Professor Michael Grubb Chair, Climate Strategies

Constructing a high efficiency, low-carbon coalition: pricing and international financing dimensions Professor Michael Grubb Chair, Climate Strategies Senior Research Associate, Faculty of Economics, Cambridge University & Editor-in-Chief, Climate Policy Journal Presentation to CAGE/CCCEP workshop Developing policy regimes for combating climate change London, Tuesday 25 January 2011

Hard times • US non-participation, Japan clearly unwilling to proceed without US • Shifting economy and trade patterns reduce role of EU & Annex I emissions globally • Recession and accumulated debt impedes financing & willingness • Cancun – a political success and measure of the ‘art of the possible’, that thereby highlights the lack of substantive commitment .. • Strategic economics of the global energy system • How effective is EU domestic action to 2020? • How can regions pursue stronger action (/carbon prices) in a world of unequal participation? • Trade-related sources of climate finance? • High efficiency, low carbon coalitions • Evolution & Conclusions

Energy is an evolutionary system .. Global Energy Costs Current emissions Time Global Emissions Present Future emissions scenarios Global Energy Costs Low carbon High carbon Future Global Emissions

.. And future costs divide on the ridge of oil depletion Low Carbon Global energy costs Number of potential energy futures near ‘minimum’ cost High Carbon Annual global emissions The clustering of ‘low cost’ energy futures around higher and lower emission levels, rather than in the middle, reflects the fundamental options in the face of oil depletion We are here Time • High carbon futures • A continued dependence on fossil fuels • Unconventional and synthetic oil in transport • Low capital costs… • …but high operating costs and a host of environmental issues beyond carbon • Low carbon futures • An integrated energy system • Electricity in transport • Low-carbon electricity • High capital costs…. • ……but low operating costs

The three policy pillars of solutions Core Solutions Instruments Challenges PILLAR I PILLAR II PILLAR III

% 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 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 Food & Beverages Chemical based products7 Construction

General pattern of ‘embodied carbon’ flows to ICs 5 2004 Data Unilateral carbon pricing may exacerbate with carbon leakage 120% Hong Kong Non-Annex 11 EU Other Annex 11 80% Wedge between consumption & production of embodied carbon 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)

Modeling of three key sectors for EU ETS Phase III (EU 20% target) Carbon leakage v.sector-dependent, modest, but …. • biggest emissions impact on cement, mainly through clinker reduction and trade • - biggest leakage as % of overall emission reductions in steel (40%)- cement and aluminium have similar leakage rates (c.20%) relative to reductions • - emission gains from finding solutions that preserve incentives biggest in cement Though absolute scale of leakage is small, it is significant for some sectors and has enormous impact on design (free allocation) & ambition Source: Climate Strategies (2009): Droege et al., ‘Tackling carbon leakage in a world of unequal carbon prices’

w By 2020, ETS caps only half of EU ‘carbon footprint’ in energy-intensives, & EU total (production) emissions maybe 10% of global total? 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)

What fundamentally needs to change? • Most major international regimes have grown out of a small core of committed countries taking action • Eg. WTO, WIPO • This looks harder for climate change if viewed just as ‘burden sharing’ – hence importance of an evolutionary perspective that integrates energy economics & geopolitics • Broad tendency has been for stronger action in importer / less energy-intensive regions (eg. EU, CA, SIDs, India ..) • No way to solve CC by a pure focus on production emissions of the developed / consumer regions: • Inherently unstable (production moves, caps declining share) • Exacerbates the divide – widens gulf between producer v consumer • Key is to move towards a more consumption-based structure over time, with attention to benefit-sharing and incentives

Fundamental options for addressing carbon leakage Adjust costs downwards Conditional allocation Adjust global costs upwards Global carbon pricing Adjust costs at border Border Levelling 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, wait to level up everywhere, or adjust at border?

