Carbon Leakage from Danish Energy Taxation

CARBON LEAKAGE FROM DANISH ENERGY TAXATION

THE CHALLENGES OF DOMESTIC CLIMATE POLICY | JANUARY 2011 Carbon leakage from Danish energy taxation

COLOPHON

Team: Project manager, Partner Helge Sigurd Næss-Schmidt, Economist Eske Stig Hansen and Analyst Holger Nikolaj Jensen Client: Confederation of Danish Industry Date: 05 January 2011

Contact: SANKT ANNÆ PLADS 13, 2nd FLOOR | DK-1250 COPENHAGEN PHONE: +45 2333 1810 | FAX: +45 7027 0741 WWW.COPENHAGENECONOMICS.COM

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TABLE OF CONTENTS

Executive summary ...... 5

Chapter 1 Main findings ...... 6 1.1. What do we know about carbon leakage? ...... 7 1.2. Defining industries with leakage risks: disaggregated approach needed ...... 9 1.3. EU regulation of carbon leakage: ETS and Energy Tax directive ...... 10 1.4. Effects of the 2009 Danish Tax Reform on industrial carbon leakage ...... 10

Chapter 2 Drivers and estimates of Carbon leakage ...... 14 2.1. Choices facing firms with high local energy and/or CO2 taxes ...... 14 2.2. Drivers of industrial carbon leakage ...... 16 Share of energy costs in total production and tradability of products ...... 16 Transportation costs ...... 17 Ability to split and outsource production processes ...... 17 Time horizon ...... 18 Relative efficiency in production ...... 18 2.3. Leakages estimates ...... 19 2.4. Summing up ...... 22

Chapter 3 Effective measures to avoid industrial carbon leakage ...... 23 3.1. Measures to avoid carbon leakage in EU legislation ...... 23 The ETS directive ...... 24 The energy tax directive ...... 25 3.2. Delineating products and processes with risk of carbon leakage ...... 25 3.3. Summing up ...... 29

3 Carbon leakage from Danish energy taxation

Chapter 4 Energy taxes in Denmark and some other EU countries ...... 31 4.1. Effects of the 2009 Tax Reform for energy intensive industries ...... 31 4.2. Comparison of energy taxation across European countries ...... 33 4.3. Summing up ...... 36

Chapter 5 Effects from Danish energy taxes ...... 37 5.1. Energy-intensive products in Denmark and EU...... 37 5.2. Global climate effects and higher Danish energy taxes ...... 39 5.3. Summing up ...... 44

References...... 45

Appendix...... 48 Appendix A: Documentation of data retrieval and adjustments ...... 48 Appendix B: Documentation of carbon leakage model ...... 50 Mathematical description ...... 50 Calibration ...... 51 Comparing results against Tax Ministry results ...... 53 Sensitivity analysis ...... 54

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EXECUTIVE SUMMARY

To meet climate policy and energy security objectives, Denmark needs to reduce emissions of greenhouse gases and the use of fossil energy sources over the coming decades. It is widely acknowledged that taxing CO2 is a cost-effective instrument to further these objectives.

However, increasing the level of industrial energy taxes in Denmark requires a very delicate approach due to obvious risk of carbon leakage. Danish tax levels for energy intensive industries already exceed levels in other OECD countries; including high energy tax countries such as Sweden, Germany, and the Netherlands. This study indeed suggests that imposing higher tax rates on energy consumption for manufacturing industries will have a very limited, if any, effect on global emissions. This results partly from the very high trade intensity of the products and processes involved, partly as a result of Danish industries being very efficient in energy use as evidenced by international comparisons at a relatively detailed industrial level. Hence, higher costs of energy will move production to countries that use energy less efficiently.

The findings have two obvious set of policy implications.

The first implication relates to the final implementation of the 2009 Danish Tax Reform as well as Danish climate and energy policies in the coming years. To finance reduced tax rates on labour income and meet climate and energy policy objectives, the Tax Reform raised energy taxes. However, the reform contained a proviso that the final tax rates on energy to be applied to energy intensive industries would be subject to an assessment of the effects on competitiveness for these industries. Preliminary findings have already led to a roll back of a fraction of the planned tax increases for the energy intensive industries. We conclude that:

Higher tax rates on CO2 and energy is a necessary element in reaching Denmark’s climate and energy policy objectives, but taxes on energy applied to leakage bound industries need to move in parallel with rates in competing countries.

