DOCUMENTS DE TRAVAIL / WORKING PAPERS

Transcription

1 DOCUMENTS DE TRAVAIL / WORKING PAPERS No Addressng leakage n the EU ETS : Border adjustment or output-based allocaton? Stéphane Monjon Phlppe Quron December 2010 C.I.R.E.D. Centre Internatonal de Recherches sur l'envronnement et le Développement UMR 8568 CNRS / EHESS / ENPC / ENGREF / CIRAD / METEO FRANCE 45 bs, avenue de la Belle Gabrelle F Nogent sur Marne CEDEX Tel : (33) / Fax : (33)

2

3 Addressng leakage n the EU ETS: Border adjustment or output-based allocaton? Abstract The EU ETS has been crtcsed for threatenng the compettveness of European ndustry and generatng carbon leakage,.e. ncreasng foregn greenhouse gas emssons. Two man optons have been put forward to tackle these concerns: border adjustments and output-based allocaton,.e. allocaton of free allowances n proporton to current producton. We compare varous confguratons of these two optons, as well as a scenaro wth full auctonng and no border adjustment. Aganst ths background, we develop a model of the man sectors covered by the EU ETS: electrcty, steel, cement and alumnum. We conclude that the most effcent way to tackle leakage s auctonng wth border adjustment, whch generally nduces a negatve leakage (a spllover). Another relatvely effcent polcy s to combne auctonng n the electrcty sector and output-based allocaton n exposed ndustres, especally f free allowances are gven both for drect and ndrect emssons,.e. those generated by the generaton of the electrcty consumed. Although output-based allocaton s generally less effectve than border adjustment to tackle leakage, t s more effectve to mtgate producton losses n the sectors affected by the ETS. Keywords : Emsson tradng, border adjustment, output-based allocaton, compettveness, carbon leakage. Lmter les futes dans le système européen d échange de quotas d émsson de gaz à effet de serre : ajustement aux frontères ou allocaton basée sur la producton courante? Résumé Le système européen d échange de quotas d émsson de gaz à effet de serre (GES) a été crtqué comme menaçant la compéttvté de l ndustre européenne et comme générant des futes de carbone, c est-à-dre une augmentaton des émssons de GES à l étranger. Prncpalement, deux optons ont été avancées pour trater ces problèmes : l ajustement aux frontères et l allocaton basée sur la producton, c est-à-dre une allocaton gratute de perms proportonnelle à la producton courante. Nous développons un modèle représentant les prncpaux secteurs nclus dans le système européen de quotas (électrcté, acer, cment et alumnum) et analysons pluseurs confguratons de chacune de ces optons, ans qu un scénaro avec enchères et sans ajustement aux frontères. Nous trouvons qu une allocaton par l ntermédare d enchères, complétée par un ajustement aux frontères, permet de lmter le plus les futes de carbone, vore de dmnuer les émssons dans les pays hors UE27 (futes négatves). Une autre poltque relatvement effcace est de combner des enchères pour le secteur de l électrcté et une allocaton basée sur la producton pour les secteurs exposés aux futes de carbone, en partculer s la quantté de perms dstrbuée tent compte des émssons drectes et ndrectes (lées à la génératon de l électrcté consommée). Ben que cette dernère opton sot généralement mons effcace qu un ajustement aux frontères pour lmter les futes de carbone, elle permet néanmons de rédure les pertes de producton dans les secteurs exposés à la concurrence nternatonale. Mots-clés: système de perms négocables, ajustement aux frontères, allocaton basée sur la producton, compéttvté, futes de carbone.

4

5 Addressng leakage n the EU ETS: Border adjustment or output-based allocaton? Stéphane Monjon 1 and Phlppe Quron 23 Abstract The EU ETS has been crtcsed for threatenng the compettveness of European ndustry and generatng carbon leakage,.e. ncreasng foregn greenhouse gas emssons. Two man optons have been put forward to tackle these concerns: border adjustments and output-based allocaton,.e. allocaton of free allowances n proporton to current producton. We compare varous confguratons of these two optons, as well as a scenaro wth full auctonng and no border adjustment. Aganst ths background, we develop a model of the man sectors covered by the EU ETS: electrcty, steel, cement and alumnum. We conclude that the most effcent way to tackle leakage s auctonng wth border adjustment, whch generally nduces a negatve leakage (a spllover). Ths holds even f the border adjustment does not nclude ndrect emssons, f t s based on EU (rather than foregn) specfc emssons, or (for some values of the parameters) f t covers only mports. Another relatvely effcent polcy s to combne auctonng n the electrcty sector and output-based allocaton n exposed ndustres, especally f free allowances are gven both for drect and ndrect emssons,.e. those generated by the generaton of the electrcty consumed. Although outputbased allocaton s generally less effectve than border adjustment to tackle leakage, t s more effectve to mtgate producton losses n the sectors affected by the ETS. Keywords: Emsson tradng, border adjustment, output-based allocaton, compettveness, carbon leakage JEL Q38 1 Correspondng author. Centre Internatonal de Recherche sur l Envronnement et le Développement (CIRED), CNRS, Jardn Tropcal, 45 bs avenue de la Belle Gabrelle, F Nogent-sur-Marne, France. Tel : 0033 (0) Emal: monjon@centre-cred.fr. 2 Centre Internatonal de Recherche sur l Envronnement et le Développement (CIRED), CNRS, Jardn Tropcal, 45 bs avenue de la Belle Gabrelle, F Nogent-sur-Marne, France. Tel: 0033 (0) Emal: quron@centre-cred.fr. 3 The authors wsh to thank, wthout mplcatng, Damen Demally for hs past work on the CASE model, Gernot Klepper and Jean-Perre Ponssard for useful comments, Jean-Lous Moray (Eurofer) for helpng wth the steel nomenclature, and the Cement Sustanablty Intatve for provdng some data from the "Gettng the Numbers Rghts" database. The authors also thank Patrck Crqu and Svana Mma for the data on margnal abatement cost curves from POLES. Ths work s part of the Clmate Strateges project "Tacklng Leakage n a World of Unequal Carbon Prces" led by Susanne Droege and has benefted from the comments of the partcpants. Stéphane Monjon also thanks the Réseau de Recherche sur le Développement Soutenable (R2DS, Régon Ile-de-France) for ts fundng. 1

