Background Note
What makes a carbon leak?
Online only 23 December 2008
Leslie Nielson
Economics Section
Contents
Introduction
In July 2008 the Minister for Climate
Change and Water, Senator the Hon. Penny Wong, released the Carbon Pollution Reduction
Scheme Green Paper.[1] The Green paper outlined the possible design of an Australian greenhouse gas
(GHG) emissions trading scheme (ETS) and invited submissions from all
interested parties by 10 September 2008. Numerous submissions were made.
Industry representatives expressed strong reservations about
the impact of the proposed ETS and some suggested that if the impact is too
severe, large scale resource and industrial projects will not go ahead.
Further, the impact of the proposed ETS may see high GHG emission production
relocate to a jurisdiction that is not subject to such a scheme or any other
restrictions on GHG emissions.[2] These concerns were repeated in response to
the recent White Paper outlining the Australian Government’s final decisions on
the design of the Australian ETS.[3]
The possible relocation of industry to another jurisdiction
and the long-term delay to major resource projects in response to the
imposition of an ETS is a manifestation of ‘carbon leakage’. The purpose of
this background note is to define what exactly this term means, consider
whether it has occurred anywhere else in the world, and outline the
difficulties in actually measuring it. The most important point for policy makers is to assess whether it might
occur and some factors in this assessment are put forward. A list of
considerations for assessing whether carbon leakage may occur, and possible
policy responses, conclude this note.
A recent major Australian report on climate change and
possible policy responses also defines the term:
carbon leakage—the shift of emissions-intensive industries
from high-mitigation to low-mitigation countries[4]
‘carbon leakage’—a loss of competitiveness and relocation of
trade-exposed, emissions-intensive industries as a result of carbon penalties
applying in some countries but not others.[5]
Trade-exposed, emissions-intensive industries represent a
special case. All other factors being equal, if such enterprises were subject
to a higher emissions price in Australia than in competitor countries, there
could be sufficient reason for relocation of emissions-intensive activity to
other countries. The relocation may not reduce, and in the worst case may
increase, global emissions. This is known as the problem of carbon leakage.[6]
As can be seen, the emphases in the above definitions are on
the relocation of productivity capacity from Australia to other countries, due
to the imposition of an ETS. This definition is repeated in recent government
reports on the possible design of an Australian ETS.[7]
Carbon leakage can also be defined as the ratio of emissions
increase from a specific sector in a second country (as a result of
environmental policy affecting that sector in the first country) over the
emission reductions in the sector in the first country.[8] As a formula, it looks like this:
Sector emissions increase in second country
----------------------------------------------------- X 100
Sector emissions reduction in first country
The increase in GHG emissions in the second country is
caused by increased emissions intensive mining activity or industrial
production, where there is either a decline in the same activities - or GHG
emissions are stable - in the first country. This increase can come about by
industrial activities relocating to or expanding in the second country which
has no ETS or other environmental policy constraints; or simply by the
reduction or cessation of the same activities inside the first country with no production
transfer to the second country. For this measure to be meaningful the overall
result must be that global GHG emissions increase more than they otherwise
would have.
To fall under the definition of carbon leakage these changes
must come about through the application of environmental policy such as an ETS.
Changes in the location of industrial production or minerals processing
activities, due to the increasing economic attractiveness of a particular
location (apart from the impact of environmental policy in the first country),
and the resulting rise in that country’s emissions, is not carbon leakage. For
example, it would be very difficult to say that increases in China’s industrial
production have come about because of an ETS. Rather, the development of
China’s internal market, the increasingly open international trading economy
and the lower costs of production, has a far greater impact on the decision to
locate industrial production in that country than the environmental regulations
of any other country.
There are several ways in which carbon leakage, due to the
direct effects of an ETS on industrial facilities, may come about:
- a short-term loss of competitiveness in one
country due to the initial introduction of an ETS. This may lead to increases
in production of an emissions intensive product in another location and an
increase in the overall level of GHG emissions. For this to occur there must be
unused capacity in the second country that can be brought into production at a
cost of less than that of increasing production in the first country, or
- an ETS may reduce the investment returns arising
from certain industries in the first country compared to a second country that
is not subject to emissions restrictions. This could cause investment capital
to flow to that second country for the purposes of building or expanding an
emissions intensive activity in that location.[9]
The first cause of carbon leakage may turn out to be
temporary as production costs vary over time between locations. However, the
second type of leakage causes a permanent increase in the carbon leakage rate.
