How to Fill the Remaining Gaps in Pricing the Emissions of the EU’s Energy-intensive Industries

Economic

Summary:

Free carbon allowances for EU industrial companies are being phased out, but inconsistencies remain.

One consequence of a major reform of the European Union’s emissions trading system in 2023 is that energy-intensive industries (EIIs) will ultimately be exposed fully to carbon pricing. In theory EIIs are subject to carbon pricing already but in practice they have received free allowances to shield them from the carbon price and protect them against foreign competition that is not subject to carbon pricing (and to prevent so-called ‘carbon leakage’ ). Free allowances allocated to many industrial sites consistently exceeded emissions during the third phase of the ETS (2013-2020), creating market distortions (De Bruyn et al, 2021).

The 2023 ETS reform thus plugs a loophole. However, some issues remain to be dealt with, including the treatment of EU exporters, the sectoral coverage of carbon pricing and the geographical misallocation of subsidies. This analysis discusses these challenges and suggests further steps that might be taken to ensure fair competition among EIIs within the EU and globally.

Industrial emissions and free allowances

We focus on three energy-intensive sectors – chemicals, basic metals and non-metallic minerals (ceramics, glass and cement) – that emit around 70 percent of industrial emissions covered by the ETS, while accounting for about 13 percent of EU manufacturing GDP (Figure 1; Sgaravatti et al, 2023) .

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Between 2013 and 2023, all ETS emissions fell by 36 percent, led by a 44 percent reduction in the power sector, while industrial emissions declined by just 17 percent. The slower progress in cutting industrial emissions can be attributed partly to free carbon allowances given to EIIs – a benefit the power sector does not receive (Figure 2).

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Because EIIs have received generous allocations of free allowances, a huge surplus has built up. Some excess allowances were sold, effectively acting as an industrial subsidy. For example, from 2008-2019, the cement sector gained up to €3 billion in extra profits because of over-allocation (de Bruyn et al, 2021). Moreover, as companies started to price-in the ETS price, they benefitted from windfall profits off the back of the free allowances.

Being shielded from the ETS carbon price meant EIIs had less of an incentive to decarbonise production, limiting their green investments in the past decade (2011-2020) to €7 billion per year on average (European Commission, 2024). From 2031-2040, decarbonising industrial production will require investment estimated at €46 billion per year (European Commission, 2024). More than 60 percent of this investment will be concentrated in chemicals, basic metals and non-metallic minerals (Table 1).

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Financing such investment could prove difficult if the current squeeze on EII profit margins, caused by high energy prices in Europe (Bijnens et al, 2024), continues.

Three remaining carbon pricing loopholes

Export competitiveness

The 2023 ETS reform reduces free allowances for some of the main products in the categories of basic metals (steel and aluminium), non-metallic minerals (cement) and chemicals (fertilisers and hydrogen). From 90 percent of their emissions in 2028, coverage by free allowances will fall to zero by 2034. Separately, from 2026, the EU carbon border adjustment mechanism (CBAM) will levy a carbon charge on imports of these products, to prevent carbon leakage.

EU exporters, however, will continue to compete on foreign markets with commodities not subject to carbon prices. EU exporters have thus called for an export carbon price rebate scheme. The annual cost of this could reach, by 2034, €4 billion for iron and steel and €7 billion overall (Table 2).

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The European Commission has ruled out export rebates, fearing they would undermine the EU’s climate goals and would risk conflicts with major trade partners. While this decision may be justified (Bellora and Fontagné, 2022), it does not address the issue of carbon leakage for EU exporters.

Sectoral coverage

Another issue is sectoral coverage and the risk of downstream carbon leakage. Since CBAM covers only certain categories of products, producers might relocate outside the EU and export into the EU products further down the value chain that are not subject to CBAM (eg machinery made of steel and aluminium). The risk varies greatly depending on the product. For example, green steel increases the final price of cars by just 2 percent (Dantuma et al, 2023), some plastics could see much higher price increases. We estimate that the price of the most common type of plastic, polyethylene, could increase by about 8 percent, for example .

Geographical misallocation of subsidies within the EU

Increased reliance on electricity to decarbonise production processes may shift investments from current EU industrial hubs to regions where electricity is cheaper because of the presence of renewable resources (such as hydro, wind and solar). Current electricity price disparities (Figure 3) favour Scandinavia and the Iberian Peninsula over central and eastern Europe, where most industrial production is located. As EIIs will be increasingly exposed to carbon pricing, governments might engage in subsidy races to retain incumbents, distorting the single market and nullifying the potential benefits of industrial reallocation – ie cheaper products for EU consumers, and more competitive firms on the global stage.