6 1. Introducton After the results of the last UNFCCC conference n Copenhagen and snce the US s unlkely to mplement a cap-and-trade system n the next years, ndustry groups n the EU wll certanly contnue to argue the threat mposed by the European Unon Emssons Tradng Scheme (EU ETS) aganst ther nternatonal compettveness. The fears of compettveness losses and of carbon leakage are the man arguments put forward by ndustry lobby groups aganst strngent clmate polces, and n favour of free allocaton of allowances. 4 Compettveness and leakage are also the motvatons of border adjustments proposals. Drectve 2009/29/EC, whch revses the EU ETS, wll be appled from the thrd perod of the ETS,.e. from 2013 onwards. Changes nclude a much hgher share of auctonng, especally n the electrcty sector, and some provsons for lmtng carbon leakage. The man one s the contnued free allowance allocaton to the sectors or subsectors whch are exposed to a sgnfcant rsk of carbon leakage (Artcle 10a-12). However, the Drectve also states that [b]y 30 June 2010, the Commsson shall * + submt to the European Parlament and to the Councl * + any approprate proposals, whch may nclude * + ncluson n the Communty scheme of mporters of products whch are produced by the sectors or subsectors [exposed to a sgnfcant rsk of carbon leakage+. In other words, the Drectve mentons, albet cautously, a border adjustment (BA) for GHG ntensve mports.. In the US, the Waxman-Markey bll, whch was adopted by the House of Representatves n 2009, ncludes more concrete provsons. If no nternatonal agreement on clmate change has been reached by January 1, 2018, the presdent of the Unted States s requred to set up an nternatonal reserve allowance program. From 2020 onwards, mports n a covered sector would be prohbted unless the mporter has obtaned an approprate amount of emsson allowances from the nternatonal reserve allowance program. 5 Hence, the poltcal debate on the compettveness mpact of the ETS, the related carbon leakage and on the most approprate polces for reducng ths mpact (f any) s not over. The debate s also stll open from an academc pont of vew: there s dsagreement among researchers both on the quanttatve mportance of leakage and on the effectveness of the polcy nstruments proposed to lmt leakage and compettveness mpacts (Droege et al., 2009). Referrng to ths debate, the objectve of ths paper s to compare the performances of both alternatves free allocaton and border adjustment to lmt carbon leakage, as well as to mtgate producton loss, followng the ncreased ambton of the EU ETS durng the thrd perod. We develop a computatonal framework allowng to represent the European ndustry at a dsaggregated level (cement, alumnum, steel and electrcty) and to analyse the desgn of the dfferent "ant-leakage" optons. Then, we provde a quanttatve assessment of the mpact of these "ant-leakage" polces on the actvty of the dfferent ndustres ncluded n the model, compared to a scenaro wthout a clmate polcy, and to a scenaro featurng auctoned allowances wthout any specfc "ant-leakage" feature. The results show that the determnaton of the best opton depends on the target,.e. lmtaton of carbon leakage or mtgaton of European producton loss, and dffers dependng on the sector 4 In ths context, carbon leakage s defned as the ncrease n GHG emssons n non-european countres caused by the mplementaton of the EU ETS. See Droege et al. (2009) for a deeper dscusson about the defnton of carbon leakage. 5 Smlarly, the cap-and-trade blls ntroduced n the U.S. Senate also nclude provsons for border adjustments, although wth less detals. Ths s the case of S. 1733, the Clean Energy Jobs and Amercan Power Act ntroduced by Senators Kerry and Boxer on October 23, 2009 (Larsen et al., 2009) and of S. 2877, the Carbon Lmts and Energy for Amerca s Renewal Act ntroduced by Senators Cantwell and Collns on December 11, The latter proposes an adjustment for both mports, through a border carbon adjustment, and exports, through a targeted relef fund for exporters (Larsen and Bradbury, 2010). 2

7 consdered as well. Ths last pont emphasses the mportance of conductng ths knd of analyss usng a hghly dsaggregated model. Ths paper s organsed as follows: secton 2 brefly dscusses the prevous assessments of carbon leakage and of ant-leakage optons; secton 3 presents the dfferent scenaros smulated, whle secton 4 detals the model; fnally, secton 5 dscusses the results; and secton 6 wll provde conclusons. 2. Carbon leakage and ant-leakage optons: results of prevous studes 2.1. Carbon leakage: assessments and man channels Snce the UNFCCC was sgned, carbon leakage has become an ssue that s regularly dscussed and evaluated (for an early reference, cf. Felder and Rutherford, 1993; for recent surveys, cf. Gerlagh and Kuk, 2007, and Droege et al., 2009). Gven the global nature of the GHG emssons, carbon leakage can reduce the envronmental effcency of a clmate polcy f only one group of countres commts to abate ther emssons whle the others do not, as n the Kyoto protocol. The man ndcator of leakage s the rato between the ncrease n GHG emssons n non-annex I countres and the decrease n GHG emssons n Annex I countres. Ths rato s called the leakage rate or leakage-to-reducton rato. 6 The varatons are calculated for a scenaro wth the clmate polcy and a scenaro wthout. The estmated leakage-to-reducton ratos n appled models vary consderably, from 2% to 130% (Droege et al., 2009). Two man channels of carbon leakage have been dentfed n the lterature (Renaud, 2008a). A frst leakage channel, sometmes called energy-prce-drven leakage, goes through the energy markets. That s, clmate polces decrease the nternatonal prces of ol, gas and coal; hence they ncrease ther use n countres wthout a clmate polcy. Another channel, often called the GHG-ntensve ndustry channel, or compettveness-drven route, s related to compettveness. For nstance, the EU ETS ncreases the producton cost of European producers n GHG ntensve sectors, some of whch are exposed to nternatonal competton. If European producers pass through the cost to consumers, then they may lose some market shares vs-à-vs foregn producers. If they do not pass through the cost due to nternatonal competton, then the European plants wth the hghest producton cost may become unproftable and cease operaton. In both cases, European ndustry wll lose some market shares n both European and foregn markets, wth two man consequences: job losses and an ncrease n GHG emssons n non-european countres,.e. carbon leakage. Two man parameters explan the wde range of leakage-to-reducton rato estmates. The frst s lnked to energy-prce-drven leakage: the rato decreases wth the supply elastcty of fossl fuels (Gerlagh and Kuk, 2007). Specfcally, wth lower supply elastcty, a gven decrease n European fossl fuel demand generates a hgher response of fossl fuels prce, hence a hgher ncrease n foregn emssons. The second parameter s lnked to compettveness-drven leakage: the rato ncreases wth the substtutablty between domestc and mported products: see the senstvty analyss n Bernard and Velle (2009, Appendx B3). Two man optons to reduce carbon leakage have been assessed wth economc models: border adjustments and output-based allocaton. As we shall see, wth only two exceptons, these optons 6 Mchael Grubb (personal communcaton) recently rghtly ponted out that the expresson leakage rate s sometmes wrongly nterpreted as the share of EU emssons (or producton) that would leak to countres wthout a clmate polcy, whch s completely wrong. Hence we prefer to use the expresson leakage-to-reducton rato. 3

8 have not been assessed n the same framework, preventng a systematc comparson of ther effectveness Border adjustments A BA s a trade measure desgned to level the playng feld between domestc producers facng costly clmate polcy and foregn producers wth no or lttle constrant on ther GHG emssons. Border adjustments have been assessed both through partal equlbrum models of a partcular ndustry and through general equlbrum models. Mathesen and Maestad (2004) smulate a carbon tax n Annex I, wth and wthout border adjustments, n a global partal equlbrum model of the steel ndustry. They show that border adjustments tackle leakage very effcently: a border adjustment based on average specfc emssons (.e. emssons per tonne) n Non-Annex I countres actually reduces steel producton and emssons n Non-Annex I countres. Consequently the leakage-to-reducton rato becomes negatve, fallng from 40% wthout the border tax to -31%. Note, however, that settng an export border adjustment at the level of Non-Annex I specfc emssons, whch are hgher than Annex I specfc emssons, consttutes an export subsdy for the average Annex I producer, whch seems hardly compatble wth the WTO (cf. e.g. Ismer and Neuhoff 2007). Demally and Quron (2008a) also smulate a carbon tax n Annex I, wth and wthout border adjustments, but ths tme n a global partal equlbrum model of the cement ndustry. Here agan, BAs effcently tackle leakage: the leakage-to-reducton rato falls from 25% wthout BA to -2% or 4%, dependng on the level of the border adjustment assumed. In the frst case, producton exported from Annex I s completely exempted from the clmate polcy and mports of cement from the rest of the world are taxed n accordance wth the CO 2 ntensty of cement producton n the exportng country. In the second case, exports beneft from a rebate correspondng only to the least CO 2 ntensve technology avalable at a large scale (a gas-fred plant wth the hghest energy effcency avalable), and mports are taxed at the same level. Peterson and Schlech (2007) specfcally examne the economc and envronmental effects of a border adjustment mposed on countres outsde Annex I, or whch dd not ratfy the Kyoto Protocol. The adjustment s appled to both mports and exports, and to both drect and ndrect emssons. The authors dscuss ther capacty to mtgate the loss n export compettveness, to neutralse the ncreased mport competton as well as to lmt carbon leakage n the whole Annex I. The performances related to the commercal flows dffer dependng on sectors and countres. For nstance, the *border adjustment+ s effectve n neutralsng the ncreased mport competton for most energy-ntensve sectors n the EU 15, whle t has lttle effect on mport compettveness n the rest of European Unon (REU). Ths s because the energy-ntensve products of the REU are more carbon ntensve and around 90% of all ther mports of energy-ntensve products come from other Annex I countres on whch no BA s mposed. On the other hand, border adjustment has only a low mpact on leakage. Ths may be explaned by the fact that border adjustments cannot prevent leakage from the nternatonal energy markets channel. Indeed, n most CGE models, and presumably n ths one also, the larger part of leakage occurs through the "energy markets channel" (Burnaux et al., 2008). Kuk and Hofkes (2009) study the effectveness of border adjustment for tacklng the leakage due to the EU ETS. Ther model comprses the followng sectors: mneral products, steel, electrcty and others. The BA s appled only to mported products and drect emssons. Two varants are examned: the adjustment s based ether on the drect CO 2 emssons per unt of smlar product n the EU, or on the average drect CO 2 emssons per unt of producton n the foregn (exportng) country. The BAs 7 Admttedly, Meuner and Ponssard (2009) also smulate both optons, but appled them n a very dfferent manner: they assess a scenaro wth auctoned allowances n the EU, output-based allocaton n Chna and a border adjustment on exports from Chna towards the EU. 4

