The Carbon Trust try to make a unilateral carbon price work

Last Tuesday, I went along to a Carbon Trust event at the Institution of Civil Engineers where they launched a new report about how to avoid carbon leakage due to the EU Emissions Trading Scheme (ETS).  That report has now been released.

Carbon leakage occurs when a country puts a price on greenhouse gas emissions - through taxation or regulation - and, when other countries don't do the same, businesses either move abroad to lower their costs or lose ground to foreign competitors.  It is a very serious problem because it means that putting in places taxes or regulations that increase the cost of energy costs the country implementing them jobs and achieves nothing in terms of cuts in emissions.  The DECC impact assessment of the Climate Change Act 2008 accepts that: "The economic case for the UK continuing to act alone where global action cannot be achieved would be weak."  Carbon leakage is one important reason why that case is so weak.  Given that the expensive farce at Copenhagen doesn't exactly suggest global action is imminent, that is a problem for people like the Carbon Trust who support the current policy agenda.

The Carbon Trust massively underestimate the scale of the problem for a number of reasons.  They only look at sectors deemed to be "at significant risk of carbon leakage":

Specifically, the EU Emissions Trading Directive states that ‘a sector or sub-sector is deemed to be exposed to a significant risk of carbon leakage’ if:

    • The sum of direct and indirect additional ‘costs induced by the implementation of this directive’ is at least 5% of the Gross Value Added and the Non-EU Trade intensity is above 10%; or

    • The sum of direct and indirect additional costs is at least 30% of Gross Value Added; or

    • The non-EU trade intensity is above 30%.

The cost of climate change policies will affect plenty of industries which don't meet that threshold; where the new costs aren't - as Lord Adair Turner put it at the event - the "defining determinant" of where to locate.  It will affect decisions at the margin.  I.e. even small increases in costs will swing some important decisions - over where to invest and who to buy from - and lead to carbon leakage.  The more energy costs are pushed up, the more carbon will leak.  That effect needs to be estimated across the economy, you can't just ask which industries and firms will find it completely impossible to compete.

They also don't take account of the fact that the Emissions Trading Scheme isn't the only climate change policy pushing up energy costs.  Jeremy Nicholson, from the Energy Intensive Users Group, pointed out that renewable energy targets are also increasing energy prices, and when they are combined with the ETS the burden is even greater on many manufacturers.

The Carbon Trust argue that we should adjust for the burden on manufacturers in different ways, in different sectors.  This glorious graphic contains their plan for three sectors: cement, steel and aluminium:

That flowchart sets out - based on the characteristics of the industry - whether the Carbon Trust thinks the best way to help the industry is to give them free allocations of permits to emit under the ETS or to put a tariff on imports to protect them against foreign competitors.  The Carbon Trust prefers the latter - as it messes up the principle of the ETS less - but thinks it is sometimes not possible as you can't come up with a simple, appropriate carbon price to adjust by at the border.

I'll leave aside the question of which approach is better.  I think they seriously underestimate the problems that a "border adjustment" would face at the World Trade Organization and the harm it could do to free trade.  But there are big problems with either approach, they both make firms and industries far more dependent on government support. That is problematic for two key reasons:

First, the fortunes of different companies would be determined more by the amount of political support they enjoy and less by their ability to efficiently produce goods that people want to buy.   That will mean a huge amount is wasted on lobbyists and lawyers as companies fight for protection against competitors outside the ETS.  And it will mean good people and capital are diverted away from those who are best at making things and towards those with the most political muscle.

Second, firms won't be able to rely on that political support over the long term.  At the Pre-Budget Report, the Government increased the rate of the Climate Change Levy on energy-intensive industries by 75%.  Businesses will be wary of building a new factory for example, if it only makes sense on the basis of a free allocation of emissions permits or a border adjustment that could be scrapped next year.  So investment and jobs will still move to other countries that don't have these expensive climate change policies in the first place.

I put that point to Michael Grubb - the former Chief Economist at the Carbon Trust who wrote the report - and he didn't really have an answer.  He just thought that was a necessary price to pay for putting a price on emissions.  But - even leaving aside the issue of carbon leakage - Britain's success or failure in cutting our 2 per cent of world emissions isn't going to make a lot of difference to future global warming.  The current approach of trying to tax and regulate people across the entire world out of using fossil fuels was never the way forward.  The failure of the negotiations at Copenhagen put the final nail in the coffin of that agenda and British politicians and organisations like the Carbon Trust are just having trouble adjusting.  They need to start thinking about alternatives.  We suggested some important reforms in the report Ending the Green Rip-Off: Reforming climate change policy to reduce the burden on families, at the end of last year.

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