The above academic definition of carbon leakage, while
generally accepted amongst commentators, is not that helpful in measuring
whether it is happening. How would governments or markets know accurately if
emissions were increasing in another jurisdiction that may have a less than
adequate GHG emissions control regime, given that such jurisdictions may not
adequately measure such emissions?
A conceptually better way of indicating whether carbon
leakage occurs may be to measure the international trade flows of industries
affected by an ETS.[10] A drop in exports of an emissions intensive product from the country with an
ETS may signal that carbon leakage is happening, all other things being equal.
That is, all other demand and supply factors remain the same.
In practice this latter condition may prove impossible to
determine because factors driving international trade (currency factors, demand
from internal verses external markets, transport costs e.t.c) frequently
change. Disentangling all these latter influences from the effects of an ETS in
a particular country may be very difficult indeed. A further difficulty is that
this measure can tell only what has taken place. This is not all that much help
to policy makers seeking to assess whether carbon leakage will take place under
a particular ETS.
Another way to determine whether carbon leakage may happen
is to rely on statements from the affected industries themselves. But, in a
time where emissions trading regimes are being developed, such statements may
be hard to distinguish from the manoeuvring of individual firms to gain the
most favourable set of conditions possible for their operations.
Economic modelling may help governments to assess whether a
particular set of climate policies may result in carbon leakage. The trouble is
that some economic modelling studies have overestimated the extent to which
carbon leakage would have happened with policies currently in place in Europe
and in compliance with the Kyoto Protocol.[11] This does not inspire confidence in the use of economic modelling. That said,
more realistic models at the sector level may be a helpful guide for policy
makers when assessing where carbon leakage may occur.
One of the key determinants of whether a sector, or a
particular firm, is open to carbon leakage is whether it has the capacity to
pass any cost increases through to its customers. If a firm or sector can pass
the cost increases on to its customers then their vulnerability to carbon
leakage is lower. The reverse is also true; if a firm or sector cannot pass on
their costs then their vulnerability to carbon leakage is higher. Many factors
bear on this decision and studies for each particular firm would have to be
carried out. Some of these factors are outlined below:
- supplier structure: is the market competitive?
One or two suppliers may well be able to recover price rises due to the
imposition of an ETS; where many suppliers exist this may not be possible as
competition in the affected market will be stronger
- proportion of overall commodity/product traded:
the higher the proportion of the commodity traded, the more open a particular
sector may be to carbon leakage, due to the increased trading of the product in
question between markets. For example, only about six per cent of all cement is
internationally traded, whereas a much higher percentage of aluminium is traded
internationally. A more traded commodity may be supplied to the end customer
from many alternative sources and the resultant market would be more
competitive. Consequently there may be a reduced capacity to pass on cost
increases to end customers
- trade barriers: markets that are open to imports
are more competitive and suppliers are less able to recover cost increases from
domestic and external customers
- long-term contractual agreements: a particular
facility may be locked into supplying its customers at fixed prices that may
not be able to accommodate cost increases arising from an ETS. Of course, this
may be a temporary influence as most long-term contracts eventually end and are
renegotiated
- commodity price cycle: if prices still afford profitable production in
a jurisdiction subject to an ETS, then the competitive impact of alternative
supplies of the same commodity may be further delayed. The higher the price the
less vulnerable a producer may be to carbon leakage
- energy costs as a proportion of total production
costs: generally, the higher the proportion of energy costs are of the total
costs of production, the higher the impact of an ETS on that activity. In other
words, there would be a relative price effect. This will increase the amount of
cost that has to be passed on. If the price cannot be passed on then the
producing firm or sector’s vulnerability to carbon leakage increases, and
- substitution effect: there may be a point at
which the higher relative costs of a particular item trigger a decision by consumers
to substitute a less expensive alternative. For example, the use of steel in
place of aluminium in packaging.[12] The greater the substitution effect the greater the vulnerability to carbon
leakage, as firms seek to lower their costs to regain competitiveness against
the substitute.
