Professor Michael Grubb Chair, Climate Strategies

1. New thinking for hard times: sustaining carbon pricing and financing in a world of unequal participation Professor Michael Grubb Chair, Climate Strategies Senior Research Associate, Faculty of Economics, Cambridge University & Editor-in-Chief, Climate Policy Journal Presentation to World Trade Organisation / ICTSD event Cancun December 2010

2. Hard times • US non-participation, Japan clearly unwilling to proceed without US • Shifting trade patterns reduce role of EU emissions globally • Recession and accumulated debt • Global uncertainty about future of regime, UNFCCC deadlocked • How effective is EU domestic action to 2020? • How can EU proceed when it finds itself almost alone in attempting to price carbon? • Trade-related sources of climate finance?

3. Hard times • US non-participation, Japan clearly unwilling to proceed without US • Shifting trade patterns reduce role of EU emissions globally • Recession and accumulated debt • Global uncertainty about future of regime, UNFCCC deadlocked • How effective is EU domestic action to 2020? • Global carbon flows: results of recent Carbon Trust study into carbon embodied in international trade • Carbon leakage as a result of EU ETS • How can EU proceed when it finds itself almost alone in attempting to price carbon? • Are there potential new sources of climate finance?

4. 5 2004 Data The impact of a consumption based view on emissions by country compared to production 120% Hong Kong Non-Annex 11 EU Other Annex 11 80% Sweden 60% France Spain 40% Percentage change in territorial emissions to reflect impact of consumption of CO2 UK Germany Italy Japan 20% USA 0% India Brazil -20% Canada Russia China Poland Czech Republic Ukraine Rest of West Asia South Africa -40% 2004 territorial CO2 emissions (27Gt) -60% 1. Annex 1 to UNFCCC Note 1: Includes CO2 emissions from production, process, transport and household sources only (27Gt in 2004); excludes non-CO2 emissions, and emissions due to land-use-change Note 2: Based on an MRIO (multi region input/output) model allocating emissions to regions of consumption Source: Carbon Trust Analysis; CICERO / SEI / CMU GTAP7 MRIO Model (2004)

5. % 2004 Data Domestic emissions have been reduced but UK carbon footprint still risen UK CO2 emissions from a consumption perspective Production emissions1 Consumption emissions 632MtCO2 845MtCO2 Householdenergy: 32% Otherconsumption: 68% International aviation & shipping Importedemissions 7% 4% Other Industry (Heat and Industrial Processes) 18% 54% Residential & Commercial Heat 17% Domesticemissions Domestic Transport 22% 46% Electricity Generation 31% Household - direct emissions2 Householdelectricity Fuel3 Public sector4 Retail & Hospitality5 Electronic equipment HouseholdTransport (fuel) Business Services6 Transport (non-fuel)9 Machinery & Equipment8 Clothing Food & Beverages Chemical based products7 Construction Note 1: CO2 only – excluding non CO2 emissions and land use change 1. Based on split of emissions from Committee on Climate Change (CCC) 2. All direct combustion of fuel in households for heating, cooking, etc 3. Includes all non-domestic Air, Rail, Sea & Road transport operation 4. Includes Defence, Health & Public Administration 5. Includes Retail, Hotels, Restaurants 6. Includes Financial Services, Communication Services and other business services 7. Includes household chemicals, cosmetics, pharmaceuticals 8. Includes domestic appliances and industrial machinery 9. Includes automotive, aviation, rail, road and marine Source: CT Analysis; CICERO / SEI / CMU GTAP7 MRIO Model (2004); CCC

6. w (excluding electricity) Projected production & consumption of EU ETS traded sectors Evolution of EU ETS Production & Consumption Drivers of change between 2005 and 2020 emissions GtCO2 GtCO2 ~2% of emissions 'leak‘ 1.6 1.6 1.4 1.4 0.2 1.4 1.4 1.4 1.4 1.4 1.4 0.2 0.04 1.2 1.2 0.5 0.5 0.6 0.7 Leakage in-flow 0.7 Imports 0.7 Imports (ETS) 1.0 1.0 0.8 0.8 0.6 0.6 0.7 0.7 0.7 Production (ETS ex electricity, net of exports) 0.6 Production (net of exports) 0.5 0.5 0.4 0.4 0.2 0.2 Production (ETS, exported) Production (exported) 0.2 0.2 0.2 0.2 0.2 0.2 0.0 0.0 2005 2010 2015 2020 2005 Abatement Leakage Flows 2020 Note 1: Declining production emissions based on expected contribution from non-electricity sectors to declining ETS cap (CASE II Model) Note 2: Growth in imported emissions based on continuation of historic growth in gross imports, and varying degrees of decarbonisation in the exporting countries. In the displayed scenario, it is assumed that the emissions intensity of exports from Brazil, Russia, India and China (BRIC nations) decline in line with 50% of the targets noted in the Copenhagen Accord (2009), that exports from the EU and other Annex I nations decline in line with the EU’s target to reduce emissions by 20% from 1990-2020, and that exports from the rest of the world achieve decarbonisation of the order of half that achieved in the BRIC countries. Source: Carbon Trust Analysis based on data from: Addressing leakage in the EU ETS: Results from the Case II Model (Climate Strategies, 2009); CICERO / CMU / SEI GTAP 7 MRIO/ EEBT Model (2004); Cutting Carbon in Europe: The 2020 plan and the future of the EU ETS, Carbon Trust (CTC734, 2008)