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Most green industrial subsidies are allocated at the national level, with the EU role limited to evaluating state aid applications.

Potential policy responses

While there are no easy fixes to the three challenges detailed above, they could be greatly mitigated by: prioritising public support for exporters, promoting carbon pricing and sectorial decarbonisation agreements globally, improving consistency in state aid, and pooling subsidies at EU level. We deal with each in turn.

Support for exporters

Exporters tend to be more productive than non-exporters (Wagner, 2007), so failing to address carbon leakage for exports could further harm EU industrial competitiveness. The EU could prioritise exporters in competitive bidding and grants for green subsidies, therefore offsetting the disadvantage they face globally, while supporting productive firms.

This could be done either through competitive bidding opened only to exporters, or by introducing qualifying premia for exporters in open auctions. Decarbonisation subsidies could target both capital costs and operating costs. The approach followed by the EU Hydrogen Bank , which subsidises only the additional costs required to make green hydrogen competitive (Kneebone and McWilliams, 2024), could be copied and adapted to specifically support EII exporters. However, operating cost subsidies should come with strict conditions and be time-limited, as they can disrupt the ETS, which is designed to ensure emissions reductions occur where costs are lowest. If not carefully managed, such subsidies could also place a heavy burden on public finances.

Additionally, lessons from the successful streamlining of permitting processes for renewable energy projects in designated areas could be applied to accelerate electrification in EII clusters focused on exports. Simplifying grid connection and permitting in these clusters would reduce delays and support faster decarbonisation.

Global persuasion

Among the major destination countries for EU CBAM exports (almost 80 percent of total value, Figure 4), several have introduced or are introducing carbon markets. The United Kingdom has its own ETS, Switzerland has linked its ETS with the EU, Norway is part of the EU ETS, China is expanding its national ETS to include EIIs, and Turkey, Mexico, Brazil and India are exploring carbon pricing systems. Canada has an advanced carbon market and Serbia and Ukraine are EU candidates, which implies a path of full convergence with EU rules, ETS compliance included.

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Though far from an easy diplomatic endeavour, advancing carbon pricing across the world seems to be a much better strategy than export rebates because it promotes the most promising tool for mitigating emissions, does not raise compatibility issues with World Trade Organisation rules, and leaves the incentive to decarbonise intact, including for EU exporters. Moreover, expanding carbon pricing globally reduces the risk of downstream carbon leakage.

A similar and complementary approach would be sectoral decarbonisation agreements, such as the Global Arrangement on Sustainable Steel and Aluminium (GASSA), creating carbon clubs for some EIIs. Finalising GASSA is particularly important given the importance of the United States as a destination market for EU aluminium and iron and steel exports, and the very remote prospect of full carbon pricing in the US.

Consistency in state aid

The EU should harmonise across countries the support given to energy-intensive firms to compensate them for higher electricity costs related to carbon pricing. Such support benefits currently from streamlined approval under state aid rules. Governments can use up to 25 percent of their national ETS revenues for this form of compensation. The EU could also introduce a floor level across all countries with considerable EII clusters, limiting the distortions by which EIIs in some countries receive much more compensation than in others. Conditions that have been introduced for this type of support, including energy efficiency measures and greening of production processes, make it more appealing and could justify its use to a greater extent than so far.

EU countries should also make more use of the top-up option for EU industrial subsidies, contributing their own financial resources . While this approach falls short of maximising efficiency (as funds are still earmarked on a national basis), it would be a great improvement on national auctions, by applying uniform allocation criteria and reducing administrative work by avoiding duplication across EU countries (Poitiers et al, 2024).

Pooling subsidies

In the medium term, moving to EU single-market mechanisms for subsidies would boost productivity and increase added value. Coordinated subsidies could increase power-sector productivity in Germany, France, Italy and Spain by 30 percent, closing 83 percent of the productivity gap with the United States and increasing added value by 6.7 percent (Altomonte and Presidente, 2024).

The European Commission has proposed increasing EU budget resources by withholding 30 percent of ETS revenues (European Commission, 2023). In 2023 the ETS raised €43 billion and by 2028 it could reach €65 billion (Saint-Amans, 2024) , compared to the overall green industrial investment needs of €46 billion per year. If the Commission’s proposal is accepted, it would mean additional EU budget revenues of €10 billion to €20 billion per year that could support industrial greening.

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