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Published on April 17, 2008

Author: UpBeat

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Slide1:  Implications of EU ETS for industrial competitiveness Presentation to Chatham House – IISD event on Climate Change, Trade and Competitiveness, Montreal, 3rd December, 2005 Michael Grubb, Chief Economist, The Carbon Trust Visiting Professor of Climate Change and Energy Policy, Imperial College, London, & Senior Research Associate, Faculty of Economics, Cambridge University Some opening remarks on competitiveness: “where’s the beef?”:  Some opening remarks on competitiveness: “where’s the beef?” Assertion: Competitiveness debates need to be grounded in quantitative analysis Observation: the quantified literature (as eg. reviewed for the Chatham House workshop) seems to be quite sparse Additions: there is some more work emerging but not a lot Hypothesis: academics haven’t studied it because its too empirical and specific (unlike the extensive theoretical literature on market modeling in general) and therefore doesn’t score much points in research rating / journal stakes ; Environmental groups havent studied it because they are frightened of the question; If industry groups have studied it they have kept the answers very quiet …. Carbon Trust study on implications of the EU ETS for industrial competitiveness: outline:  Carbon Trust study on implications of the EU ETS for industrial competitiveness: outline Introduction & Overview Results for the focus sectors A broader quantitative look at competitive-ness issues Background to the study Main determinants of competitiveness impacts (qualitative) Approach to study: interviews and modeling analysis of price pass-through issues Scenarios Each analysed according to appropriate market scale (UK / EU) Indices of net value at stake and exposure EU vs non-EU trade Sensitivity to allocations Relative exposure of sectors will depend on value at stake and price pass through - the study examines a mix of sectors in depth:  Relative exposure of sectors will depend on value at stake and price pass through - the study examines a mix of sectors in depth Higher Low High Lower Value at stake as a proportion of sector profit Ability to pass on costs to customers “Value at stake based on potential increase in energy costs*” “Cost pass through and impact on consumer demand linked to location, number and behaviour of competitors” Unaffected Offset / gains? At risk? Note: *e.g. cost increase driven by uplift in electricity price and need to purchase allowances Marginal impact Ferrous metals Cement? Oil refining Glass Aluminium Chemicals Sectors selected for detailed analysis, illustrating range of possible effects EU ETS: Electricity Cement Paper Steel (cold Refining Climate Change Agreements: Aluminium Vehicle Manufacturing Brewing Service sectors: Hotels Groceries Electricity Cement? Paper (newsprint) Pharmaceuticals Food & drink Retail Transport Vehicle manuf. EU ETS sectors Non- EU ETS sectors Sectors analysed Previous studies did not examine the price pass-through issue seriously:  Previous studies did not examine the price pass-through issue seriously Most studies and claims have been based (implicitly or explicitly) on combination of 100% price pass through for electricity producers 0% price pass through for electricity consuming sectors This extreme combination maximises perceived adverse impacts on energy consuming industries Reality will be more complex; so is modeling it! We focus upon three scenarios corresponding to UK NAP and plausible phases in evolution of EU ETS:  We focus upon three scenarios corresponding to UK NAP and plausible phases in evolution of EU ETS Price €5/tCO2 Allocation as UK draft National Allocation Plan: Electricity on trend to projection* minus 5.5MtCO2 by 2010 Other sector allocations equal to projection* / updated Climate Change Agreement (CCA+) targets Scenario /Phase 1 Price €10/tCO2 [expected to scale over range 10-20 €/tCO2] Allocation based upon NAP principles extended to 2008-12: Electricity leads cutback, sufficient to achieve national 20% reduction (=> elec allocn 28.3% below projection*) Other sector allocations equal projection* / CCA+ targets Scenario / Phase 2 Scenario Long Term Price €25/tCO2 Allocation 30% below projected* emissions / CCA+ targets for all participating sectors Possible allocation scenarios Allocation = allowances granted freely, additional emissions to be covered by auctioning or trading *Updated Energy Projections (UEP*) including other Climate Change Programme measures Electricity: even with large (25-30%) allocation cutbacks, sector can gain if it passes through > c.30% of marginal cost increase:  Proportion of increase in marginal cost passed through to prices, % Electricity: even with large (25-30%) allocation cutbacks, sector can gain if it passes through > c.30% of marginal cost increase Phase 1 €5/tCO2 Phase 2 €10/tCO2 Long term €25/tCO2 Increase in marginal production cost, % Minimal value at stake in phase 1 as allocation is close to total cost uplift; required cost pass through in phase 2 & long term scenarios increase as c. 30% allocation cut back 0.9% 28.9% 25.3% 12% 23% 58% Increase in wholesale electricity price, % 0.1% 4.9% 10.6% Cost pass-through required to maintain sector operating profits