9 succeed n lmtng the decrease n domestc output n steel and mneral products but (by desgn) does not mtgate the loss n export compettveness. The authors fnd an aggregate leakage-toreducton rato of 11% wthout a border adjustment, whch decreases to 10% f the border adjustment s based on the drect CO 2 emssons per unt of smlar product n the EU and to 8% f t s based on the average drect CO 2 emssons per unt of producton n the foregn (exportng) country. The lmted mpact of the border adjustment s due to two factors. Frstly, as explaned above, border adjustments obvously cannot tackle energy-prce-drven leakage. Secondly, the scope of the border adjustment studed s lmted snce t covers nether exports nor ndrect emssons. Alexeeva-Taleb et al. (2008a) compare, n a CGE model, the mplementaton of a BA and of what they call an ntegrated emsson tradng (IET) scheme as a complement to the EU ETS. In ther BA scenaro, the carbon content of the mported goods s based on average specfc emssons n the EU. In contrast, n the IET, foregn producers have to purchase emsson allowances for ther mports on the bass on ther own specfc emssons. The authors show that BA mtgates domestc producton losses more effectvely, whle IET acheves a greater reducton n foregn emssons snce t encourages abatement abroad. Alexeeva-Taleb et al. (2008b) analyse the mplcatons of BAs and of access to the clean development mechansm (CDM) wthn the EU ETS, compared to a scenaro wth a unlateral mplementaton of the EU ETS n 2020, no BA and no access to the CDM. Employng a CGE model, they show that BAs effcently mtgate the producton declne caused by a unlateral European clmate polcy on energyntensve and export-orented ndustres, especally f appled both to mports and exports, and f based on foregn rather than on EU average emsson factors. Ths declne reaches 1.69% n the EU27 wthout a BTA, vs. 1.23% wth a BA on mports only, 0.58 wth a BTA on exports only and 0.11% wth a BTA on both, f EU emsson factors are used. Wth foregn emsson factors, EU output n the sectors covered by the BA actually ncreases snce EU average emsson factors are lower than foregn ones. Manders and Veenendaal (2008) also examne whether a BA mtgates the mpacts of clmate polcy, makng use of the general equlbrum model WorldScan. They fnd a rather low leakage-to-reducton rato wth a unlateral clmate polcy: 3.3%. Ths rato becomes negatve wth an mport BA (-1.4%), wth an export BA (-1.3%) and even more wth a BA on both mports and exports (-2.8%), even though the EU average emsson factors are used to calculate the BA. The negatve leakage-toreducton ratos often nduced by BAs n smulatons wth partal as well as general equlbrum models may be surprsng; we wll explan these results n secton 5, whle presentng our own fndngs. 2.3 Output-based allocaton Output-based allocaton appled to clmate polces has been assessed n two partal equlbrum models and n a few general equlbrum ones. Demally and Quron (2006) use a modfed verson of the world partal equlbrum model of the cement ndustry whch was used by the same authors (Demally and Quron, 2008a) to assess a BA. They compare full auctonng to OBA for a unlateral mplementaton of the EU ETS and show that OBA would effcently tackle leakage: at 20/tCO2, the leakage-to-reducton rato would fall from 50% 8 to 9%. The same authors (Demally and Quron, 2008b) develop a smple partal equlbrum model of the steel sector and fnd a leakage-to-reducton rato n the range of 0.5% to 25%, dependng on the 8 Ther model does not nclude the possble substtuton between clnker and CO 2 -free substtutes, whch, as we shall see n secton 5, greatly reduces abatement n the sector. Ths explans the hgh level of leakage whch they fnd under full auctonng. 5

10 parameters and on the polcy optons. Wth an output-based updatng of allowance allocaton every fve years, the leakage-to-reducton rato s roughly halved compared to auctonng. Fscher and Fox (2009b), followng other works nvolvng the same authors (e.g. Bernard et al., 2007), smulate wth a general equlbrum a tax at $14/t CO 2 n the US appled to the sx major energyntensve sectors: electrcty, petroleum and coal products, ron and steel, chemcals, non-metallc mnerals, and paper, pulp, and prnt. They compare a scenaro wth producton rebates, equvalent to output-based allocaton, to a tax wthout rebates (equvalent to auctonng). Interestngly, the rebates have lttle effect on the leakage-to-reducton rato, ether overall or for the covered sectors as a whole. The reason s that whle foregn emssons ncrease less wth the rebates, domestc sectors also decrease less. However, what the authors call domestc leakage of emssons to uncovered sectors s substantally reduced. 2.4 Comparsons of border adjustments and output-based allocaton Demally and Quron (2008b) use a former verson of our model to compare BA and OBA. Compared to ther study, ours s based on an mproved model and assess several versons of these ant-leakage optons, so we wll not present ther results here. The other paper whch compares these optons n the same framework s Fscher and Fox (2009a) but for the US and Canadan context. The authors consder a tax at $20/tCO 2. They dsentangle the carbon leakage between an average leakage whch reflects the relatve changes n emssons nduced by the overall carbon prce and what they call the margnal leakage, that s the change n the foregn sector emssons nduced by producton changes n that sector (.e. the compettveness-drven leakage mentoned above). In scope, the leakage attrbutable to shfts n producton turns out to be a small part of the aggregate leakage: for nstance, n the steel sector, the average leakage amounts to 60%, whle the margnal leakage s 14%. The authors fnd that for most US sectors a full BA s most effectve at reducng global emssons. In contrast, when the BA s set at the domestc emssons rate or lower, a domestc rebate can be more effectve at lmtng emssons leakage and encouragng domestc producton. 2.5 Lmts of prevous studes CGE models encompass a rch set of economc mechansms but most of them are lmted by the sectoral resoluton of the GTAP database on whch they are typcally based. Indeed, several compettveness analyses (e.g. Lund, 2007 for the EU; Hourcade et al., 2007 for the UK, Grachen et al., 2008 for Germany, de Bruyn et al., 2008 for the Netherlands, and Ho et al., 2008, for the US) have shown that wthn GTAP sectors lke non-metallc mnerals or non-ferrous metals, subsectors dffer wdely as regards ther exposure to nternatonal trade and ther GHG-ntensty. Assessng carbon leakage thus requres focusng on more detaled sectors. Sector-specfc partal equlbrum models, though not coverng the whole range of mechansms and aspects through whch carbon leakage could occur, fll a gap left by top-down macroeconomc models, because they are more detaled n ther data sets and they nclude sector-specfc technologcal patterns or economc geography. However snce they model only one sector they cannot compare the mpact on dfferent sectors or the mpacts of nter-sectoral trade n carbon allowances. Aganst ths background the contrbuton of ths paper s threefold. Frstly, we develop a computatonal framework whch enables examnaton of all the relevant optons n a unfed setup: we compare the performances of the two alternatves output-based allocaton and border adjustment to lmt carbon leakage, as well as to mtgate producton loss, due to the unlateral EU emsson regulaton n the EU ETS durng the thrd perod ( ). Secondly, the model features a hgher level of dsaggregaton than most general equlbrum models. Four sectors are represented: cement (wth a detaled treatment of clnker producton and trade), alumnum, steel and electrcty. 6