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 by protecting domestic carbon pricing • 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

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 • Different legal and practical issues for imports vs exports • 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) • For imports, 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)

Charging embodied carbon on sector-by-sector basis as appropriate Sectoral approach to 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 policy 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

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 • Under sever pressure from national debt • The court of public opinion • Impact of recession and fear of the emerging economies as economic competitors • Additional sources of finance will increasingly have to circumvent these constraints, ideally • Be outside the scope of existing sources of national finance, and preferably not fall naturally under any specific national jurisdiction; • Be visibly connected with climate change, and preferably contribute directly to mitigation of climate change; and • Carry mutual incentives that could facilitate all sides agreeing to use it as a funding source Source: M. Grubb (2010), ‘International climate finance: the case for international use of border levelling charges,’ forthcoming in Climate Policy 11:3

Border levelling charges – Incidence & ‘ownership’ Incidence – net economic effects • Relatively low demand sensitivity in energy intensive commodities means almost all cost increases passed to consumers • Ie. mainly paid by consumers of energy intensive products in the importing (ETS) countries Ownership • There is no clear ‘moral’ basis of ownership/responsibility for emissions between producers and consumers • Emissions from production of goods for export logically exist in an ‘international’ space, like international bunker fuels, their assignment is a matter of political decisionmaking • Either producer or consumer countries could charge border leveling: • Consuming countries – could offer the revenues to international expenditures eg. to fulfil multilateral goals and reduce potential trade-related tensions • Producer countries – would benefit from a multilateral framework to address loss of competitiveness vis-à-vis other producers * Source: M. Grubb (2010), ‘International climate finance: the case for international use of border levelling charges,’ forthcoming Climate Policy 11:3; * See B. Mueller and A.Sharma, Trade tactic could unlock climate negotiations, SciDev, 23 June 2005

Table 1. Indicative carbon revenues from cement and steel • Revenues from Production and border levelling on imports trade, US$m/yr • @$30/tCO2 Source: Grubb (2010) ‘International climate finance: the case for international use of border levelling charges’, in review for Climate Policy

Carbon added charging in north-south coalition – Reiterate: Most major international regimes have grown out of a small core of committed countries taking action; key challenges leakage & finance Within coalition • Revenues raised at the border returned, used for international expenditures or returned to producers in the coalition under agreed procedures to support low carbon development plans • Agreement on evolution from fixed border benchmarks to verified embodied carbon charging • Carbon that is charged at source deducted at the border, ie. evolution of a ‘carbon added’ structure analogous to VAT Outside coalition • No basis for returning revenues to producers • Revenues raised at the border put into to international climate expenditures

Climate policy in a world of unequal participation Requires structuring solutions to support the three pillars of domestic policy • Investment for innovation and infrastructure • International finance for low carbon infrastructure and avoiding carbon lock-in • Networks of innovation centres to facilitate learning, cost-sharing, and supportive IP regimes • Carbon and efficiency pricing • Negotiated systems of border levelling for trade in primary commodities, with recycling of associated revenues • Development of ‘carbon added’ pricing strucutres within and between countries • Consumer, business and voter engagement • Standardisation of product efficiency and carbon footprint labelling • Sectoral agreements, consumer norms .. • Welded together by long-term agreement to form public price expectation

This needs to be seen as an evolutionary journey - With border leveling as a key part of journey towards broadening action

Bottom line: 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 • free allocation is a poor solution and even this is insufficient to forestall debate as caps tighten (or precludes tightening of action) • 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, this will only happen if there is border leveling • Revenue from the border component would be several €100ms annually and use of these revenues could be subject to international negotiation • Steel bigger, especially the international component • 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

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 • Strategic economics of the global energy system • How effective is EU domestic action to 2020? • How can regions pursue stronger action (/carbon prices) in a world of unequal participation? • Trade-related sources of climate finance? • High efficiency, low carbon coalitions • Technical annex material • Mostly from CS & Carbon Trust report “Tackling Carbon Leakage”

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, ‘carbon leakage myths’ need to be dispelled

Common fact, though national differences in structure, eg. Compared to UK:Germany has higher % Value Added in the most cost-impacted sectors, US refining sector exceptionally large CO2 emissions heavily concentrated in a few primary activities Source: Grubb, Brewer, Houser & Sato, ‘Climate policy and industrial competitiveness: ten lessons from the EU ETS’, German Marshall Fund – US, Washington DC, 2009 28

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

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

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

Own academic papers: http://www.econ.cam.ac.uk/faculty/grubb/index.html Forthcoming : Grubb with Hourcade and Neuhoff, The carbon connection (Earthscan, 2011) PUBLICATIONS ** Key papers published as Special Issue of the Climate Policy journal, www.climatepolicy.com

Professor Michael Grubb Chair, Climate Strategies