Profit-maximising pass through predicted by market modeling: c.90% Slide8:  Electricity sector modelling results Modelling basis: standard (Cournot) profit-maximising model with limited number of firms:  Modelling basis: standard (Cournot) profit-maximising model with limited number of firms Market structure determined by the ratio of fixed and operating costs, demand elasticities, and degree of foreign competition Limited number of firms, seeking to maximise operating profits to cover fixed costs and to generate surplus Simplified model assumes all firms ‘typical’ of the sector average, and market is homogenous Model represents ‘geographical market’ in question – UK for electricity and cement, Europe for paper and aluminium Degree of price pass-through is determined by firm profit-maximising behaviour, not as an a-priori assumption Model allows firm entry and exit (though in cases we study this only happens for Aluminium) Results are reported for the aggregate sector not individual firms With data obtained and single parameter adjustment, the model adequately mimics current observed market outcomes I.e. price, quantities and number of firms Slide10:  Percentage of original EBITDA Scenario 1 Scenario 2 Scenario 3 Marginal cost increase Marginal cost increase with permits After price adjustment Demand adjustment After abatement Impact on a sector, defined in terms of impact on earnings before interest, tax & depreciation (EBITDA) can be ‘built up’ in terms of five analytic stages - Example of electricity Optimal pricing that reflects marginal costs results in large profits Electricity prices through 2005 indicate that companies are pricing as expected to pass through most of marginal CO2 costs :  Electricity prices through 2005 indicate that companies are pricing as expected to pass through most of marginal CO2 costs Evolution of Germany 2006 forward prices Though the sector profits, individual company impact can be diverse and depends upon carbon intensity [Oxera sector model, Central (Phase II) scenario, 90% pass-through]:  Though the sector profits, individual company impact can be diverse and depends upon carbon intensity [Oxera sector model, Central (Phase II) scenario, 90% pass-through] t C02/mWh generated Coal increasing as % of capacity Change in operating profit per MW capacity % A B C D E F G H I J UK generators Source: Oxera modelling Slide13:  CT study results for other heavy industry sectors Cement: significant rise in marginal cost but only small pass-through required to maintain profits under ‘electricity leads cutback’ allocations:  Cement: significant rise in marginal cost but only small pass-through required to maintain profits under ‘electricity leads cutback’ allocations 27.3% 54.5% 136.3% 0.6% 1.3% 16.8% 7.0% 7.5% 39.7% Profit-maximising pass through predicted by market modeling: c.80% Proportion of increase in marginal cost passed through to prices, % Increase in marginal production cost, % Increase in wholesale cement price, % Cost pass-through required to maintain sector operating profits Phase 1 & 2, direct allocation helps offsets electricity price rise (c.90% cost pass-through in electricity) Long term scenario, required cement cost pass through increases as its direct allocation is cut back 30% Phase 1 €5/tCO2 Phase 2 €10/tCO2 Long term €25/tCO2 Cement: divergent perspectives point to complex market with varied pass-through:  Cement: divergent perspectives point to complex market with varied pass-through Modelling and some industry participants predict price pass through “Cement is a local commodity market, with 95% of cement used in UK manufactured in UK – haulage costs are significant …… therefore expect significant cost pass through” Cement manufacturer Comments based on interviews with 3 of 4 UK cement manufacturers Others believe price pass through will not be possible “As import prices often cap selling prices, margins will be squeezed as costs … we expect no change in current cement prices” Analyst “Cement travels on water, not well on land…… imports set the price anywhere close to water with a decent port facility…… UK is an island, nowhere is over 100 miles or so from the coast” Cement manufacturer “Price rises could lead to increase in penetration from less efficient plant from outside EU without reducing overall emissions levels” Cement manufacturer Reality is hard to predict due to complex nature of cement market but some degree of cost pass through likely “Transport is a sufficient cost that high imports is a sign of market imbalance – it is not like steel or Aluminium – not a world price…… logistics in the port are important, need big ships and on land doesn’t travel far” Cement manufacturer Newsprint: small rise in marginal cost and only small price increases required to maintain profits:  Newsprint: small rise in marginal cost and only small price increases required to maintain profits 0.6% 1.1% 2.8% 0% 0.1% 1.2% 7.9% 6.9% 51.3% Profit-maximising pass through predicted by market modeling: c.80% Proportion of increase in marginal cost passed through to prices, % Increase in marginal production cost, % Increase in wholesale newsprint price, % Cost pass-through required to maintain sector profits (EBITDA) Scenario 3, required paper cost pass through increases as its direct allocation is cut back 30% Scenario 1 €5/tCO2 