11 Lastly, the framework allows precse analyss of the desgn of the dfferent "ant-leakage" optons and thus dentfyng the key characterstcs of each opton n each sector. 3. The scenaros Our goal s to evaluate the effcency of dfferent nstruments to mtgate the producton loss and to lmt carbon leakage due to the EU ETS. We consder two possble optons: output-based allocaton (OB) and border adjustment (BA). Each opton can be appled n dfferent ways, whch, as we shall see, mpacts ts capacty to lmt carbon leakage or to allevate ndustral producton loss n Europe Output-based allocaton (OB) Drectve 2009/29/EC, whch revses the EU ETS for 2013 onwards, ncludes some provsons to lmt carbon leakage. The man provson s the contnued free allowance allocaton to the sectors or subsectors whch are exposed to a sgnfcant rsk of carbon leakage (Artcle 10a-12). Yet as explaned n Matthes and Monjon (2008) and Ellerman (2008), snce allocaton n the EU ETS s lnked to producton capacty, not to actual output, t can reduce the ncentve to relocate producton capacty (nvestment leakage) but not the ncentve to use exstng plants abroad rather than EU plants (operatonal leakage). A suggested approach for tacklng ths problem s output-based allocaton, n whch, for example, a steel producer would receve a gven amount of allowances per tonne of steel actually produced. Practcally, ths requres an update of the allocaton when producton s known. Output-based allocaton presents both pros and cons, whch are dscussed n Boemare and Quron (2002) and Quron (2009). In partcular, an OB allocaton, called home rebate by Fscher and Fox (2009a), keeps the playng feld at home and abroad but at the expense of opportuntes to reduce emssons by reducng consumpton. Snce actual producton s partly lnked to producton capacty, the allocaton method n the EU ETS can be seen as an ntermedate one between pure lump-sum allocaton and output-based allocaton. In the present paper, we model output-based allocaton snce t would more effcently tackle leakage than the capacty-based allocaton of the EU ETS. Several confguratons of such OB allocaton are then consdered Border adjustment (BA) A growng body of lterature (cf. secton 2.2 above) has come to the concluson that BAs may effectvely prevent clmate polces from negatvely mpactng European ndustry's compettveness 9. In the EU, rectal 25 of the Drectve 2009/29/EC adds: An effectve carbon equalsaton system could be ntroduced wth a vew to puttng nstallatons from the Communty whch are at sgnfcant rsk of carbon leakage and those from thrd countres on a comparable footng. Such a system could apply requrements to mporters that would be no less favourable than those applcable to nstallatons wthn the Communty, for example by requrng the surrender of allowances. Interest s heatng up n the US as well 10 : n the Waxman-Markey bll adopted by the House of Representatves a cap-and-trade scheme wth a BA s planned for 2016 onwards (James, 2009; van Asselt and Brewer, 2010) There s consderable lterature whch debates the legalty of BA for clmate polces under WTO rules, whch we do not refer to n further detal n ths paper. See for nstance UNEP and WTO (2009) or Kommerskollegum (2009). 7

12 When a BA s consdered, we assume that allowances are auctoned. Indeed, a BA s much more dffcult to justfy under free allocaton than under auctonng: wth a BA the European ndustry does not suffer from a compettve dsadvantage (or much less so), there s thus lttle ratonale for free allocaton, whch creates economc dstortons (Matthes and Neuhoff, 2008). Dfferent elements requre beng defned, n order to mplement a BA as a complement to the EU ETS: form of the BA (tax-based or allowances-based), coverage of the BA (mports or mports and exports; drect emssons or drect and ndrect emssons) and adjustment base (EU or foregn average specfc emssons, n partcular). 12 In the paper, the modellng of the BA s equvalent to a tax on mports and a subsdy on exports, equal to the allowance prce. For the other elements, we compare several confguratons. 3.3 Scenaros We analyse nne clmate polcy scenaros and compare them to a no-polcy ("busness-as-usual") scenaro. The scenaros am to compare contrasted polcy optons currently dscussed among researchers and/or stakeholders Common features across clmate polcy scenaros We present results for the md-term of the thrd perod of the EU ETS,.e., All scenaros assume a cap at 85% of 2005 emssons, whch s the average cap for the perod , and the cap for the year 2016 (European Commsson, 2008). Another pont shared by the scenaros s that we assume that no other country mplements a clmate polcy. Whlst perhaps unduly pessmstc, ths assumpton enables assessment of the consequences of the EU ETS n a worst case scenaro. 13 One last feature common to all of the scenaros s that we do not account for the Kyoto mechansms,.e. CDM and JI, because the amount of CDM and JI projects avalable to EU frms after 2012 s very uncertan. Nor do we account for the bankng of allowances unused durng the second perod. The quanttes of these permts could be substantal (European Commsson, 2010). Consequently the reader should keep n mnd that by dong so, we overestmate the CO 2 prce and hence the mpact of the EU ETS on ndustral compettveness (cf. Alexeeva-Taleb et al., 2008b). However, our focus s on comparng polcy optons rather than on estmatng absolute values, and there s no reason to thnk that these lmtatons wll change the rankng of polcy scenaros Dfferences across clmate polcy scenaros The nne polcy scenaros are as follows: 1. Aucton: 100% auctonng of allowances n every sector, wthout border adjustment % auctonng, wth border adjustment. We dstngush fve varants: 10 The Amercan Clean Energy and Securty Act of 2009 (ACES) s an energy bll n the 111th Unted States Congress (H.R.2454) that would establsh a cap-and-trade system for greenhouse gases. The bll was approved by the House of Representatves on June 26, 2009 by a vote of , and s stll n consderaton n the Senate. 11 A BA s also sometmes presented as a way for the EU to nduce other countres to partcpate n an nternatonal clmate protecton agreement (Stgltz, 2006). However some experts come to the opposte concluson snce a BA may be seen as a trade sancton by developng countres and threaten the goodwll n nternatonal clmate negotatons (see the dscusson n Droege et al., 2009). 12 See Monjon and Quron (2010) for a deeper analyss of the dfferent elements of a BA. 13 However, we suppose that electrcty consumpton and specfc emssons n the rest of the world evolve exogenously. For that we extrapolate the recent trends. 8

13 . BA full: border adjustment on both exports and mports. In every sector, the export adjustment s proportonal to the EU average specfc emssons for drect emssons and to the EU average specfc electrcty consumpton for ndrect emssons (.e. emssons due to the producton of electrcty used n ths sector) whle the mport adjustment s proportonal to the Rest of the World (RoW) average specfc emssons (drect emssons) and to the RoW average specfc electrcty consumpton (ndrect emssons). The next four scenaros represent varous weaker forms of border adjustments, whch are less effcent at preventng leakage but may be chosen nevertheless, n order to mprove the lkelhood of WTO acceptance or because they mght be more easly accepted by other countres, thereby reducng the rsk of the nternatonal negotatons on clmate change beng jeopardsed (Monjon and Quron, 2010).. BA mport: same as BA full but wthout the export adjustment.. BA drect: same as BA full but only for drect emssons, not ndrect. v. BA EU average: same as BA full but the mport adjustment s proportonal to the EU average emssons. v. BA mport drect: same as BA full but wthout the export adjustment and only for drect emssons, not ndrect. 3. Output-based scenaros: allowances are dstrbuted for free n proporton of current producton. We dstngush three varants:. OB full: output-based allocaton n all sectors. In every sector, the amount of allowances allocated per unt produced s calculated by applyng a reducton rato to the 2005 specfc emssons. The reducton rato s equal across sectors and calculated so that the emsson cap s 85% of 2005 emssons, as n every clmate polcy scenaro. Note that snce we apply the same reducton rato to several sectors that dffer by ther abatement cost, the sectors wth the cheapest abatement opportuntes wll typcally sell some allowances to the sectors wth the most costly abatement.. OB exposed drect: auctonng n electrcty, output-based allocaton n exposed ndustres (cement, alumnum and steel) for drect emssons. The amount auctoned s 85% of the electrcty sector emssons of In every other sector, the amount of allowances allocated per unt produced s calculated by applyng a reducton rato to the 2005 specfc emssons. Agan, the reducton rato s equal across sectors and calculated so that the emsson cap s 85% of 2005 emssons, as n every clmate polcy scenaro.. OB exposed drect & ndrect: auctonng n electrcty, output-based allocaton n exposed ndustres for drect and ndrect emssons. The amount auctoned s 85% of the electrcty sector emssons of 2005 mnus ndrect emssons by cement, steel and alumnum. In every other sector, the amount of allowances allocated per unt produced s calculated by applyng a reducton rato to the 2005 specfc emssons. Agan, the reducton rato s equal across sectors and calculated so that the emsson cap s 85% of 2005 emssons, as n every clmate polcy scenaro. 9