The second implication relates to energy tax reforms in the EU countries in general. The ETS as well as the Energy Tax Directive have provisions that aim at preventing industrial carbon leakage. But the directives differ in their scope: the provisions in the ETS Directive are meant to reduce carbon leakage from the EU to global competitors with typically much lower carbon taxes (USA, China, India etc). The Energy Tax Directive allows lower tax rates for leakage exposed industries to prevent intra-EU leakage. The details of these provisions are not finally adopted, but we will highlight what should be the two most important elements of the final overall package as regards carbon leakage:

Both potential trade intensity and energy intensity should determine the degree to which an industry may receive beneficial treatment to avoid carbon leakage. Reviews of the risks of carbon leakage should take place at a disaggregated level: a large number of products and processes with a very high trade and energy intensity are grouped together in industrial statistics with industries with much lower risk of leakage. The study provides a number of examples of this.

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Chapter 1 MAIN FINDINGS

The EU and its member states are committed to address the twin challenges of climate change and energy security over the coming decades. The implications of this policy are to achieve substantial reductions in energy use as well as expanding low carbon technologies such as renewable energy, carbon capture technologies etc. over the coming decades.

There is widespread recognition that an effective way to address the twin challenges is through market based regulation such as taxing emissions of greenhouse gases or cap-and trade systems: it creates an incentive to save energy and provides a cost advantage to zero/low carbon technologies. In the EU, this has resulted in the adoption of the EU ETS system – a cap-and-trade system for power generators and energy intensive manufacturing – supple- mented by the EU Tax Directive providing a framework for the taxation of energy for sectors and firms not covered by the ETS at the member state level.

However, such economic instruments have two emission effects going in opposite directions. First , it leads to reductions in emissions in the jurisdiction that impose such taxes as consumers and industries shift their purchases to services and goods with low carbon content (less cars, more restaurants) and leads to less CO2 content in produced units (car fuel efficiency goes up), the effects marked with green in Figure 1.1. Second , it can boost emission of greenhouse gases outside the jurisdiction pursuing carbon abatement policies, an effect known as carbon leakage . Domestic producers will experience deterioration in their position on the global market where foreign competitors will increase production to take over the lost market shares, i.e. industrial (carbon(((carbon)carbon ))) leakage . Moreover, lower energy consumption from within the region/country with abatement policies lowers the effective global (before tax) energy price, hence stimulating energy demand outside the region/country, i.e. re-rrre-e-e- bound (carbon(((carbon)carbon ))) leakage (the latter two effects are marked with red in Figure 1.1).

Figure 1.1: Conceptual presentation of leakage

Loss of international Rebound from lower market shares prices on fossil fuels (Trade flows)

External increase in CO2 emissions = Industry leakage Rebound leakage

Domestic abatement = Abatement Demand elasticity Reduction of Shift in demand to emissions pr. low carbon goods unit and services Source: Copenhagen Economics based on IEA (2008)

The size and determinants of industrial carbon leakage is the core of this project focusing on the national dimension for a small open economy like Denmark: to what extent will higher cost of energy by way of increased energy taxes:

Lead to industrial carbon leakage? Undermine the intended aim of abatement policies – namely to reduce global CO2 emissions?

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We look at the issue under four headings:

What do we know about industrial carbon leakage? Identifying industries with risk of carbon leakage Regulation of carbon leakage under the EU ETS and Energy Tax Directive Estimating the leakage effects of the 2009 Tax Reform Package (Forårspakke 2.0)

1.1. WHAT DO WE KNOW ABOUT CARBON LEAKAGE ? Leakage is formally defined as the degree to which domestic reductions in emissions are offset by increased emissions outside the region pursuing climate policies. So if EU implements policies that reduce emissions by 100 units and they increase emissions by 20 units outside, then leakage is defined as 20 per cent.