Scenario 2 €10/tCO2 Scenario 3 €25/tCO2 Cold-rolled steel: profits rise in weaker price scenarios but sector could struggle to maintain pre-ETS position in long term scenario:  Proportion of increase in marginal cost passed through to prices, % Cold-rolled steel: profits rise in weaker price scenarios but sector could struggle to maintain pre-ETS position in long term scenario Scenario 1 €5/tCO2 Scenario 2 €10/tCO2 Scenario 3 €25/tCO2 Increase in marginal production cost, % 33.0% 31.6% 63.3% 3.2% 6.3% 15.9% Increase in price of cold-rolled steel, % 0.8% 1.5% 7.0% Cost pass-through required to maintain sector profits (EBITDA) Profit-maximising pass through predicted by market modeling: c.66% Aluminium smelting highly exposed to electricity prices and international competition, no allocation benefit => serious impact on grid-based plant?:  Aluminium smelting highly exposed to electricity prices and international competition, no allocation benefit => serious impact on grid-based plant? Assumes plants are buying electricity from grid with 90% electricity sector cost pass-through In long term scenario, one firm predicted to exit; remaining firms have increased output. 2.6% 5.2% 13.1% 3.1% 6.2% 9.9% [149.3%] [151.3%] [96.4%] Required pass though > 100% as no ETS allocation Implied price increase unlikely to be possible at higher carbon prices Loss-minimising pass through predicted by market modeling: c.66% Proportion of increase in marginal cost passed through to prices, % Increase in marginal production cost, % Increase in wholesale aluminium price, % Cost pass-through required to maintain sector operating profits Phase 1 €5/tCO2 Phase 2 €10/tCO2 Long term €25/tCO2 Aluminium sector has problems, new EU plant unlikely for mix of reasons:  Aluminium sector has problems, new EU plant unlikely for mix of reasons Smelted Aluminium - “solid-electricity” “Currently we are shielded from electricity price impacts through a long term contract, this will expire in 2009. Not part of EU ETS in phase 1 but expect to join in next phase …… big concerns about potential impacts when fully exposed to both effects” Al smelter “~20% of EU Al smelters are self generated, the rest tend to have long-term contracts with specific suppliers and will be exposed to electricity market price uplift” European Al. Association Comments based on interviews with major Al smelter, industry consultants & trade associations Ability to pass through cost increases is very limited due to international trade, industry also concerned about EU divergences “Al is a commodity with set international market price……margins are tight, low profit per tonne of CO2e…… EU ETS therefore represents a significant threat” Industry consultant “We are concerned about EU competition…… UK tends to gold-plate implementation of EU legislation” UK Al smelter Limited abatement opportunities, but even if in EU ETS key exposure will remain electricity “Primary sector has very limited opportunity to reduce direct CO2 emissions further…… industry has achieved in recent years 60% reduction in PFC gases released when electrolysis is reversed (up to 9,000 more potent than CO2)…… CO2 released as the carbon anode is consumed during electrolysis cannot be controlled as it is dictated by stoichiometry of the reaction” Al Federation Future investment likely to focus outside EU for mix of reasons, not just energy / ETS “New investment will focus outside EU (South Africa, Australia, China) driven by energy prices, energy availability and labour costs…… only new smelter in EU+ is likely to be in Iceland which has large hydro and geothermal capacity” European Aluminium Association Allocation changes do not feed through to other sectors and results are not too sensitive to allocation: UK goal of 20% national CO2 reductions by 2010 appears feasible primarily with cutback in operating profits to electricity sector:  Allocation changes do not feed through to other sectors and results are not too sensitive to allocation: UK goal of 20% national CO2 reductions by 2010 appears feasible primarily with cutback in operating profits to electricity sector Phase II NAP extrap-olation Phase II 20% UK, electricity leads cutback Phase II 20% UK, even allocation Electricity and other sectors allocation* 21.2% below projection / CCA+ Electricity allocation* 28.8% below projection Other sectors allocation* equal to projection / CCA+ Electricity allocation* 3.8% below projection Other sector allocation* equal to projection / CCA+ Source: Oxera modelling Relative change in operating profit with optimal price pass-through * Allocation = allowances granted freely, additional emissions to be covered by auctioning or trading CCA+ = revised climate change agreement targets Slide21:  A wider view on competitiveness issues – (i) generalising the findings to other sectors, scales and scenarios Slide22:  Non-EU trade intensity, % Net value at stake, % Cement & construction Food & tobacco Pulp & paper Refining & fuels Glass & ceramics Iron & steel Chemicals & plastics Textiles Metal manufacture Metal casting Al production Indices of net value at stake and trade intensity indicate Aluminium is unique: for many industries, ETS unlikely to have significant adverse impact Price rises required to maintain profits suggest that steel and cement may have cause for concern in some