Carbon Pulse Dialogues are discussions about carbon markets and climate policy by a selection of leading experts.

Europe’s heavy industries fear the European Commission’s post-2020 ETS reform proposal will bring increasing costs for them, as it cuts their free allocation of CO2 allowances by a quarter while potentially trebling the market price of any additional units they will need to buy.

(For more details on the proposals, read our key takeaways or our analysis on what they mean for industry)

We asked several experts how they expected the proposal to affect the approach that heavy industries take to participating in the EU ETS, and what kind of effect this would have on the carbon market.

Emil Dimantchev, analyst, Thomson Reuters Point Carbon – @EDimantchev

Michiel Cornelissen, advisor, USG, International Federation of Industrial Energy Consumers (IFIEC) Europe

Yann Andreassen, analyst, ICIS Tschach Solutions – @ICIS-energy

Louis Redshaw, director, Redshaw Advisors – @RedshawAdvisors

Damien Morris, head of policy, Sandbag Climate Campaign – @DamienMorris

Emil Dimantchev – 1100 GMT: The Commission’s proposal places a cap on free allocation after 2020. Our analysis suggests that in phase 4 the Commission will apply a cross sector correction factor to installations’ allocations to keep the total amount of free allowances from exceeding this cap. This means that the total amount of free allowances given out every year will decline with the overall EU ETS cap.

However, the proposal will likely not significantly encumber the industry sector as a whole. This is because the industry sector has received and is about to receive enough free allowances to cover its compliance needs until 2030, according to our projections. And though the impact will vary across sectors, the Commission’s impact assessment projects that most large sectors may even make money from the carbon market, assuming they continue to pass on some of the carbon cost to their customers. We therefore do not expect to see significant amounts of carbon leakage.

Industrial companies, which may have expected to get a better deal, now have to prepare for a time when they will run out of their surplus allowances. How industries respond to this long-term signal will depend on how forward-looking they are and how much priority they place on their energy and carbon management strategies.

Our surveys show more than half of all companies plan their carbon management between 1 and 4 years in advance, due to a combination of risk-off attitude towards carbon, shareholder return expectations and staff turnover.

We believe that the sector as a whole will slowly become more forward-looking to adequately prepare for the time when its surplus of allowances will run dry. This means that companies will likely hold onto their current reserves more dearly the closer we get towards the second half of phase 4. We expect this gradual behavior shift to be the primary driver for the European carbon price at least for the next decade. All in all, Commission’s proposal confirms our view that the European carbon price will rise gradually from now on.

Michiel Cornelissen – 1230 GMT: With the 15 July 2015 EU Commission’s proposal for ETS reform, the competitiveness of EU industry would be severely undermined. Keeping the industry in Europe, as main economic driver and jobs source, needs a significant upgrade of this ETS reform proposal. Such upgrade should also ensure a healthy investment climate to enable industrial growth.

Companies that face international competition need to be compensated for carbon cost that their non-EU competitors don’t have. These additional European costs influence production and investment decisions; with too high carbon costs, energy intensive industry cannot produce and invest in Europe.

In the current scheme, compensation occurs for those sectors that are at risk of losing competitiveness. This is done at an already strict benchmark level. Only 5% of companies can meet that benchmark. Even these best performers are not fully compensated; this compensation is reduced with a reduction factor (CSCF).

With the proposed scheme, fewer sectors would be compensated and the benchmarks would be made even stricter: -1%/y from 2008, entailing for 2021-2030 -15% to -20%. For most industries this is an unrealistic reduction rate that they cannot achieve. For many sectors the emissions are even unavoidable and the stricter benchmarks can therefore never be reached. On top of that, there would be the possibility of again the reduction factor (CSCF). This would mean that the best performers do have carbon cost and face an unlevelled international playing field.

IFIEC, also member of the AEII (Alliance of Energy Intensive Industries), has given constructive input to the EU commission to combat climate change and at the same time ensure competitiveness and encourage industrial growth in Europe. The current EU ETS reform proposal needs a significant upgrade to ensure that the energy intensive industry has a future in Europe.

Yann Andreassen – 1310 GMT: Overall, the new post-2020 EU ETS rules – through an increase of the linear reduction factor (LRF) to 2.2% together with more stringent post-2020 free allocation rules – will translate into reduced long positions alongside more and higher short positions. On the price side, in addition to the new LRF, EU ETS players will face a second bullish impact due to the MSR – we are forecasting EUA prices, subject to the final design of the post-2020 rules, of around €30 Euros and €36 in 2020 and 2030 respectively.