14 4. The model CASE II s a statc and partal equlbrum model, whch represents four sectors: cement, alumnum, steel and electrcty. 14 Although general equlbrum effects have sgnfcant mplcatons for the clmate polcy, they play a role n energy market leakage, above all but are less mportant for comparng ant-leakage polces (Fscher and Fox, 2009a). The sectors have n common the potental large cost mpact of carbon prcng but contrasted drect and ndrect emssons as well as exposure to nternatonal competton (Hourcade et al., 2007). Besdes, these sectors represent around 75% of the emssons covered by the system (Kettner et al., 2007). The model ams at evaluatng the mpact of dfferent desgns of the EU ETS for the thrd perod on the producton levels, the prce levels and the trade flows of each ndustry. Then, t s possble to calculate the leakage-to-reducton rato for each sector and for the whole ETS Consumpton The model comprses two regons: the European Unon 27 (EU) and the rest of the world (RoW). In each regon r={eu, RoW}, the representatve consumer s assumed to have a two-ter utlty functon. The upper ter s a (logged) Cobb Douglas functon of the utlty derved from consumng the goods produced by each ndustry, gvng rse to fxed expendtures shares (α r ) out of ncome (Y r ): å å (1) U = a.ln( u ) + (1 - a ).ln( Z ) r r r r r = { C, A, S, E} = { C, A, S, E} where α r s the expendture share of the regon r n ndustry, u r s the sub-utlty from the consumpton of the varetes produced n the ndustry and Z r represents the consumpton level of the numérare good. Indexes C, A, S and E represent cement, alumnum, steel and electrcty respectvely. Expendtures n regon r n goods produced by ndustry are then ryr We assume that the expendture parameters stay constant between 2006 (year used to calbrate the model) and 2016 (year used for the smulatons of the busness as usual and the dfferent clmate polces). GDP Y r s exogenous and growng. 15 In turnng to the lower-ter of the utlty functon, we examne expendtures allocaton n the ndustres C, A and S, each consstng of a domestc varety and a foregn varety. 16 The sub-utlty u r s a constant elastcty substtuton (CES) aggregate of the two varetes. The representatve consumer has dfferent preferences over varetes dependng on ther places of producton, allowng n partcular for home bas. Ths preference parameter n regon r for the domestc varety s denoted pref rr whle the preference parameter for the mported varety s denoted pref rr ' where r and r ={EU,RoW} and r r. The sub-utlty functon s then: 1 1 ' ' r rr rr rr rr u pref Q pref Q (2) 1 14 CASE II s an evoluton of the CASE model (Demally and Quron, 2008b). Among the dfferences between the two versons, CASE II models an mperfect competton n the cement, alumnum and steel sectors and the alumnum sector s ncluded n the EU ETS. 15 See Appendx 1 for the assumptons on exogenous data. 16 We assume that all domestc varetes are perfect substtutes for each other, as are all foregn varetes, but that domestc and foregn varetes are ncomplete substtutes. 10

15 Where ={C,A,S}, Q rr (resp. Q rr ' ) s the consumpton level n regon r of the good produced by ndustry n regon r (resp. r ) and σ represents the elastcty of substtuton (the Armngton elastcty) between domestc and foregn varetes n ndustry. Maxmsng ths sub-utlty functon subject to expendtures and the delvered prces from the two possble product orgns, we obtan the demand curves: Q Q Y rr r r Y 1 prefrr prr prefrr prr prefrr ' prr ' prefrr ' prr ' prefrr prr prefrr ' prr ' rr ' r r (3) (4) where p rr and p rr ' are the delvered prces respectvely of the domestc and of the foregn varety of the ndustry faced by the consumers of the regon r. For electrcty, we do not account for nternatonal trade snce t s neglgble at the EU level. The electrcty demand n regon r s then the sum of the demand from the cement, alumnum and steel E frms localsed n regon r and of a fxed expendture share out of ncome r Y from the r representatve consumer. 4.2 Supply The CES specfcaton of the representatve consumer s utlty has mostly been used n monopolstc competton models followng Dxt and Stgltz (1977) and Krugman (1980) where frms do not take nto account the effect of ther behavour on other frms. Strategc nteractons are therefore neglected, whch s not very relevant for the ndustres analysed n ths paper snce they feature a small number of large frms. Consequently we explore the case where frms compete n quanttes, as n a standard Cournot olgopoly. Thus, our modellng framework encompasses both the standard Cournot olgopoly (the substtuton elastcty between the mported and the domestc varety tends toward nfnty) and the pure competton Armngton framework (f the number of frms tends towards nfnty). In the cement, alumnum and steel sectors, each frm sells n both regons. In each regon, there are n r domestc frms n competton. Frms are n competton regonally and, less ntensvely, nternatonally. Trade between the regons entals a constant per-unt transportaton cost. Then the proft functon of a frm localsed n regon r s: p mc q p mc tc q FC (5) r rr r rr r ' r r r ' r r ' r r where r and r ={EU,RoW} and r r, ={C,A,S}, p rr and p rr ' are the delvered prces of the good produced by a frm of ndustry localsed n regon r and sold, respectvely, n regon r and n regon r, mc (resp. FC ) the margnal (resp. fxed) producton cost of frms localsed n regon r, q (resp. r r q rr ' ) the quantty sold n the domestc market (resp. n the foregn market) and rr ' transportaton cost from regon r to regon r. rr tc the (unt) Ths framework allows frms to set dfferent prces n each market. Ths contrasts wth the Dxt- Helpman-Krugman model n whch frms perceve the same elastcty of demand n each market and therefore set export prces (net of transport costs) equal to ther domestc prces (Head and Res, 2001). 11

16 Each frm sets ts producton for domestc and foregn markets to maxmse ts proft, under quantty competton wth the frms of the same regon and of the other regon. To determne the number of frms n each regon, we assume that free-entry sets profts equal to nl n both regons. At the equlbrum, all frms from the same regon beng symmetrc, we have Q = n. q (resp. Q = n. q ). r ' r r r ' r rr r rr Excludng expendtures related to the clmate polcy, producton costs (varable and fxed) are assumed constant but dffer across regons. When a clmate polcy s carred out n the EU, EU frms ncur three types of addtonal cost: - Abatement cost: The abatement cost s based on the margnal abatement cost curves (MACC) of the POLES model n 2020 for the EU27. In POLES, the MACC are avalable for the CO 2 energy emssons from, among others, non-mneral materals, steel and electrcty sectors. The MACC have been used to defne a curve whch gves for each CO 2 prce the decrease n specfc emssons. The abatement cost enters the varable cost as n Fscher and Fox (2009a). POLES does not allow MACC for the alumnum sector; hence we use data from the Energy Modelng Forum EMF-21 project on mult-gas mtgaton (Weyant et al., 2006). - Purchase of allowances: The producton cost depends on the need for purchasng allowances. - Increase n electrcty prce: The margnal producton cost of cement, alumnum and steel frms s ncreased by the rse n electrcty prce. We assume a cost pass-through of 100% n the power sector, whatever the scenaro. The electrcty prce rses by the sum of the abatement cost and of the purchase of allowances Assumptons about the sectors Targeted products The rsk of carbon leakage seems to be the hghest for sem-fnshed products (Hourcade et al., 2007). Consequently, the model focuses on ths stage of the producton chan. For the steel sector, we represent sem-fnshed products (e.g. slabs), because they feature hgher CO 2 /turnover and CO 2 /value added ratos than fnshed products; hence carbon leakage s more lkely to happen at ths stage of the producton process. We aggregate long and flat products and both producton routes (basc oxygen furnace and electrc arc furnace). The alumnum sector only covers prmary alumnum, nternatonal trade occurrng manly at ths stage of transformaton. We do not consder secondary alumnum,.e. recycled alumnum, whch s around ten tmes less energy and GHG-ntensve and whose producton s manly nfluenced by scrap avalablty. Alumnum has been treated n a specfc way n the model because Iceland and Norway have mplemented an ETS whch s lnked to the EU ETS snce 2008 and these two countres account for almost half the alumnum exports to the EU 27 (Renaud, 2008b). 18 Consequently the model ncludes Iceland s and Norway s alumnum sector n the EU ETS. In the model, all sectors consume electrcty. We do not take nto account the fact that some ndustrals produce ther own electrcty or the role of long-term power supply contracts (Renaud, 17 Chernyavs'ka and Gullì (2002) show that the ncrease n electrcty prce can be ether lower or hgher than the margnal CO 2 cost. Lse et al. (2010) examne the mpact of the EU ETS on the electrcty prces n EU and fnd pass-through rates between 70 and 90% dependng on the CO 2 prce, the market structure and the demand elastcty assumed. 18 Accordng to the UN COMTRADE database, n 2006, cement and steel exports from Iceland and Norway to the EU 27 represent respectvely around 0.4% and 1% of EU mports, whle cement and steel exports from EU 27 to Iceland and Norway account around 6% and 3% of EU exports respectvely. 12