In practice both the European Union and the Australian
government have outlined rules for assessing whether a particular firm or
industry is potentially vulnerable to carbon leakage. In Europe, these rules
are:
- a sector is deemed to be exposed to a
significant risk of carbon leakage if the sum of both direct and indirect
additional costs arising from environmental controls leads to an increase in
production costs exceeding 5 per cent of its gross value added and, if the
total value of its exports and imports divided by the total value of its
turnover and imports exceeds 10 per cent, or
- if the sum of the direct and indirect additional
costs arising from environmental controls leads to production costs exceeding
30 per cent of its gross value added or if the total value of its exports and
imports divided by the total value of its turnover and imports exceeds 30 per
cent.[13]
The proposed Australian ETS will provide assistance to
emission intensive trade exposed firms or sectors. Trade exposure will be defined by having a trade share
(defined as the ratio of the value of imports and exports to the value of
domestic production) of greater than 10 per cent in any year between 2004-05
and 2007-08, or a demonstrated lack of capacity to pass through costs due to
the potential for international competition.[14]
As can be seen, in practice the
degree of trade exposure is the key part in assessing whether a sector or
entity is likely to be vulnerable to carbon leakage. The European approach is
more sophisticated that the Australian one. Only time will show which approach
yields the best results.
Should a company or sector find itself vulnerable to carbon
leakage, and the associated falling profits, then it may decide to relocate its
activities to a jurisdiction that is not subject to an ETS. In no particular
order some of the considerations when relocating may be:
whether a facility is the highest cost facility
in a globally integrated industry. For example, the global aluminium industry
is dominated by a few major multinational companies with aluminium smelters in
many locations. Such companies would relocate production from the highest cost
smelters first
- the availability of an alternative location with
the necessary physical attributes, particularly for achieving the necessary
scale of production if establishing a new facility
- whether the alternative location can physically
expand production if the activity in question is already present? This may
require the establishment of additional power stations e.t.c
- the availability of less expensive energy in the
alternative location
- the availability of a trained workforce in the
alternative location
- if there are strong nearby markets with low
import barriers: one of the reasons why emission intensive activities are
located where they are close to their markets. This is particularly important
for products where transport costs to markets are a major cost. Transport costs
are not so important for low volume high value commodities such as aluminium
- whether there is a stable government willing to
host the activity in question without extracting a disproportionate ‘rent’ in
the form of fees and charges
- whether there are less stringent tax and
environmental regimes in the alternative location, both now and over the
economic life of the new investment
- as the income of developing countries increases,
they may well demand enhanced environmental controls. Further, participation in
any new international agreement to limit GHG emissions may radically affect the
decision to relocate
- whether it is less expensive to upgrade an
existing facility compared to the investment required to relocate, and
- whether by relocating, a company risks a major
negative impact on its reputation.[15]
The answers to these questions will be different for each
particular firm and activity. But the important point is that a decision to
relocate an activity due to the impact of emissions trading is not a simple
decision. Some firms may choose to absorb the additional costs and continue
operating within a region subject to an ETS.
There appears to be no substitute for assessment on a
case-by-case basis before deciding that a firm or sector may be vulnerable to
carbon leakage. However, governments are seldom able to respond on a case by
case basis when implementing such a broad economic policy such as the
introduction of an ETS.
If carbon leakage was going to occur it would have happened
in Europe, where environmental taxes have been applied for some years and where
a multi country ETS is in operation. To date there has been little, if any,
observed carbon leakage from areas subject to emissions trading schemes or
environmental taxes.[16]
The reasons for this lack of ‘leakage’ in Europe to date may
be due to the particular design features of the European Union Emissions
Trading Scheme (EU ETS) during its first trading period (2005–2007). The very
high proportion of free emission permits issued, the scheme’s low coverage
(only 40 per cent of the emissions of one GHG, carbon dioxide), and the
over-allocation of permits, blunted its economic impact. Further, many
environmental taxes in Europe were not overly severe.[17] Another reason may be that during the recent buoyant economic circumstances,
energy intensive industries’ returns were sufficient to postpone a decision on
whether or not to relocate.
Thus, in Europe there has not yet been a strong economic
incentive for carbon leakage to occur. This may change as the EU ETS evolves
and other countries, including Australia, implement their own GHG emissions
trading schemes.
Some doubts have been raised whether Australian emissions
intensive industries are really vulnerable to carbon leakage under the proposed
Carbon Pollution Reduction Scheme (CPRS). Recent Treasury modelling suggests that there may be a minor amount of
carbon leakage at most expected prices of a tonne of carbon dioxide or
equivalent. Where carbon prices are double the highest expected price range per
tonne of carbon dioxide or equivalent, significant leakage may occur.[18] Treasury also concluded that recent concerns raised about carbon leakage, based
on private economic modelling, may be exaggerated.[19]
However, these conclusions reflect Treasury’s modelling
assumptions. One important assumption is that other countries also adopt GHG
emissions control measures within a few years of the start of the Australian
ETS in 2010. If other countries also adopt significant GHG emission control
measures the scope for carbon leakage is lower. Treasury did not model the
outcome in respect of carbon leakage should this not occur.