7. Myth 1: “EU faces large scale carbon leakage from the EU ETS” • But: • without countermeasures may be significant for key sectors (eg. 40% of steel “emission savings” are due to offshoring) • leakage rises with the degree of effort (eg. EU move to 30%) • effects may vary a lot between different regions, facilities • “all politics is local” • growing international carbon flows undermine impact of domestic measures anyway Source: Carbon Trust / Climate Strategies Myth 2. “… So if aggregate leakage is modest it is not a big problem” Carbon flows lesson impact, and economic loss with no environmental benefit is never politically acceptable

8. Hard times • US non-participation, Japan clearly unwilling to proceed without US • Shifting trade patterns reduce role of EU emissions globally • Recession and accumulated debt • Global uncertainty about future of regime, UNFCCC deadlocked • How effective is EU domestic action to 2020? • How can EU proceed when it finds itself almost alone in attempting to price carbon? • Basic options • Impact of free allocation • Paying for consumption – border levelling • Trade-related sources of climate finance?

9. ‘Leveling down the costs’ with free allocation Myth 3. “Free allocation is an effective solution” • To be effective in tackling carbon leakage, such ‘leveling down’ must be aligned with production and investment decisions • Fixed allocation under the EU ETS may not deter operational leakage • Effectiveness declines under declining caps or finite duration • Protecting energy intensive sectors inevitably requires the rest of the economy to ‘work harder’ to reach a given emissions target • Degrades the underlying incentives to decarbonise • The need to align may negate more of the incentives to decarbonise along supply chain – particularly with ‘output-based’ allocation (US and EC models greatly underestimate this potential impact) • Also can be seen as a trade distortion – eg. through over-allocation, output-based and (eg. agricultural) offsets • And yet, this is the solution dominant in EU, Australia (& former US proposals) Myth 4. “Free allocation is free” Source: Climate Strategies (2009): Droege S. et al., Tackling Carbon Leakage in a world of unequal carbon prices, final report

10. Fundamental options for addressing carbon leakage Adjust costs downwards Conditional allocation Adjust global costs upwards Global carbon pricing Adjust costs at border Border Adjustments Price with carbon cost Imports into ETS Exports from ETS Price without carbon cost ETS ETS ETS Rest of World Rest of World Rest of World - Level down, adjust at border, or wait to level up everywhere?

11. CARBON LEAKAGE – MYTHS AND REALITIES We have two profoundly different Border Adjustment discussions Trying to deter ‘inadequate’ action by other countries is very different from focused objective to tackle carbon leakage • Threatening trade measures against countries not taking ‘comparable’ action • Extra-territorial judgement on ‘adequate’ action • Explicitly discriminatory • Tackling carbon leakage through border levelling • In principle, cost-levelling between domestic and international where a specific problem can be demonstrated • Generally non-discriminatory

12. CARBON LEAKAGE – MYTHS AND REALITIES Myth 5. “The best general solution is to protect our economies and pressurise other countries using border adjustments” • The feasibility, effectiveness and economic and political consequences of border adjustments varies according to sector characteristics • Diverse production processes and products increase potential for distortions and abuse • May be more controversial for exports than (benchmarked) imports • Any border measures need justification on sector-specifics not generalities Myth 6. “All Border adjustments are discriminatory, threaten trade & political relations” • We already do it … (eg. excise taxes on petroleum, and VAT) • Benchmarked ‘Best Available Technology’ border levelling is compliant with GATT Articles I and III - no need to negotiate exemptions • Border leveling is particularly relevant to sectors that are: • Energy intensive and operate in international markets • Relatively homogenous products - operates on price competition • Relatively homogenous production processes – benchmarks are useful • High operating carbon cost impacts (plants might otherwise part load)

13. Charging embodied carbon on sector-by-sector basis as appropriate Characteristics of border leveling Global emissions from different industrial processes Key criteria • Scale of emissions • Scale of leakage concern: • Relative impact of carbon costs • Scale of existing trade barriers • Availability of alternatives • Effectiveness and losses associated with free allocation • State of international sectoral agreement • Feasibility of border leveling • Diversity of products • Diversity of production processes • Cement is the most obvious sector initially

14. Hard times • US non-participation, Japan clearly unwilling to proceed without US • Shifting trade patterns reduce role of EU emissions globally • Recession and accumulated debt • Global uncertainty about future of regime, UNFCCC deadlocked • How effective is EU domestic action to 2020? • How can EU proceed when it finds itself almost alone in attempting to price carbon? • Trade-related sources of climate finance?