17 2008b). Moreover, we do not consder electrcty savngs due to the rse n power prce but we extrapolate the recent trends n the electrcty consumpton per ton of product. In the cement sector, we consder that n the EU, cement may be mported as a fnshed product, or n the form of clnker whch must be mlled and blended nto cement at the pont of arrval. We assume out clnker exports from the EU to the RoW snce they are already neglgble absent clmate polcy. For the EU, we take nto account the substtuton between clnker (the CO 2 -ntensve ntermedate product) and CO 2 -free substtutes (e.g. fly ashes or blast furnace slag) as well as the substtuton between domestc and mported clnker. The proporton of clnker used to produce CK cement n the EU, Sh, and the market share of mported clnker n the EU, Sh CK EU, RoW, are modelled through nested logt functons 19 : Sh CK CK 1 TCEU CK SUB TCEU TCEU 1 1 Where Sh TC Sh. TC 1 Sh. TC CK CK CK CK CK EU EU, RoW EU, RoW EU, RoW EU, EU CK 2 TCEU, RoW CK CK TCEU, EU + TCEU, RoW CK EU, RoW 2 2 CK SUB TCEU and TCEU represent, respectvely, the total cost of usng clnker and of usng CO 2 -free CK CK substtutes (flyng ashes, blast furnace slag ) n EU cement producton, TCEU, EU and TC EU, RoW represent, respectvely, the cost of usng domestc and mported clnker to produce cement n the EU CK and 1 and 2 are postve parameters representng the responsveness of Sh and Sh CK EU, RoW to the changes n the relatve costs. The logt functonal form conserves the mass, whch s a great advantage over a CES functon snce we want to represent physcal quanttes of cement. In the logt functon representng the choce between clnker (ether mported or domestc) and substtutes, the parameters are calbrated to represent the share of substtutes n cement n 2006 (23%) and an ad hoc assumpton that a doublng of the clnker cost, other thngs equal, would ental a doublng of the share of substtutes n cement. In the logt functon representng the choce between domestc or mported clnker, the parameters are calbrated to represent the share of mported clnker n 2006 (6%) and to ft the followng result from GEO-CEMSIM, a detaled geographc model of the world cement ndustry featurng transportaton costs and capacty constrants: wth a CO 2 prce of 20, the share of mported clnker doubles (Demally and Quron, 2006) Model structure All sectors are lnked through the CO 2 market. 20 The CO 2 prce clears the market: thanks to specfc emssons abatement and producton fall, the sum of the emssons from these sectors equals the total amount of allowances allocated for free or auctoned. 19 Such functons are used n hybrd energy-economy models such as CIMS (Murphy et al., 2007) and IMCALIM-R (Crassous et al., 2006). 20 In fact, PFC emssons from the alumnum sector are covered as well but CO 2 market and CO 2 prce are the usual terms. 13

18 EU 27 TRADE Rest of the World CO2 Market Steel Alumnum Electrcty We do not model emssons n the rest of the EU ETS or emssons outsde the ETS. These emssons could dffer across our scenaros, due to some ndrect effects (e.g. substtuton between electrcty and gas n buldng heatng) but ths effect s most lkely to be neglgble Calbraton and smulatons Cement Clnker The model has been calbrated on 2006 data (prces and quanttes). The values of the preference coeffcent and the unt transport costs are determned by the calbraton and are supposed to be constant. Concernng the values of the Armngton elastcty, large dfferences exst across sectors and countres. 21 Moreover, estmates for Europe are rare (Welsch, 2008) 22. Our strategy has been to test the robustness of our results by usng two sets of assumptons for Armngton elastcty, the frst one reflectng rather low values whch can been found n the lterature and the second one rather hgh values: - Low values: 1.5 for cement, 2 for alumnum and 2 for steel; - Hgh values: 3 for cement, 3.5 for alumnum and 5 for steel. The larger the Armngton elastcty, the more easly mported commodtes may substtute for domestc commodtes. 21 See Grachen et al.(2008) for a recent survey on Armngton elastcty at sector level and Donnelly et al. (2004) for a recent and complete analyss made by the U.S. nternatonal trade commsson for the US. 22 Accordng to Welsch (2008), central values employed recently n studes of carbon taxaton or emssons tradng wth respect to Europe go from 2 to 4. 14

19 / t CO2 ; bllon The BAU scenaro s smulated for 2016 wthout clmate polcy. Ths scenaro s based on a growng GDP and changng techncal coeffcents (specfc emssons, specfc electrcty consumpton). Other exogenous varables stay constant (n partcular producton costs). We then smulate dfferent polcy scenaros for the future whch are then compared to a busness-asusual scenaro. The output varables are: the prces n the domestc and the foregn markets, the producton levels for the domestc and the foregn markets, the number of frms, the CO 2 prce and the specfc emssons. 5. Results Results are reported for the year 2016,.e. around the md-term of the thrd phase of the EU ETS. Snce results dffer sgnfcantly only for carbon leakage, for the other varables we show only the results of Varant L, whch s based on low values of Armngton elastctes. Results from Varant H, based on hgh values, are avalable from the authors upon request A contrasted mpact on carbon leakage and on the CO 2 prce Fgure 2 presents the man results aggregated over the sectors covered by the model Aucton BA full BA mport only Fgure 2 - CO 2 prce and publc revenues BA drect only BA EU average BA mport drect OB full OB exp. dr. OB exp. dr.&ndr. PCO2 publc revenues The CO 2 prce s the lowest under Aucton (24 /t) and the hghest under OB full (48 /t). The explanaton s the followng. Free allowances under OB full consttute a subsdy to the producton of CO 2 -ntensve goods, so producton levels are hgher than under the Aucton and BA scenaros. Consequently, to get the same aggregate emssons under OB full as under the other scenaros, lower CO 2 emssons per unt produced are requred, whch mples a hgher CO 2 prce (Fscher, 2001). The CO 2 prce s at an ntermedate level (34-36 /t) under OB exposed drect and OB exposed drect & ndrect, whch s ntutve snce these two scenaros are a combnaton of auctonng and outputbased allocaton. The CO 2 prce s slghtly hgher under the BA scenaros than under Aucton, because 15

