The Credibility of European Leadership: Business "Angst” and EU Climate Strategy

Jacques Pelkmans 16 December 2007

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The EU has become ever more explicit in claiming leadership in combating climate change. EU political leaders have committed to 20% greenhouse gas (GHG) mitigation in 2020 (compared to 1990 and irrespective of what others do or don't) or 30 % if others do credibly commit via successful global negotiations (to be initiated in Bali this week). The Union also committed to the sourcing of 20% of its overall energy mix from renewable energy in 2020 as well as to a savings target of 20 % of total primary energy consumption (compared to today). These ambitions follow from the political commitment of the EU to move on a path of mitigation consistent with a ceiling of global warming of no more than 2% by the end of this century; given the lagged responses in the world's climate, this demands a path leading up to roughly 80% GHG mitigation (compared to 1990) by developed countries in 2050.

The credibility of EU leadership depends of course on its own delivery (first the 2012 Kyoto target of -8 % compared to 1990, which the EU-15 will realise as the Commission noted late November; second, the actual realisation of the 20-20-20 strategy for 2020 which is a tall order) but no less on getting followers in the rest of the world. And the first factor is likely to be a necessary – though not a sufficient – condition for the second.

It is thus not surprising that the Commission is adamant in the pursuit of the internal climate strategy – it is a condition sine qua non for the Union's credibility in Bali and during the coming years of 'persuasion'. However, the credibility problem also goes the other way. The second factor ('getting followers' in the rest of the world) begins to look more and more like a necessary condition for the internal EU strategy to deliver.

The EU is a big player in the world economy and in the climate strategy game, but its emissions amount to no more than roughly 20% of world emissions. Moreover, the EU share will fall due to rapidly rising emissions of emerging economies. How much leverage the Union has – given its shrinking share – is critical for its capability to entice others to follow suit. Given the limited and slowly shrinking leverage, the perceived problem of (cost) competitiveness for EU business becomes ever more pressing and begins to erode the avowed preparedness to engage in ambitious voluntary agreements with the Commission or to support a wider scope and tighter emissions trading (the so-called ETS). Without active collaboration of EU business, it is exceedingly hard to believe that the 20-20-20 strategy can be realised and this, in turn, will tend to undermine the preparedness of those world partners, who are 'willing & able', to commit ambitiously.

The widening and tightening of the emissions trading is fiercely resisted by EU business despite their continued support of the ETS as a least-cost approach. The widening of scope by bringing in the airlines (without so far a tax on kerosine, without VAT and without any ceiling on CO2, whilst growth of their CO2 emissions since 1990 has soared by 85%) has led to a battle, with the EU airlines claiming that their profits will be eaten away. The issue is neither the curtailing of demand (expected to go up by 138% in 2020 and by 1 ½ % - 3 % less under the ETS dependent on the CO2 price), nor the price increases by consumers (by 2020, and assuming a CO2 price of EUR 30, short haul flights would go up by EUR 4.6 and long haul ones by EUR 39.6). The real issue is 'pass through'. The simulations mentioned assume full pass-through but the airlines claim that their pass-through is more like 29% to 36%, implying a huge loss of profits in the medium-run.1 Curiously, PriceWaterhouseCoopers found, in a 2005 study on the pass-through of higher kerosine prices, that pass-through of EU airlines had been complete. The argument that non-EU airlines obtain a competitive advantage does not apply as far as the European air services market is concerned because all airlines landing in or departing from the EU are treated the same.

The tightening of the Emissions Trading Scheme, ETS, in the second round of trading (2008 – 2012) is supported by EU business as far as the harmonisation of highly diverse and arbitrary national ETS rules is concerned – having caused numerous distortions – but not when it comes to the auctioning of allowances (as against free allocation, basically 'grandfathering' minus the desired mitigation). Not only does a low or zero share of auctioning of allowances lead to a range of arbitrary differences in 'windfall profits' between sectors, it also softens the impact on market conduct and leaves little or no room for entrants. Since the CO2 price in 2008 and later is expected to return to a range between EUR 20 and EUR 30 (because national plans have been tightened and energy companies, when switching partially to coal in the light of high oil & gas prices, will push up the demand for CO2 allowances, simply because coal generates much more CO2 emission), energy-intensive EU industries begin to express serious worries. Indeed, they suggest alternatives or schemes complementary to the ETS so as to reduce a perceived gap in cost competitiveness worldwide.

