Under the EU and UK emissions trading systems (ETS), millions of euros of auction revenue are spent each year to compensate electro-intensive industries for increased electricity costs arising from CO2 cost pass-through in the electricity sector. The argument is that this reduces the risk of carbon ‘leakage’ – where emissions are simply moved into jurisdictions with less stringent regulations. But is the compensation scheme working?

This study examines the causal impact of compensation payments for indirect carbon costs on UK manufacturing plants. It offers new, robust evidence that the compensation is effective in discouraging industrial displacement and carbon leakage from electro-intensive industry. At the same time, the authors find that, as expected, output-based compensation provisions for carbon- and energy-intensive industries weaken incentives for compensated companies to reduce their output and hence their overall energy consumption.

The compensation scheme enables compensated producers, for example in the steel, chemicals, paper and aluminum sectors, to keep producing electro-intensive goods. In the years following the introduction of the compensation scheme, compensated firms increased production by between 16% and 30%, and electricity use and carbon emissions by between 22% and 24%, relative to firms that didn’t receive the compensation. Further, the authors find that compensation has no significant effect on energy intensity.

While mitigating negative impacts on carbon leakage and competitiveness, the compensation has a number of downsides. By allowing electro-intensive producers to keep emitting CO2 to meet overall emission reduction goals, other producers need to work harder to reduce their emissions, though it may be more expensive for them to do so. This increases the societal costs of meeting national emission reduction targets. Using auction revenue to compensate electro-intensive companies lowers their leakage risk, but it also implies that a smaller amount of public funds can be earmarked to support low-carbon activities and investments.

 Key points for decision-makers

  • Carbon pricing through the EU and UK ETS as well as the UK Carbon Price Support (CPS) increases electricity prices. Compensation schemes for these indirect emission costs for electro-intensive manufacturers work insofar as production displacement and carbon leakage are discouraged.
  • Simultaneously, the known downsides of preventing leakage through output-based compensation have also materialised. The compensation scheme creates perverse incentives on the supply side to artificially inflate output, resulting in higher emissions compared with a scenario without compensation.
  • Output-based compensation for indirect carbon costs means that compensated firms refrain from passing forward the full CO2 cost to product prices. As a result, incentives along the production and consumption chain to switch away from energy-intensive goods are dampened. This suggests the need for supplementary consumption-based measures to encourage mitigation through demand-side substitution.
  • Compensation had no statistically significant effect on employment or productivity, suggesting that increased electricity prices due to carbon pricing have not led to the displacement of workers in electro-intensive sectors and have not hampered technological improvements in terms of increased energy efficiency.
  • Compensation to electro-intensive sectors increases the overall compliance cost of meeting mitigation goals, as the mitigation burden shifts towards sectors with relatively lower energy intensity.
  • Using ETS auction revenue to compensate energy-intensive companies for indirect carbon costs comes as a trade-off with other climate-related investments or redistributing climate policy costs to the public through alternative revenue recycling schemes (such as lump sum transfers), which could contribute to enhancing the public acceptability of carbon pricing schemes.
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