In that context, we see two main behaviour trends among EU industrials: (1) less selling of surplus and (2) more purchasing due to shortages. The cement sector for instance, is already experiencing a fundamental shift having been very long in the second phase but getting increasingly shorter in the third trading period. While the sector has been very active in terms of selling activities in the past years, we expect cement players to hold on to the lion share of their current surpluses to use them when they experience shortages in the later years of the third or in the fourth trading period.

Other sectors, like oil and gas, are already short in the third trading period. The fourth trading period will deepen the sector’s short positions which might have to be covered at over four times the current price. In that context, some industrial players will probably consider securing some share of their future short positions in advance to benefit from lower carbon prices. However, not all industrials will change behaviour in the same way as they have a different carbon profile as well as market access capabilities, financing capacity, and risk appetite.

Finally, in a post-2020 world with an MSR, auction volumes will at some point no longer be sufficient to accommodate annual hedging needs from utilities. In that context, industrials will have to compete aggressively for volumes with highly price insensitive utilities which can easily pass on the carbon cost to consumers. To conclude, EU industrials will no longer have the option to “just comply” and will have to move towards a more active and long-term orientated carbon trading strategy.

Louis Redshaw – 1320 GMT: Most companies, rather than view carbon as a risk to manage like other commodities they have exposure to (for example natural gas and electricity), currently view the EU ETS as an irritation. This is because the cost of compliance is more often about the time spent on the administration (monitoring, reporting, verification, registry access and allowance surrender) and the cost of external consultants and accountants. Until now the cost of buying a carbon shortfall for compliance has been relatively small or nothing at all.  This is for a variety of reasons, not limited to; a banked excess, borrowing from forward allocations, reduced emissions, leakage list inclusion, CER switching or simply because carbon prices are very low, by historical measures.

This state of affairs is set to change. Most companies will see themselves short by the end of this phase (Redshaw Advisors’ EU ETS analysis sees at least 60% of all installations short by 2020). In phase IV the accelerated fall in free allocation, reduction in leakage-list sectors and the change to benchmarking rules will see all but the fortunate few become short carbon. Coupled with the forecast rise in prices (most analysts are suggesting around €20 by 2020 and the EC themselves are suggesting €25 by 2026) the irritation is fast becoming a financial risk to compare with the cost of buying fuels. Companies can therefore be expected to start to manage carbon risk in the same way that they hedge fuels and so their participation in the carbon market will swing from passive to pro-active. The effect on the wider market will be felt through increased demand and ultimately to increased prices, in line with the analyst forecasts that are all based on this future supply / demand balance change.

The saving grace is that it could have been worse, free allocations were due to be phased out by 2027 and under the EC’s review the vast majority of companies will be, perhaps surprisingly, better off.

Damien Morris – 1901 GMT: As Member States and industry wrestle over their share of the next cap, it’s important not to lose sight of the bigger picture: Europe’s carbon market remains massively oversupplied and Europe’s targets remain out of alignment with its stated long-term climate goal. This is where the fight is. It will not advance Europe’s climate ambition to arbitrarily penalize manufacturers – but neither should they be given a free ride.

Under the Commission proposal the volume of free allowances available to industry may be reduced, but their share of the cap remains essentially undiminished. As for a trebling of the carbon price, the Commission has a history of making bullish forecasts and we remain sceptical that the proposed cap, in concert with the MSR, is yet sufficiently ambitious to deliver these prices. Moreover, trebling the carbon price would still leave it below levels seen in 2008, and below the price currently used to determine whether companies receive carbon leakage protections.

If allowances are awarded more selectively and the persistent problem of overcompensation is addressed, there should be sufficient free allowances available under this proposal to protect industrial competitiveness. It’s encouraging to see the Commission proposing to update the production baselines and technology benchmarks, and reducing the sectors eligible for leakage protections. However in all of these areas, we argue that the Commission should go further, and note that its own Impact Assessment encourages it to do so.

As we outline in our latest report, stricter criteria would better ensure enough allowances are available for the leakage-exposed best-performers that really need them. It could even free up more allowances under the cap to direct towards innovation funding and new entrants. Ultimately, the more allowance we dedicate to these purposes, the faster we can usher in the clean industrial revolution that Europe urgently requires.

Compiled by Ben Garside – ben@carbon-pulse.com

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