if you produce cement in an efficient plant, cement prices will not reflect any carbon costs. And that implies that people who use cement will not be using more “safe” cement in their building sector.
And in the end, what we need to do if you want long-term emissions reductions, is to be more economic with these carbon-intensive commodities. With a benchmarking approach, you eliminate that incentive and you risk missing out on a large potential of emission reduction.
So in theory, benchmarks sound very nice. But in practice, because there are specific formulations for each sector or product, it tends to be a lot more tricky to put in place. In the end, you risk getting some distortions in their specific application unless they are very tailored to a specific circumstance. And you then undermine incentives for innovation.
For example, if a producer of cement with an efficient plant does not pay for carbon emissions, then he can sell cement at this price for centuries. If you now come in with a new product which could substitute for cement, then you have to compete with cement at this low price even though cement actually has a higher cost for our society because it has all these carbon emissions associated with it which are ignored in the system. So it does not really create these new opportunities for innovative products and innovative services to compete with carbon intensive commodities and services.
And so with the benchmarks, they will fail to internalise the carbon price and allow the carbon price to feed through the economy.
Essentially, you mean this amounts to a sort of free-ride for the industries which beat the benchmark because they don’t integrate the CO2 price?
Under the benchmark system, companies that beat the benchmark still have carbon emissions but they do not pay for the carbon emissions. Therefore, their products will not reflect the carbon costs and will not allow consumers or users of this product to make efficient choices.
To summarise, you believe that benchmarking makes things a bit more complicated than they need to be? Is auctioning a clearer, simpler and more efficient system in your view?
I think that benchmarking is less effective in reducing CO2 emissions than auctioning because it allows companies to free-ride or allows sectors that are receiving loans on the benchmark to free ride on the overall carbon emission reduction.
However, benchmarks are probably better than free allowances. Benchmarks do create some incentive for efficiency improvement in the production process. I think that this is an important component. I don’t want to find it negative here
On the issue of carbon offset and the use of CDMs: Have you identified a sort of “tipping point” at which using too much CDMs will actually start to seriously undermine the ETS by encouraging emissions projects abroad but preventing emissions cuts at home?
For me, the objective of climate policy in Europe is to demonstrate that we can reduce CO2 emissions and get on the trajectory to a low-carbon economy. And I think that by going on the trajectory we then create opportunities for companies to take forth new ideas about low-carbon products and have a stable investment environment to do that.
If we now open up the system for a lot of CDM credits, then first of all you do not really know how many will come in. This creates a lot of investment uncertainty in Europe. Secondly, it reduces the efforts which are done in Europe. I think that if we do not really do something in Europe, we lose the credibility to other countries. We are just spending a few billion on CDM project somewhere else and not really demonstrating a strong commitment to climate policy. I think the draft proposal right now already is altogether rather generous on the CDM side.
How does that translate in terms of percentage?
From 2008 to 2012, all countries were allowed to use somewhere between 6% and 15% of CDM. As they will probably not use much of that, they can use all the remaining share after 2012.
And it ties with the question you asked at the beginning: what will be the impact on the carbon price? To me, it looks like CDM credits and renewables and some other efforts will reduce CO2 emissions but it is not clear how strong the remaining carbon price will be.
Obviously the situation would change considerably if some international agreement was reached, I guess?
This is another area: how do we want to engage with other countries on climate policy and with CDMs? How do we support specific, low-carbon projects in other countries?
I think CDMs have been effective in taking forth technologies, creating local stakeholders, generating interest in this idea. But in the end, we continue to put money into energy and carbon intensive sectors with these projects.
I think we need to find a way of shifting from subsidies in these sectors towards creating policy frameworks for carbon intensive sectors. So my stance is that we perhaps can try to find ways of engaging with developing countries in a way that goes beyond the CDM approach. It would help them incorporate all the connotations of domestic policy and to that extent, I think I would only see a limited role of CDMs even if we actually move up to the 30% emission target.