In three such industries (aluminium, steel, cement), sectoral approaches have been initiated by business itself. Thus, the International Iron & Steel Institute took a surprising initiative in May 2007 that suggests replacing cap & trading by a sector-specific regime which would ensure the phasing-out of obsolete technologies and a gradual move to best-practice technology in all 200 member companies (including the leading Chinese and Indian ones). In doing so, CO2 mitigation worldwide would be ensured for up to two decades, presumably at lower costs, while reducing the cost competitiveness problem for EU steel (they would probably have to transfer technology or support enormous investments to this effect).

Studies in aluminium, steel and cement show that disparities in both technical and energy efficiency and/or distances from the best-practice frontier are very considerable in the world so that win-win strategies can be devised. Apart from effective incentives, the Chinese companies will gradually have to improve anyway in the light of the energy-intensity strategy which China has now adopted. The ambivalence of EU business is exemplified by the strong European presence in the IIS, even when Eurofer (EU steel lobby) supports the ETS and has even developed a methodology for a "CO2 footprint" (on a life cycle basis, that is, including all indirect emissions) as a necessary condition for worldwide trading in the sector.

It is probably against this backdrop that one has to read the letter of BusinessEurope (the EU business lobby, formerly UNICE) of 26 November 2007 to Commission president Barroso. After asserting that the Emissions Trading Scheme has induced 'negative consequences for large sections of European industry', great concern is expressed about 'introducing a general system of auctioning for allocation of ETS allowances', due to direct and indirect costs and the virtual impossibility of passing on these costs to their customers for industries exposed to world competition. Again, the suggestion is made that, in some sectors, all yearly net earnings would have to be spent on it.

The competitiveness 'Angst' is said to be a compelling motive to keep free allocation but now based on technological benchmarking as well as to pursue international sectoral approaches. It is most doubtful, to say the least, whether such preferences would be consistent with the aim of 20% mitigation in 2020. Moreover, the harmonisation of national rules is said to be easier if all small emitters are taken out of the ETS. Furthermore, the credits that companies under the ETS can buy under the Clean Development Mechanism (i.e. from developing countries when having certified projects) or under Joint Implementation (i.e. from lower cost sources in Kyoto countries) should be unlimited.

To economists, this suggestion may sound convincing since climate change is a world, and not an EU, problem which must mean that low-cost mitigation elsewhere is desirable for combating climate change and cost-effective. In the absence of a worldwide cap & trade system, unlimited credits do have one huge drawback, however. Since the EU is simply not 'big enough' in terms of overall CO2 emissions worldwide, an improved and enlarged Clean Development Mechanism (of the Kyoto Protocol) might eventually generate a massive supply of credits to the EU against a relative limited demand, resulting in a collapse of the ETS. The EU would lose all credibility in its leadership role and 'followers' would think twice before embarking on ambitious cap & trade themselves and/or linking up. Finally, the letter emphasises cost-effective approaches in non-ETS sectors like households but fails to mention the car sector where the German car producers recently watered down the imposition of a considerably tighter regulatory emission standard.

When it comes to renewables and energy efficiency, EU business advocates the latter (indeed, everybody is in favour but it should not be assumed that ambitious targets are merely win – win, since energy efficiency improvements above roughly 1.5% annually are likely to be costly). One can agree with BusinessEurope that a 20% target for renewables is hard to accomplish and going to be very costly. The recommendation to move to market-based approaches here and to subject specific EU renewables legislation to ('in depth') impact assessment is sensible as it will clarify the true costs of high-handed objectives pushed by groups in the European Parliament. Nonetheless, the letter adds an encouragement to allow state aids for renewables projects in future.

Conclusion

European business is getting increasingly concerned about EU leadership in climate strategies. Though couched in politically correct terms, the gap between ambition and implementation for delivery seems to widen appreciably. The shortage of ‘followers’ adds to the nervousness about cost competitiveness and pass-through, which, in turn, may eventually undermine the credibility of EU strategies internally.

It is still early days for the post-Kyoto regime, but reading these 'signs on the wall' and addressing them convincingly is vital for EU leadership in Bali and beyond. Even if the US gets a cap & trade bill through Congress in 2009 – as leading observers expect – it would be amazing if the upshot would be a return to its 1990 levels of CO2 emissions in 2020. EU leadership will thus remain critical for many years to come.

Footnotes

1 The simulations are reported in the Commission Impact Assessment published as a Commission Staff Working Document SEC (2006) 1684 of 20 Dec. 2006. They are based on exercises with three different models: AERO, PRIMES and TREMOVE due to their respective advantages (e.g. energy vs. CO2 emissions).

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Topics:  Environment

Tags:  competitiveness, EU climate strategy, emissions trading, pass-through

Jan Tinbergen Chair of European Economic Integration and Director, Economic Studies Department, College of Europe

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CEPR Policy Research