Carbon Market Forum Carbon Leakage Options Paper CEPS – Carbon Market Forum meeting, Rome, 18 June 2014 Eni Congress Center - Piazzale Mattei, 1 Vianney Schyns Advisor Climate and Energy Policies Utility Support Group, utility provider for esp. chemicals’ site Chemelot (a.o. SABIC, OCI Nitrogen, DSM, Lanxess, INEOS, Borealis)

1. Major problems in the EU Energy & Climate field 1. Natural gas and feedstock Natural gas prices in Europe are amongst the highest in the world (next to Japan) Unconventional gas causes also a huge feedstock disadvantage for Europe versus esp. USA; potentially also big reserves in e.g. China 2. Electricity Electricity prices in Europe are amongst the highest in the world (next to Japan) 3. EU climate package is not (yet) geared to competitiveness Inefficient overlap EU ETS with EED (Energy Efficiency Directive)  SHOULD BE ENDED High RES costs (subsidies) for generation, upcoming issue is “capacity mechanisms” with also high cost. Energy Intensive Industry (EII) is not shielded from RES costs in all MSs (NL: yes, so far; Germany: to a large part). Increasing pressure that EII must pay also (a part)  NO RES COST FOR EII, LEGAL CERTAINTY Present EU ETS is likely to cause significant investment & production carbon leakage even in the absence of price gaps for natural gas, feedstocks and electricity Good global competitiveness = good resistance to energy and carbon leakage See e.g. the recent Manifesto of Energy Intensive Industries 2

2. Need for Structural Reform EU ETS /16 EU ETS structural reform, without drastic overhaul: massive carbon leakage  Incumbents: Top 10% benchmark is ambitious and CSCF soon becomes unbearable  New entrants (new plants for growth or replacement of old inefficient plants): relevant evaluation period is 2020 to 2035/40 (new build by  2020): Major barriers and risks for growth (see Cefic-IFIEC (2012), A reality check of the EU Emissions Trading Scheme; Does it allow growth – the major objective of the EU industry policy?, Vianney Schyns (Utility Support Group), Lieven Stalmans (Borealis) and Els Brouwers (Essenscia), 18 June 2012, see website publications) And if nevertheless the allocation would succeed, top 10% benchmark x LRF is killing for new investments: e.g. BM cracker (2013: ton CO 2 /ton HVC) is ton CO 2 /ton HVC in 2030, goes further down year by year with 2.20% points 3

3. Qualification leakage & two mains options in CMF Options Paper Qualification carbon leakage risk: less enthusiastic about “gliding scale” In practical terms, the EU ETS contains the most carbon intensive sectors. –Who should we leave out? This would have limited volume impact. In most sectors the markets are continuously further globalising –Next to steel, chemicals, fibres, etc. also e.g. natural floor stones, ceramics –Transport costs over the globe are relatively cheap Carbon price level is important policy decision: up to which carbon price shall the system work well – like € 75 or 100/ton – must be forward looking! Getting off and on the CLL makes no sense, this only creates investment uncertainty The CMF Options Paper comes to two basic options to avoid carbon leakage 1.Border Adjustments, or 2.Dynamic free allocation, based on realistic benchmarks and actual production 4

3. Option Border Measures in CMF Options Paper WTO issues – import obligations – border adjustment measures With fixed import obligation for allowances (like sometimes suggested on BAT level) –Undue advantage for importers with higher CO 2 intensity (can be big difference) –Obligation probably required that importers can demonstrate that they have lower emissions than a fixed ex-ante BAT level –Import to e.g. EU can become opposite of a “pollution heaven”, a “green haven”, which may be low volumes globally but high volumes on the EU market What about export from EU? –Full exemption creates emissions outside the EU ETS? Or need for special reserve? –A benchmark-based free allocation for exports (which then must be based on provisional export ex-post adjusted to actual export) Border adjustment measures remain very cumbersome, would create huge administrative efforts and costs and would certain be politically sensitive for countervailing measures –There is little appetite for border adjustment measures Anyway: –Border adjustment measures can never be based on historical frozen activity levels 5

3. Option free allocation in CMF Options Paper Free allocation as solution to avoid carbon leakage – three basic parameters well covered 1.Method of allocation: ex-ante frozen or dynamic? –Ex-ante frozen is inbuilt incentive for leakage –Production leakage in EU ETS: incentivised until 51% of historical production –Barriers and risks for growth leads to investment carbon leakage, growth disabler –Frozen allocations enhance frozen market shares (distortions winning/losing market share) –Dynamic allocation solves these problems 2.Level of the benchmarks: geared to avoid leakage or too strict? –Benchmark level of zero = full auctioning; benchmarks must be realistic 3.The carbon price: until which level is carbon leakage avoided (policy decision needed). Dynamic allocation remarks: Present system of partially ceased operations is a partial ex-post already, change to full ex-post is therefore really easy Not any ETS copied a historical frozen allocation like EU ETS. Next to the ETS of New Zealand also the ones of California and Australia are in some way “ex-post” (“true-up”) Total EU cap can become too stringent, in case of continued absence of a global ETS 6