The size of this effect depends inter alia on the importance of:

Share of energy costs in total production: the higher the share, the more will the relative output price of the industry go up relative to international competitors Transport costs: is it worthwhile to save taxes by sourcing production from longer distances? Product characteristics: can the good or service with high energy content be trans- ported at long distances without perishing? Ability to split processes: can energy-intensive processes be outsourced without serious interruptions to production flows? Trade barriers: are lower cost products also at the margin kept out by high import tariffs that more than compensate for higher domestic production costs? Time horizon: for how long time can and will firms stick to their old plants and machinery collecting revenue from irreversible investments and thereby postponing the closing down of domestic production (the sunk costs argument)? Relative efficiency in production: are firms in countries with abatement policies more energy efficient such that each unit of production moved out leads to a net increase in CO2?

Empirical work has attempted to measure leakage rates for different policies, e.g., compliance with the Kyoto targets or compliance with ETS reduction targets. The higher the rate of leakage, the less effective and potentially the more distortive is the policy: it results in production moving to other countries that are a priori 1 unable to compete on equal terms with domestic producers, leading to a less efficient use of world resources including fossil fuels.

1 The fact that local producers are currently able to deliver goods to the domestic and global markets strongly suggests that they are at least as efficient as their foreign competitors. In some cases, part of the efficiency advantage comes from an optimal location (minimisation of transport costs, access to resources), while other cases are due to, e.g., superior technologies.

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Typical macro estimates with conservative assumptions lie in the range of 10-30 percent for large geographical areas such as the OECD, while smaller geographical areas – such as Swe- den and Denmark – tend to have significantly higher leakage rates, which can approach 100 percent, c.f. Figure 1.2.

The explanation is pretty straightforward. The smaller the region, the larger the share of total sales to countries outside the region and the larger the share of imported goods and services in the domestic market. In many Danish manufacturing industries, exports and imports together have the same or higher value as local production evidenced by high trade intensities (see Chapter 5.1).

Figure 1.2: Leakage rates as resulting from models with different geographical scopes Leakage rate

1.2

0.8

0.6

0.4

0.2

0 Small EU Countries EU OECD Annex I

Source: Copenhagen Economics and models described in references.

We must stress the risk of underestimating the likelihood of industrial carbon leakage in some of the applied models. The carbon leakage rate is often based on small price changes in models with relatively aggregated industrial sectors. Reality is that industrial consumption of energy is very much concentrated in very few firms that can be very “footloose” if differences in energy costs exist. In this context it is worth noting that OECD estimates suggest that bringing China, India and Brazil into a global climate agreement would have close to zero effect on leakage despite these countries accounting collectively for nearly half of all production in very energy intensive industries (steel, cement, aluminium etc): that is hard to believe.

8 Carbon leakage from Danish energy taxation

1.2. DEFINING INDUSTRIES WITH LEAKAGE RISKS : DISAGGREGATED APPROACH NEEDED When identifying industries with risk of industrial carbon leakage, it is very important to get the level of aggregation right. By aggregation, we mean the extent to which industries are being grouped together in industrial statistics. For example, all manufacturing industries are grouped together by Eurostat as a sector (sometimes denoted NACE 0-digit level). In addition, Eurostat uses four levels of industry aggregation, from NACE 1 to 4-digit aggregation codes.

A case in point is the evaluation of the cost share of energy which is one of the key drivers of carbon leakage. One of the industries with the highest cost share for energy is paper and pulp production. A typical classification of paper and pulp would start at the NACE 2 level with “Manufacture of pulp, paper, and paper products”, cf. Figure 1.3. This industry forms part of a more aggregated group of industries at NACE 1 digit level with much lower level of energy costs (including publishing). Within the NACE 2 sector, we can split up the production into very energy-intensive parts reaching first 30 percent at NACE 3 level and then almost 50 percent at NACE 4 level (“Other articles of paper and paperboard”).

