Carbon leakage myth buster

The concept of “carbon leakage” is a major area of discussion in the legislative proposal to revise the EU’s Emissions Trading System (EU ETS) for the post-2020 period. The Commission’s proposal continues the trend of awarding free allowances, effectively representing a financial subsidy of €160 billion, to heavy emitters without providing evidence for the need of such beneficial treatment. A new Carbon Market Watch policy brief “Carbon leakage myth buster” shows how certain manufacturing companies have profited from selling the free EU ETS allowances they were given and recommends how to avoid such windfall profits in the future.

Most manufacturing industries currently receive up to 100% of their CO₂ allowances for free because EU’s policymakers have decided that they are at risk of “carbon leakage”. To date however there has been no compelling evidence for any production displacement due to the EU ETS. A study by the London School of Economics indicates that this is also unlikely to happen in the future even with a complete phase out of free allowances and a ten-fold increase in the carbon price.

The concept of “carbon leakage risk” is also by itself questionable as more and more nations take action on climate change. Countries responsible for almost 90% of global emissions have already submitted climate action plans for the post-2020 period ahead of the Paris climate summit. Some observers have therefore started wondering: where can the carbon still leak to?

Certain industrial companies nevertheless overstate their carbon leakage risks in order to maximize their gains from selling freely obtained emission allowances. In the past five years, industrial companies such as ArcelorMittal and Lafarge have made almost €1 billion from the EU ETS (according to their own annual reports) and they are about to make even more from the EU ETS in the future. The analysis by the European Commission shows that the steel sector is set to make at least €13 billion from the EU ETS in the post-2020 period. While such windfall profits might benefit the shareholders of these companies, they appear to have little benefit for the society at large by spurring investments in climate friendly technologies.

Since European industrial companies receive their allowances to CO₂ for free, they are hardly exposed to the carbon price. That means that European companies are currently not receiving a sufficient price signal to produce more efficiently or invest in innovative technologies that reduce CO₂. The result is that certain EU industries have fallen behind the global average in carbon efficiency. Europe’s industry emissions are hence not projected to decrease up to 2030, according to the European Environment Agency.

Despite lacking evidence that carbon leakage is a real threat, the latest proposal for the EU ETS revision continues the preferential treatment of heavy industry by awarding them free allowances. An overhaul of the carbon leakage rules is needed to transform the ETS from a pollution subsidy scheme into a system supporting industrial frontrunners that are ready to invest in a climate friendly economy. Phasing out free allowances and increasing the share of auctioned allowances could instead mobilise up to €160 billion that can inter alia be ring-fenced for low-carbon innovations in the EU.

Carbon Market Watch’s key recommendations:

Phase out free ETS allowances by gradually increasing the share of allowances to be auctioned from the current 57% in 2021 to 100% in the future. The additional auctioning revenues can be invested in the just transition to a climate friendly society.
Do not give free allowances to sectors that are not at risk of carbon leakage (and hence not on the carbon leakage list).
Only compensate industry on the carbon leakage list for the share of carbon costs that are not passed on to customers to avoid windfall profits.
Introduce a more targeted and tiered approach to carbon leakage to help ensure that support is focused on those industries who really need protection.