15. International finance - challenge • Most sources of international public finance have to pass through the sieve of domestic politics in developed countries • The hand of the Treasuries, subject to high-level political commitments • But under pressure from national debt • The court of public opinion • Under pressure from recession and fear of the emerging economies as economic competitors • New sources of finance .. Source: Climate Strategies (2009): Droege S. et al., Tackling Carbon Leakage in a world of unequal carbon prices, final report

16. Table 1. Indicative carbon revenues from cement and steel - Revenues from Production and border levelling on imports trade Source: M. Grubb ‘International climate finance: the case for international use of border levelling charges’, forthcoming in Finance Special Issue of the Climate Policy, Ed. Erik Haites, March 2011

17. New thinking for hard times: sustaining carbon pricing and financing in a world of unequal participation Professor Michael Grubb Chair, Climate Strategies Senior Research Associate, Faculty of Economics, Cambridge University & Editor-in-Chief, Climate Policy Journal Presentation to seminar at Centre for Policy Research, Delhi October 2010

19. ANNEX Six key myths regarding the issue of carbon leakage... • Carbon leakage is a major economic and environmental problem... • ... Oh: so if aggregate numbers are small it is not a big problem • Free allocation is an effective solution • Free allocation is free • We can and should protect our economies with border adjustments • Border adjustments are discriminatory and threaten world trade and political relations

20. Why we need a mature debate about consumption accountability and border levelling • The problem is ultimately one of consumption, so it makes sense to hold consumers accountable for the emissions of their consumption choices • & Why should consumers discriminate against their own producers in favour of imports? • Leakage fears are messing up cap-and-trade schemes around the world • & as caps tighten, even free allocation is insufficient to forestall debate – border-related measures already included in the US and rising in the EU • Money: Using the European cement sector as an example, • 100% free allocation could increase sector profits by between €2.5-4bn per annum to 2010. Equivalent funds could be generated for the public sector if these allowances were auctioned. • Revenue from the border component would be several €100ms annually and use of these revenues could be subject to international negotiation. • If regions that are willing to take stronger action are expected to suffer unnecessary economic losses that are not even associated with saving any emissions, there is no way to solve climate change

21. CARBON LEAKAGE – MYTHS AND REALITIES After Copenhagen, sustaining action in a world of unequal carbon prices – and raising revenue for ‘greening growth’ at home and abroad - is of fundamental importance and so these myths need to be dispelled

22. Technically speaking, border leveling clearly more effective Free allocation cuts leakage but increases carbon price - Border levelling cuts leakage without significant efficiency loss, and greater scope Source: Carbon Trust / Climate Strategies

23. CARBON LEAKAGE – MYTHS AND REALITIES Tackling carbon leakage Available at: www.carbontrust.co.uk Available at: www.climatestrategies.org

24. A few key sectors may need sector-specific journeys towards global action

25. NEW THINKING FOR HARD TIMES Thank you for your attention! Climate Strategies contact details Climate Strategies c/o University of Cambridge, 13-14 Trumpington Street, Cambridge, CB2 1QA, UK Office: +44 (0) 1223 748812, www.climatestrategies.org Managing Director: Richard Folland Chair: Michael Grubb Non Executive Directors: Michel Colombier, Director, IDDRI, France Benito Müller, Oxford Institute of Energy Studies and Oxford Climate Policy, UK Jon Price, Director, Centre for Low Carbon Futures Hans-Jürgen Stehr, Director, Danish Commission on Climate Change Policy Thomas L. Brewer, Georgetown University, Washington DC Climate Strategies is grateful for funding from the government of Australia, Agence de l'environnement et de la maîtrise de l'énergie (ADEME) in France, Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ) in Germany, Ministry of Foreign Affairs (MFA) in Norway, Swedish Energy Agency (SEA) Sweden, Department for Environment, Food and Rural Affairs (DEFRA), the Office of Climate Change (OCC), Department of Energy and Climate Change (DECC), Department for International Development (DFID) in the UK, The Carbon Trust, Nordic COP15 Group, Corus Steel, Center for International Public Policy Studies (CIPPS) in Japan, European Climate Foundation (ECF) in The Netherlands, and the German Marshall Fund of the United States.