20 Leakage-to-reducton rato the border adjustment lmts (completely or partally) the substtuton of foregn producton to domestc producton, whch s a way of reducng CO 2 emssons n the EU. Hence a hgher CO 2 prce s needed to get lower specfc emssons. The publc revenues are, of course, nl for the OB full scenaro, and around 35 bllon for all the others. The BA scenaros, especally BA full, brngs about more revenues than Aucton, partly because there are slghtly more mports than exports (expressed n embedded CO 2 ), partly because the CO 2 prce s slghtly hgher under the BA scenaros, as explaned above. Interestngly, the two scenaros combnng auctonng and output-based allocaton provde almost as much revenue as Aucton, although a sgnfcant part of the allowances s allocated for free (27% for OB exposed drect and 31% for OB exposed drect & ndrect). Ths s because the remanng allowances are sold at a hgher prce. Fgure 3 - Aggregate leakage-to-reducton rato Aucton BA full BA mport only BA drect only BA EU average BA mport drect OB full OB exp. dr. OB exp. dr.&ndr. Varant L Varant H As s apparent from Fgure 3, the leakage-to-reducton rato,.e., the ncrease n RoW emssons dvded by the decrease n EU emssons, s very senstve to the Armngton elastctes. For nstance, under full auctonng, ths rato reaches 11.4% under Varant H vs. only 4.5% under Varant L. However the results are qualtatvely robust n the sense that the rankng of the scenaros, n terms of the leakage-to-reducton rato they generate, s generally the same n both varants. As expected, the leakage-to-reducton rato s the hghest under Aucton. The OB scenaros brng ths fgure down to 1-4%, the OB exposed drect scenaro beng the least effcent n ths regard because electrcty-ntensve sectors (manly alumnum and steel) suffer from the rse n power prce. OB exposed drect & ndrect s a lttle more effcent at preventng leakage than OB full because t entals a lower CO 2 prce, hence less abatement per ton produced and less ncrease n producton cost None of the ant-leakage polces modelled here offset the cost ncreases due to changes n producton methods to reduce emssons. 16

21 Nevertheless, whatever the varant, OB full and OB exposed drect & ndrect lead to very low aggregate leakage-to-reducton ratos (around 1-2%). Under all BA scenaros except BA mport drect, the leakage-to-reducton rato s negatve, meanng that emssons n the RoW actually decrease. Consequently, even when the adjustment s set only on mports (BA mport only), only on drect emssons (BA drect only), or when the adjustment on mports s set at the EU average rather than at the RoW average (BA EU average), border adjustment s more effcent than output-based allocaton to prevent leakage. The man explanaton for ths s that these clmate polces decrease the consumpton of steel, alumnum and cement n the EU, and therefore exports from the RoW to the EU as well as producton and CO 2 emssons n the RoW. A complementary explanaton s that snce, n most sectors, EU nstallatons emt less CO 2 per tonne produced than RoW nstallatons, they face a lower ncrease n producton cost than ther foregn compettors. Thus they wn some market shares on European markets, whch reduces mports and hence emssons n the RoW further. Of course, ths last effect does not apply when the mport adjustment s proportonal to the EU average specfc emssons rather than to the RoW average. For the narrowest BA, BA mport drect, the sgn of the leakage-to-reducton rato depends on the varant: negatve but almost nl for Varant L and postve for Varant H. In the last case, BA mport drect entals a hgher leakage rato than some of the OB scenaros. The scenaros OB exposed drect and BA mport drect are partcularly nterestng to compare gven the current debates n the EU and the US: n the EU ETS, allowances wll be auctoned for electrcty generaton from 2013 onwards (wth a transtonal perod n new member states) but not for ndustres deemed exposed to carbon leakage. Moreover, n the EU and the US, the most dscussed optons for a BA focus on mports and drect emssons. The leakage-to-reducton rato s slghtly hgher under BA mport drect than under OB exposed drect: +2 ponts n Varant L and +1 pont n Varant H. Hence, even f we focus on the polcy scenaros whch currently receve the closest attenton, the above-mentoned concluson of the superorty of border adjustments over outputbased allocaton for tacklng leakage remans. The man reason s that the mplementaton of a BA sgnfcantly decreases the consumpton of carbon-ntensve products n the EU, whle an OB allocaton does not. It s nterestng to compare our results wth Fscher and Fox (2009a) who conclude that a full border adjustment s most effectve at reducng global emssons but, when border adjustment s lmted for reasons of WTO compatblty, a domestc rebate can be more effectve at lmtng emssons leakage. Here, we see that the concluson depends on the value of Armngton elastcty and on the desgn of the rebate (ncluson or not of the ndrect emssons). In the followng, we wll see that the concluson can dffer dependng on the sector as well. Fgure 4 splts up the absolute level of leakage (.e., the varatons n RoW emssons between BAU and clmate polcy the numerator of the leakage-to-reducton rato) nto sectors. Each bar represents a sector and s splt-up between drect and ndrect emssons. The clnker bar reports the change n emssons due to the clnker mported from the RoW to the EU. Gven that the emssons reducton n the EU s the same whchever the scenaro, Fgure 4 nforms about whch scenaros lead to the largest emsson decrease worldwde as well. In the Aucton scenaro, between 40% (Varant L) and 60% (Varant H) of leakage comes from steel. Leakage from clnker s the same n both varants because the modellng of clnker mports s not based on Armngton elastcty but on a logt share functon, the parameters of whch do not change across varants. In the steel sector, under Aucton, leakage s three tmes hgher n Varant H than n Varant L. The dfferences are lower for the other clmate polces. Also n the steel sector, when a BA s mplemented, the ncluson of the export part has a larger mpact than the ncluson of the ndrect emssons: for nstance, n Varant H, BA mport only leakage remans postve whle t becomes negatve wth BA drect only. The magntude of the dfference n leakage between BA full and BA EU 17

22 average comes from the much lower specfc emssons n the EU than n the RoW. Indeed, wth a BA based on an mport adjustment proportonal to the RoW specfc emssons, EU frms face a much lower ncrease n producton cost than RoW frms. Under OB full and OB exposed drect & ndrect, the emssons ncrease n the RoW s very lmted. However, when the rse of the electrcty prce s not compensated (OB exposed drect), emssons n the RoW jump, above all n Varant H. In the alumnum sector, the crucal pont s the ncluson of the ndrect emssons, whle the export part of a BA plays a mnor role. For the clnker sector, all the ant-leakage optons lead to lmt the emssons ncrease n the same scale. In the cement sector, the dfferences are more mportant. As for the steel sector, leakage s three tmes hgher n Varant H than n Varant L. However, unlke steel, cement emssons never decrease n Varant H, and only slghtly decrease under BA full, BA drect only and BA EU average, whch shows the mportance of the export part of the BA to lmt carbon leakage. Indeed, gven the low consumpton of electrcty n the cement sector, ncludng ndrect emssons do not change the results sgnfcantly. Lastly, the OB scenaros are less effcent to reduce leakage. Consequently, n the cement sector, the most effcent optons to lmt carbon leakage are BA full, BA drect only and BA EU average. 18

23 Mt CO2 Mt CO2 Fgure 4 - Emssons varaton n the rest of the world Upper panel: Varant L. Lower panel: varant H Aucton BA full BA mport only BA drect only BA EU average BA mport drect Clnker drect Clnker ndrect Cement drect Cement ndrect Alumnum drect Alumnum ndrect Steel drect Steel ndrect OB full OB exp. dr. OB exp. dr.&nd Aucton BA full BA mport only BA drect only BA EU average BA mport drect OB full OB exp. dr. OB exp. dr.&nd. Clnker drect Clnker ndrect Cement drect Cement ndrect Alumnum drect Alumnum ndrect Steel drect Steel ndrect 19

24 5.2. Sector-by-sector analyss In ths secton, we present the results relatng to prce, producton levels, specfc emssons and total emssons for each sector n a frst fgure. In a second one, we then decompose the determnants of the emsson decrease. Appendx 2 presents the decomposton method. As already mentoned, changes n prces, producton levels and specfc emssons n clmate polcy scenaros relatvely to busness-as-usual scenaro are very close between both varants. Consequently, we present the results only for Varant L Electrcty Under Aucton, as shown n Fgure 6, the electrcty prce for ndustral consumers ncreases by 10%. The ncrease s slghtly hgher under the BA scenaros and sgnfcantly hgher under the last two OB scenaros because of the hgher CO 2 prce. The ncrease n electrcty prce s very small under OB full snce power producers, lke other sectors, receve for free a large part of the allowances they need. The decrease n specfc emssons depends on the allowance prce. They fall by around 10% under Aucton and slghtly more under the BA scenaros. Under the OB scenaros, the decrease n specfc emssons s even hgher, from 14% to 18% snce the CO 2 prce s hgher. Fgure 6 - Electrcty sector: prce, producton, specfc emssons and total emssons (varant L) Fgure 7 splts up the decrease n electrcty emssons between the European producton declne and the fall n specfc emssons. Under OB full, only 6% of the emsson reductons are due to a decrease n producton whle ths rato reaches 35 to 38% under the other scenaros. In other words, except under OB full, a sgnfcant part of abatement comes from electrcty savngs. 20