4. Objectives Reform and key points in present debate (1) Sound objectives for the new free allocation , the method of allocation should be 1.Simpler 2.Predictable for companies 3.Effective (clear incentive to reduce emissions and effective against carbon leakage) The search for solutions must be facts-based (very good). Key discussion points: Ex-post actual production allocation is acknowledged as being in debate, but about simplicity … –Partially ceased production rules (50%, 75%, etc.) are perceived by the Commission as simple while total ex-post recalculation is perceived as complicated –But perverse incentive to keep plants at least at 51% production level, as also mentioned by CAN Europe, is so far ignored –It remains totally unclear why ex-post calculation to actual production is perceived as complicated (while this is in the ETSs elsewhere) –“20% capacity increase/reduction = 20% higher/lower allocation” sounds like simple, in reality the outcome is a gamble, can be anything different –Our judgment: Ex-post would be a huge simplification, a needed one! 7

4. Key points in the present debate (2) Ex-post actual production allocation suffers from a lower (product) carbon price signal, to get the opportunity costs in product prices the allocation should remain ex-ante –Agreement: With a global auctioning system, the full carbon costs (direct & indirect emissions) become reflected in product prices, thus enhancing lower demand by price elasticity of demand and enhancing inter-product competition –However: The ex-ante allocation objective of the product carbon price signal cannot be combined with the objective to avoid carbon leakage, both are mutually exclusive However also: –First: Also the Commission acknowledges that sub-sectors at risk for carbon leakage cannot pass on the full carbon costs in product prices »So what about enhancing lower demand by price elasticity of demand and enhancing inter-product competition? –Second: Price elasticity of demand is exaggerated, example: »Cement 0.5 means 5% lower demand at 10% price increase; thus 50% lower demand at 100% price increase. This is not credible (whole theories are build on the price elasticity of demand and inter-product competition). –Third: Fact is that the CO 2 break-even prices for carbon leakage are quite low for ex-ante and quite high for ex-post allocation – a world of difference 8

5. Four flaws of ex-ante allocation and allocation solution 1.Possibilities of windfall profits –By over-allocation (e.g. Sandbag), and if charging opportunity-costs –Although, environmental economists (and Commission Impact Assessment 2008): opportunity-costs should be charged, for product carbon price signal (windfalls!) 2.Over-allocation during recession or crisis 3.The clear (perverse) incentive for production carbon leakage 4.Under-allocation for growth: huge risks and barriers for investment carbon leakage, often insufficiently noticed Dynamic allocation (as also proposed by the Netherlands Energy Agreement, worked out in an Ecofys report, basics: realistic benchmarks incl. for indirect emissions, actual production and an Allocation Supply Reserve) –Solving the four flaws: allocation = benchmark x actual production –To avoid over-allocation and price collapse during recession or crisis and under- allocation for growth, an “Allocation Supply Reserve” (ASR) is needed: reference e.g. median or median At lower production the lower allocation flows in the ASR and vice versa (proposed by AEII in 2007 and often again) –ASR builds up during recession/crisis, will last longer –ASR can co-exist with MSR (is an MSR accelerator) 9

6. Indirect (electricity) emissions Indirect (electricity) emissions Well covered in the CMF report –EU ETS financial compensation has turned out as a policy failure: only applied in some (but important) MSs, it is inherently unstable – cannot be a basis for investment decisions –Based on historical frozen production (consumption) levels, while virtually all MSs strongly advised actual levels »Austria, Belgium, Denmark, Finland, Germany, Italy, Latvia, Poland, Slovakia, Spain and UK »Many MSs did not advise but we know they favour actual production, e.g. France, Czech Republic, Luxembourg and Estonia and also Netherlands –Incomplete (sectors) and undue correction factors, e.g. for products without product benchmark the compensation is 75% x 80% = 60% in 2020 –While the direct allocation = 100% (apart from LRF and CSCF), indirect emissions are treated inferior to direct emissions Indirect allocation (properly done) is inevitably needed –Like in Australia, South Korea and (in another way) in California 10

7. A closer look at carbon leakage (1) Carbon leakage break-even points, of three kinds of carbon leakage Hard cash cost production carbon leakage: selling allowances delivers more revenue than selling product (worst form – happens at highest break-even prices) – regardless of transport cost –Takes place at the actual CO 2 price Arbitrage production carbon leakage: same company arbitrages between ETS and non-ETS region, selling allowances (avoiding costs) give revenues to cover transport costs to Europe –Takes place at the actual CO 2 price –Note ex-ante allocation break-even prices do not depend on the allocation level, but on the carbon intensity of the individual plant –The ex-ante allocation break-even prices are equal to those of auctioning; but then any producer can produce cheaper outside the ETS region (while still paying the transport cost) Investment carbon leakage: company has a high risk of severe under-allocation, potentially even zero (risk assessment) because “New Entrants’ Reserve” could be depleted –Takes place at the expected CO 2 price in the long term (e.g to 2030/2035) Important boundary condition: ETS must remain effective (through benchmark-based allocation), thus same benchmarks for new entrants and incumbents 11

