EU ETS, free allocations and activity level thresholds, the devil lies in the details

Headline issue

Energy intensive and trade exposed sectors receive a proportion of their allowances (EUAs) for the European Union emissions trading system (EU ETS) free of charge to prevent carbon leakage. The number of free EUAs plants receive is reassessed annually and adjusted to reflect their output.  If a plant’s production falls by 50 percent then it receives 50 percent less free EUAs. If a plant’s output falls by 25 percent or 10 percent then the number of free EUAs they receive falls by 75 percent or 100 percent respectively. Research comparing the output in 246 clinker plants across Europe in 2011 and 2012 finds that these rules give incentives for cement firms to produce excess volumes of clinker in order to maximise their free allocation. This has contributed to the reduction of efficiency and increased the overall carbon intensity of cement made in the EU. These findings suggest that for some sectors such as cement, it would be preferable to abandon these rules (known as Activity Level Thresholds). The idea of abandoning ALTs raises broader questions about the appropriateness of ex ante free allocation as an approach to mitigating leakage in some sectors.

Key findings

–    The analysis shows that firms strategically adjusted their output in response to the introduction of Activity Level Thresholds (ALTs). This trend is particularly noticeable in countries where cement demand has significantly reduced.
–    Between 2011 and 2012 the introduction of the ALT rules should have reduced the number of EUAs allocated free of charge by 17.1million EUAs. However, the actual reduction was 6.4 million EUAs, because cement companies increased clinker output in order to stay above the activity level threshold levels.
–    Altogether ALTs induced 5.8 million tons of excess clinker production in 2012 (4 percent of total EU output). This corresponds with excess carbon dioxide emissions of approximately 5.2 million tons.
–    Excess clinker production led to production being inefficiently coordinated across plants, production of cement with higher clinker content and greater exports of clinker outside of the EU.

Policy implications

–    These findings suggest that the ALTs should be abandoned for sectors like cement where carbon costs represent a significant proportion of overall production costs.
–    Introducing full auctions of EUAs and introducing border carbon adjustments is likely to be the most efficient solution but resolving issues around political feasibility will likely take time. In the meantime, a more workable solution would be to move to a full ex-post output based allocation.

Frédéric Branger, Jean-Pierre Ponssard, Oliver Sartor and Misato Sato