Further, recent equity analysis reports on the impact of the
proposed ETS on Australia’s largest companies (including Woodside) suggest that
its impact should not have a significant effect on their financial positions.[20] This conclusion was repeated in the wake of the release of the Australian
government’s recent white paper outlining the final design of the proposed
Australian ETS.[21]
The above analysis does not appear to apply to the aluminium
smelting industry. The Garnaut Climate Change Review noted that Australia’s
aluminium smelting industry may well eventually decline due to the introduction
of an ETS in Australia. The review suggested that this industry would relocate
to take advantages of cheaper energy in Africa, Asia and the island of New
Guinea.[22]
Whether carbon leakage is a good or bad thing will depend on
what criteria is used in this assessment.
Where carbon leakage occurs through a stagnation of
production in Australia, or its relocation overseas, it may cause an
undesirable loss of employment and a reduction in economic output. During a
period of subdued economic activity this would not be a desirable outcome.
In Australia, the aluminium industry is one of the most
vulnerable to carbon leakage. While some of the existing smelters are relative
new, others are of an older design. It may be appropriate that some older
Australian facilities should close, and that amount of production be relocated,
so that newer, less emission intensive facilities are constructed.[23] If new facility was coupled with a less emissions intensive power source (say
hydro electricity) from an environmental point of view it may be a very good
thing indeed. If that production is relocated to a developing nation, then a
useful transfer of skills may also occur.
The validity of the above argument depends on the
alternative location having a low emissions power source. It also depends on
the alternative country have a sufficiently robust emissions control regime to
ensure that the lowest possible emitting technology is deployed in the
alternative location. Neither of these two conditions can automatically be
assumed to exist.
Before governments take specific action to deal with carbon
leakage, care should be taken to clarify that the activity in question is
either ceasing production or relocating solely because of the impact of
emissions trading. A comprehensive study of this issue in 2004 noted that
industrialised countries have been losing production of emissions intensive
production for most of the last few decades.[24] Factors, other than the possible impact of an emissions trading regime, have
been driving these decisions. These factors are not going to disappear simply
because an ETS commences.
Should governments wish to restrict carbon leakage, the
available policy options may include the following:
- implementing as wide a global agreement on
emissions trading as possible
- the greater the number of countries where a
global agreement applies, the less the possible alternative locations for
carbon leakage. The wider the coverage in terms of GHG covered and industries
included, the lower the overall cost of compliance, and
- encourage technical advances in low emission
production so that affected industries don’t have to move
- part of this approach may be to maintain as high
an emissions permit price as required to foster technical innovation.
Should the adoption of a global emissions trading scheme be
uneven in terms of the number of countries participating, sector specific
measures may be required, such as the allocation of free emissions permits to
those sectors most at risk of carbon leakage, direct financial assistance and policies
to advance technical solutions for further emissions reduction.
Finally, should all else fail, the imposition of discriminatory
tariffs on environmental grounds on the imports of products from jurisdictions with
less stringent environmental controls (these are known as ‘border measures’ in
the jargon surrounding this topic) is a possible policy response.
The best option is the adoption of a robust global
agreement. But this may not be practicable for some time yet. The last option
is the least desirable option as it may well lead to the imposition of counter
tariffs between countries and an increase in industrial protectionism - both practices
in which nobody ultimately wins.
[1]. Senator the Hon. Penny Wong, Minister for
Climate Change and Water, Carbon Pollution Reduction Scheme Green
Paper, Canberra, July 2008.
[2]. Woodside Energy Limited, Submission on the proposed carbon pollution
reduction scheme, No. 485, Part A. See also press articles, for example
‘Woodside chief threatens to take gas plant to East Timor’, Sydney Morning Herald, 17 November 2008,
p. 6, and Alcoa Australia, ‘Alcoa’s
position on climate change’, accessed 20 November 2008.
[3]. Australian Government, Carbon Pollution Reduction
Scheme – Australia’s Low Pollution Future, Canberra,
December 2008. See Lenore Taylor, ‘Industry
revolt on green plan’, Australian, 17
December 2008, p. 1. This latter article cites comments by representatives of
the Australian cement industry to locate new production in either Indonesia or
Thailand.
[4]. Garnaut Climate Change Review, Final Report, Canberra, October 2008, p. 7.
[5]. ibid, p. 230.
[6]. ibid, p. 316.