7. A closer look at carbon leakage (2) Carbon leakage break-even points Hard cash cost carbon leakage break-even prices are surprisingly low and esp. a problem for weighted average efficiency (WAE) and quartile 3 and quartile 4 plants –Cracker value chain: WAE to Q4 at “healthy” margins, about € 75 to € 50/ton CO 2, which can easily drop to € 50 to € 30 level (and below during crisis) –Ammonia is considerably worse: at “reasonable healthy” margins around € 40/ton CO 2 for WAE to € 15/ton CO 2 for Q4 plants. Arbitrage ex-ante and thus auctioning carbon leakage break-even prices are very low –Cracker value chain: WAE to Q4 about € 20 to € 15/ton CO 2 –Ammonia: WAE to Q4 about € 15 to € 10/ton CO 2 Arbitrage ex-post and top 10% benchmark break-even prices become much higher, the resistance to leakage depends very much on level of benchmark –Cracker value chain without CSCF: WAE to Q4 about € 110 to € 65/ton CO 2 –Cracker value chain with CSCF 0.82: WAE to Q4 about € 55 to € 40/ton CO 2 –Ammonia top 10% without CSCF: WAE to Q4 about € 80 to € 35/ton CO 2 –Ammonia with CSCF 0.82: WAE to Q4 about € 45 to € 25/ton CO 2 –Lesson: Top 10% without any CSCF is already quite ambitious 12

8. Conclusions (1) Carbon leakage break-even points conclusion (1) Ex-ante frozen historical allocation provides for a bad resistance to carbon leakage Break-even prices cracker value chains and ammonia will be roughly similar for sectors like cement and respectively steel The shown arbitrage ex-post and thus auctioning carbon leakage break-even prices are shown with CSCF 0.82 in 2020; that is tomorrow. But CSCF becomes soon unbearable: 13

8. Conclusions (2) Carbon leakage break-even points conclusion (2) Sector roadmaps like from Cefic, Eurofer suggest an already accelerated abatement speed of roughly 0.8% per year (accelerated because of higher oil price and higher carbon prices) Commission Energy Roadmap diversified supply scenario € 52/ton in 2030, € 95/ton in 2040 and € 265/ton in 2050 – remember 2020 to 2035/40 and beyond is evaluation horizon for new plants after the crisis For CCS, this cannot be applied yet in the foreseeable future (high costs, public acceptance), an emerging global carbon market seems a prerequisite Therefore a balance is needed between e.g.: –Weighted Average Efficiency (WAE) benchmarks with Industry Linear Reduction factor (ILRF) related to realistic abatement speed, e.g. 0.8% per year –Ultimate stringency would be top 10% without any ILRF (until global approach with equal burdens globally) »Provided that there is reasonable certainty that the carbon price is “controlled” to levels like € 50-60/ton until 2030 »Provided that there are special solutions with a higher allocation for products like ammonia and probably also steel 14

9. Appendix: Structural Reform EU ETS /16 (1) EU ETS structural reform: Objective: good global competitiveness = good resistance to carbon leakage Comprehensive solution package: (1) Revisit the total cap and industry allocation in function of more or less global participation by e.g and beyond (2) Actual production allocation (“ex-post”) instead of “ex-ante” allocation, this avoids not only over-allocation during recession and crisis but avoids also under- allocation for growth by removing the present barriers and risks for growth and it mitigates the incentive for carbon leakage (to zero for an efficient plant) (3) Complete unrestricted indirect (electricity use) allocation, to replace the restricted and uncertain financial compensation (restricted: correction factors + for certain selected sectors only) (4) The too stringent “top 10%” benchmark not for now but replaced by a Weighted Average Efficiency Benchmark (WAE BM) (5) Abandon CSF (cross-sectoral correction factor) for incumbents and LRF for new entrants, replace both by a more realistic “ILRF” (Industry LRF) of e.g. 0.8%/year  Allocation is then: WAE BM x ILRF x actual production 15

4. Appendix: Structural Reform EU ETS /16 (2) EU ETS structural reform: (6) A “Allocation Supply Reserve” (ASR) is used to balance the market: lower production x BM than historical (median or ) to ASR, higher production x BM than historical taken from the ASR. –Guarantee to refill ASR from auction volume, if depleted –No auctioning of left-overs end of trading period (7) Certainty about carbon leakage status, e.g. by including electricity and gas prices (ref. shale gas) and more robust criteria such as carbon cost (real and shadow) outside Europe into the Carbon Leakage List assessment  will be preparation years, Council decision on headlines in October 2014 and detailed legislative proposal by Commission possibly in in 2016 (earliest 2015) should not only focus on the macro adjustment (MSR), but should contain a robust comprehensive anti-leakage package  MSR fundamental flaw: it reacts to abatement (unlike ASR) –Australian ETS is a leading example: Benchmark based on Weighted Average Efficiency, indirect allocation of 1.0 ton CO 2 /MWh (!) to “exposed” sectors, ex-post allocation (“true-up” to actual production) 16