post-2012 scenarios and/or specific border exposure:  Price rises required to maintain profits suggest that steel and cement may have cause for concern in some post-2012 scenarios and/or specific border exposure Net value at stake** (% of current EBITDA) Product price rise required to keep profits flat (% of current price) 2010 2020 EU ETS sectors High scenarios* Cement (in EU ETS) 2010 2020 20% 52% 5% 10% Steel (in EU ETS) 9% 27% 1% 4% Newsprint (in EU ETS) 1% 3% <0.1% 0.5% Petroleum (in EU ETS) 0.5% 1% 0.1% 0.3% Car manufacture (in EU ETS) 1% 3% <0.1% 0.1% Brewing (in EU ETS) 1% 3% <0.1% <0.1% Aluminium (in CCA) 80% 170% Unable to maintain current profits CCA sectors Note: *Includes impact of doubled CCL plus direct and indirect EU-ETS effects **= (inc. in total costs after allocation)/(starting EBITDA), ETS prices 2010:15 €/tCO2, 2020:30€/tCO2, allocation cut back 1%pa from 2005; ***Assuming 100% auctioning at EU ETS prices Cement and steel potentially under threat by 2020 Aluminium very exposed to EU ETS electricity price rises across EU Slide24:  A wider view on competitiveness issues, (ii) Energy efficiency and the ‘Porter-Decanio Hypothesis’ The general Porter Hypothesis is considerably buttressed by emergent network theories of firm organisation and innovation processes:  The general Porter Hypothesis is considerably buttressed by emergent network theories of firm organisation and innovation processes DeCanio et al papers demonstrate the impossibility of the traditional ‘ideal firm’ assumptions and underline fundamental importance of firm internal organisational patterns the role of external stimuli and shocks in forcing restructurings that may lead to greater innovation and profitability Innovation systems theories underline the complexity of innovation processes and the role of policy in leading firms towards cost-reducing innovations particularly in: Sectors that do not primarily compete on product differentiation and consequently are low-R&D intensity (and structurally conservative) sectors like utilities and construction; Relation to ‘public-good’-related innovation where returns are contingent upon future public policy In such contexts, there is a strong theoretical basis for ‘Porter Hypothesis’ type arguments. .. And by continuing evidence on cost-effectiveness of energy efficiency measures, also improving productivity - assessed value of energy efficiency savings from 2004-5 CT programmes at least twice the cost of policy and co-investment :  .. And by continuing evidence on cost-effectiveness of energy efficiency measures, also improving productivity - assessed value of energy efficiency savings from 2004-5 CT programmes at least twice the cost of policy and co-investment Investment costs and lifetime energy savings 2004-05 (£m) Carbon Trust Spend Client capital expenditure Lifetime Savings 26 83 67 Low High Low High 280 152 Source: Carbon Trust Impact Assessment Conclusions: competitiveness implications of CO2 policies:  Conclusions: competitiveness implications of CO2 policies EU ETS not adverse for most sectors, some profit Transition issues need to be considered Impact mitigation for the few, highly exposed sectors? Electricity not only sector likely to gain: value of free allocations in ELC principles, plus some cost pass-through, can outweigh cost increases except for sectors and firms that are both electricity-intensive and internationally exposed Firms can increase profits at margin through abatement action and lobbying on allocation, but cost pass-through is biggest determinant Market prices and targets uncertain and pass-through may take time Elec companies could defer operating profits strategically to increase market share –reducing impact on elec consuming sectors Potential operating profits may also be tapped to fund investment including emissions abatement Most exposed sectors few & high concentration – often only one or two firms Aluminium smelting probably most exposed – self generation a key? Potential impact will increase as price rises and special elec contracts expire Present impacts appear manageable, later phases may raise more complex mitigation and protection issues For some sectors (eg. cement), model results show profits whereas industry fears loss - inconsistencies need to be explored further Previous studies have used extreme combination of assumptions, but modeling also very simplified: reality may lie between the two Cost pass-through is a key and complex issue Need to maintain wider, Porter+’ view Climate policy is largely about resource efficiency and innovation – not things inherently bad for competitiveness, if policies can target imperfections of firms Increasing theoretical and empirical basis for ‘Porter type’ hypotheses in context of energy & carbon Slide28:  Implications of EU ETS for industrial competitiveness Presentation to Chatham House – IISD event on Climate Change, Trade and Competitiveness, Montreal, 3rd December, 2005 Further information: The European Emissions Trading System: implications for industrial competitiveness, Carbon Trust, Oct 2004 The UK Climate Change Programme: potential evolution for business and the public sector, Dec 2005 (launch event, Montreal, Tues 6th Dec, 2.30pm) Reports downloadable from www.thecarbontrust.co.uk

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