25 Fgure 7 - Electrcty sector: decomposton of the decrease n emssons (varant L) Steel Evolutons are more complex for the other sectors due to nternatonal trade. Fgure 8 dsplays, for steel, the prce ndex for EU consumers 24, the EU producton, specfc and total emssons, and the leakage-to-reducton rato (ncludng ndrect emssons). The prce ndex rses slghtly more under the BA scenaros than under Aucton, both because of the hgher CO 2 prce and because the BA rases the mported steel prce. However the fall n producton s lower under the BA scenaros snce EU producers loose less (or even wn some) market shares vs-à-vs the RoW. Compared to auctonng, output-based allocaton consttutes a subsdy to producton and consumers beneft from a hgher consumpton of CO 2 -ntensve goods, at a lower prce. Thus, under the OB scenaros, both the prce and the producton level are closer to BAU than under the other scenaros. Specfc emssons evolve dependng on the CO 2 prce: they fall by 20% when the allowance prce s at 25/tCO 2 and by 28% when the prce reaches 47/tCO 2. Total emssons reductons are roughly smlar among scenaros (between -25 and -28%) but Fgure 9 reveals that ths stablty hdes n fact contrasted roles of the varous emsson reducton channels. The leakage-to-reducton-rato under Aucton reaches 9% (Varant L) or 30% (Varant H), fgures n lne wth exstng models of the steel sectors (Okonomou et al., 2006). For BA full, the strong negatve leakage-to-reducton rato (-12% for Varant L) n ths sector comes from the very dfferent specfc emssons n the EU and the RoW (1.26 vs t CO2/t steel). Indeed, wth a BA based on an mport adjustment proportonal to specfc emssons of the RoW, EU nstallatons face a much lower ncrease n producton costs than ther foregn compettors. Under OB full and OB exposed drect & ndrect, the leakage-to-reducton rato s close to nl. However, the OB exposed drect opton s less effcent to lmt leakage n partcular n Varant H, because the ncreasng producton cost due to the rse n the electrcty prce s not compensated. 24 The prce ndex s the weghted average of the prce of domestc producton and of mports. 21

26 It s nterestng to note that, dependng on the objectve lmtng the leakage-to-reducton rato or lmtng the declne n European producton the conclusons dffer. In terms of lmtatons of the leakage-to-reducton rato, BA full and BA drect only do better than OB full and OB exposed drect & ndrect but the opposte concluson prevals f the objectve s to lmt producton loss. In terms of producton loss avoded n the steel sector, our results dffer from Fscher and Fox (2009a) snce they fnd that an mport tax (based on RoW specfc emssons) lmts the producton loss more than a home rebate (close to our OB allocatons) n the US. However they fnd the opposte result for Canada (as we do), suggestng the crucal role of the specfc emssons factors used (foregn emsson ntensty relatve to the EU: 137% n ths paper; foregn emsson ntensty relatve to the US: 295% and to Canada: 115% n Fscher and Fox (2009a)). Fgure 8. Steel sector: prce, producton, mports, specfc emssons and total emssons (varant L) As shown n Fgure 9, the decrease n specfc emssons s the man emssons reducton channel, n partcular under OB scenaros. Under Aucton and the BA scenaros, the reducton n European consumpton s also a sgnfcant determnant of the decrease n EU emssons, but not under the OB scenaros, for the same reasons as n the electrcty sector. Internatonal trade (mports and exports) also contrbute to the emssons decrease under Aucton, leadng to leakage, but almost not under the OB scenaros whch effcently shelter the compettveness of European nstallatons. Under all BA scenaros, mports actually have a negatve contrbuton to EU emsson reducton snce they decrease compared to the BAU scenaro. In BA full and BA EU average, exports also contrbute negatvely to EU emsson reductons snce they ncrease slghtly. In contrast, under the other two BA scenaros, exports postvely contrbute to emsson reducton, leadng to leakage. 22

27 Fgure 9. Steel sector: decomposton of the decrease n emssons (varant L) Alumnum The leakage-to-reducton rato for alumnum can be poorly nformatve snce the low value of the numerator leads to an artfcally large varablty. The analyss of the other varables s thus even more mportant for ths sector. Under Aucton, the leakage-to-reducton rato of 26% corresponds to a decrease n European producton (ncludng Iceland and Norway) of 14%, whch s more mportant than n the steel sector. The performance of the dfferent ant-leakage optons vares a lot dependng on the ncluson (or not) of a compensaton for the electrcty prce ncrease. As usual the most effcent optons n lmtng the producton loss are OB full (3%) and OB exposed drect & ndrect (2%). When ndrect emssons are covered by the BA, the fall n European producton s lmted to 8-9%, whle t reaches 12% n BA drect only and BA mport drect, whch do not cover ndrect emssons. OB exposed drect does not better ths, wth a decrease of 12% as well. In contrast, whether or not exports are ncluded n the border adjustment does not mpact the results a lot: compare BA full and BA mports only. Ths s due to the fact that the level of exports n the BAU scenaro s already low. As for the steel sector, the conclusons dffer dependng on the objectve. In terms of lmtatons of the leakage-to-reducton rato, BA full, BA mport only and BA EU average do better than OB full and OB exposed drect & ndrect but the opposte concluson prevals for the decrease n European producton. 23

28 Fgure 10. Alumnum sector: prce, producton, mports, specfc emssons and total emssons (varant L) As shown n Fgure 11, under Aucton, although the decrease n specfc emssons s the man drver of emsson reductons the decrease n consumpton and the ncrease n mports are relatvely more mportant than for steel. The explanatons are that abatement optons n alumnum are more expensve and that the sector s more open to nternatonal competton. Under some BA scenaros, the decrease n consumpton s even the man drver of emsson reducton: the hgher alumnum prce ndex drves consumpton down more than under Aucton. As wth the other sectors, under the OB scenaros, almost all emsson reductons come from the decrease n specfc emssons, although under OB exposed drect, mports and exports brng also a sgnfcant contrbuton. Ths s due to the fact that ths scenaro does not effcently shelter the sector compettveness snce alumnum suffers from the ncrease n electrcty prce. Fnally, the contrbuton of exports s neglgble n every scenaro, due to ther low level n the BAU scenaro already. 24

29 Fgure 11. Alumnum sector: determnants of the decrease of the emssons (varant L) Cement and clnker As explaned above, for cement we model two producton steps: manufacturng of clnker, whch entals drect CO 2 emssons and requres electrcty, and manufacture of cement from clnker (mported or domestc) and CO 2 -free substtutes, whch also consumes electrcty but does not ental drect CO 2 emssons. Clnker has the hghest CO 2 ntensty among the products covered by our model and thus features the hghest ncrease n average cost (Fgure 12): more than +50% for the Aucton and BA scenaros. As a consequence, the decrease n European producton s also the sharpest: more than 40% for Aucton and the BA scenaros. On the other hand, OB optons lmt the ncrease of the producton cost to 10-15%, so that the decrease n European producton s also lmted, amountng to between 10-15%. Under Aucton, clnker mports (+36%) are used to compensate the fall n European producton. The BA optons lmt ths substtuton effect, hence the ncrease n mports to 7-9%. The OB optons also lmt the ncrease n mports between 7 and 12 % by contanng the producton cost ncrease. The decrease n specfc emssons s very lmted (3-5%) because 60% of clnker emssons are process emssons that cannot be cut and only lmted opportuntes exst to reduce the remanng 40%, whch are due to fuel combuston. The other mportant means of cuttng emssons n the cement sector s related to the use of CO 2 -free substtutes. It wll be dscussed n the followng. 25