[7]. Senator the Hon. Penny Wong, op. cit., p. 27
and 293; Australian
Government, Treasury, Australia’s Low Pollution Future – The
economics of climate change mitigation, Canberra, October 2008, p. 3
and 169.
[8]. Julia Reinaud, International Energy Agency, ‘Issues
behind competitiveness and carbon leakage – Focus on heavy industry’, IEA Information Paper, October 2008, p.
3. See also B Metz, O R Davidson, P R Bosch, R Dave, L A Meyer (Eds), IPCC
Climate Change 2007: Mitigation.
Contribution of Working Group III to the Fourth Assessment Report of the Intergovernmental Panel on
Climate Change, Cambridge Univ. Press, Cambridge and New
York, 2007.
[9]. A third way is that a fall in fossil fuel
energy demand (not prices) in the country subject to the ETS may cause an
increased demand in a country not subject to an ETS. All other things being
equal, the unconstrained country would use additional amounts of fossil fuels.
See Julia Reinaud, ‘Issues behind competitiveness and carbon leakage’, ibid,
pp. 3 and 4.
[10]. Julia Reinaud, ‘Issues behind
competitiveness and carbon leakage’, ibid, p. 6.
[11]. See discussion in Reinaud, op. cit., p.
38 and following. This point was recently made in the report of the outcome of
recent Treasury modelling. See Australian Government, Treasury, ibid, p. 170.
[12]. Julia Reinaud, ‘Issues behind
competitiveness and carbon leakage’, ibid, p. 43 and following.
[13]. Council of the European Union, ‘Note from
the General Secretariat of the Council to Delegations on energy and climate
change – Elements of the final compromise’, 17215/08, Brussels, 12 December
2008, pp. 3-4.
[14]. Australian Government, Carbon Pollution Reduction Scheme – Australia’s Low Pollution Future, Executive
Summary, Canberra, December 2008, p. xxxiv.
[15]. See discussion in J P M Sijm, ibid, p.
160 and Reinaud ibid.
[16]. Reinaud, ibid., p. 6 and T Barker, S
Junanker, H Pollitt and P Summerton, ‘Carbon leakage from unilateral
environmental tax reforms in Europe 1995–2000’, Energy Policy, No. 35, 2007, p. 6291, and J P M Sijm, O J Kuik, M
Patel, V Oikonomou, E Worrell, P Lako, E Annevelink, G J Nabuurs and H W
Elbersen, ‘Spillovers of Climate Policy – An assessment of the incidence of
carbon leakage and induced technological change due to CO2 abatement measures’, Netherlands Research Program on Climate Change, Report 500036 002,
December 2004, Appendix C, p. 153, and Julia Reinaud, International Energy
Agency, ‘Climate
Policy and Carbon Leakage – Impact of the European Emissions Trading Scheme on
Aluminium’, IEA Information Paper,
October 2008, p. 5. This last study also noted that it was too early to say
with confidence that the EU ETS would not have a long term effect on the
location of aluminium production.
[17]. Barker et al, ibid.
[18]. Australian Government, Treasury, ibid, p.
169. The price of carbon or its equivalent amount in other greenhouse gases
depends on the ETS implemented and the rate at which GHG in the atmosphere are
stabilised. The greater the rate of GHG emissions reduction and the faster the
time table for stabilization as a set rate (measured in GHG parts per million
in the atmosphere), the higher the carbon cost. Treasury has modelled the costs
of stabilizing GHG concentrations at 450 parts per million using what is known
as the Garnaut – 25 scenario. The expected cost of carbon permits in these
circumstances is $US47 in 2013, rising to $US158 in 2050 in then year terms
(Australian Government, Treasury op. cit., p. 93). Double this figure is $US94
in 2013 and $US316 in 2013 and 2050 respectively. These costs are for a tonne
of carbon dioxide or its equivalent in other GHGs. The equivalent of a tonne of
carbon dioxide is the amount of one or more of the five other GHG mentioned in
the Kyoto Protocol to the United Nations Framework Convention on Climate Change
in terms of their capacity to contribute to global warming.
[19]. Australian government, Treasury, ibid, p.
170.
[20]. The Climate Institute, Clearing the Air – Clean energy investments
to power a low carbon future – and the myths polluters sue to stall progress,
Sydney, December 2008, p. 12.
[21]. Paul Gravey, ‘Minimum impact on the worst
polluters’, Australian Financial Review,
17 December 2008, p. 5.
[22]. Garnaut Climate Change Review, Final Report, Canberra, October 2008, p.
497.
[23]. ibid.
[24]. J P M Sijm, ibid, p. 147.
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