Figure 1.3: Energy purchases costs across aggregation levels - from NACE 0 to NACE 4

60 NACE NACE NACE NACE NACE 0 1 2 3 4 50

0 Manufacturing Pulp, paper and Publishing, Pulp, paper and Articles of paper Pulp, paper and Corrugated paper Other articles of paper products; printing, paper products and paperboard paperboard and paperboard and paper and publishing and reproduction of of containers of paperboard n.e.c. printing recorded media paper and paperboard

Source: Eurostat, Structural business indicators

In chapter 3, we provide more examples of the need to look carefully at the level of aggregation before concluding whether any particular sector/industry is subject to the risk of carbon leakage. The important conclusion is that even looking at NACE 3 level, one may miss out on some industries that de facto are at the risk of leakage and/or include some industries with very low shares of energy costs and hence low risk of carbon leakage.

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1.3. EU REGULATION OF CARBON LEAKAGE : ETS AND ENERGY TAX DIRECTIVE The risks of industrial leakage are well recognised within the EU in the context of both the Emission Trading System (ETS) and the Energy Tax Directive. For ETS post 2012, this has resulted in favourable treatment – free allowances – to industries with estimated “significant risk of carbon leakage”, which is linked mainly to two drivers of leakage factors: (1) the effect of the ETS on overall costs for the industry and (2) its exposure to trade as measured by the trade intensity of the industry. Within the current Energy Tax Directive (in the process of being revised), which provide for minimum energy tax rates for certain uses and users at the national level, some energy intensive users are completely exempted from its application (chemical reduction process, mineralogical processes and metallurgic processes) while it allows reduced rates for energy intensive industries with respect to tax rates on energy products and electricity. The requirement is that the costs of purchasing energy at the national level including national taxes exceed certain levels.

The two directives differ in four dimensions in their approach for allowing favourable treatment First , within the ETS system the emphasis is on the directive’s effect on total energy/CO2 related costs for the industry at EU level, while in the Energy Tax Directive it is the relative importance of total energy costs including national taxes that is critical. This dis- tinction makes sense as it is the member states that define their own tax rates on energy provided they exceed the minimum rates. The minimum rates in the Tax Directive are well below actual rates in a number of EU15 countries. Hence, the extent to which industries benefit from reduced rates depend partly on the rates set at national level. Second , measurement of the tradability of products has an effect of treatment under the ETS while it has none in the Energy Tax Directive. Third , certain industries are completely exempted from application in the Energy Tax Directive, while favourable treatment within the ETS can only be achieved on the basis of specific market characteristics. Fourth , within the ETS the focus is on leakage outside of the EU while in the Energy Tax Directive the focus is on leakage at the national level vis-à-vis both other EU countries as well as outside the EU.

Generally, the ETS Directive is more targeted towards preventing industrial carbon leakage by including both trade and energy intensity, both of which are relevant: the higher the potential trade exposure for a given level of energy intensity, the larger the risk of industrial carbon leakage.

1.4. EFFECTS OF THE 2009 DANISH TAX REFORM ON INDUSTRIAL CARBON LEAKAGE In 2009, a Danish Tax Reform Package (Forårspakke 2.0) was adopted, increasing the effective rates of energy taxation on the use of energy for process purposes. Until 2008, energy

input for industrial processes was faced with CO2 taxes, but not energy taxes. After the Tax Reform, from 2010 and onwards energy taxes will be gradually raised, cf. Table 1.1. More- over, taxes on electricity use – which comes on top of the ETS effect on power market prices – were also raised for process industries. Further increases in 2013 were included in the

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original Tax Reform Package; however, final rates are subject to a review of effects on competiveness.

Table 1.1: Energy tax rates on energy used in industrial processes Rates as applied in Rates as applied in Old regime original Tax Reform Revised Tax Reform Tax, Kr. / GJ. 2009 2010 2012 Fuel Energy taxation, fuel 0 4.5 8 CO2 taxation, fuel 11.5 11.5 11.5 Electricity Energy taxation, electricity 2.8 7.2 7.2 Note: The table shows effective standard rates in the relevant year of introduction. The 2012 rates are lowered in the revised tax package from 2009, compared to the original planned rates in tax package 2009. Source: Danish Tax Ministry, Brøns-Petersen (2009).

These changes make Denmark even more of an outlier in terms of taxing energy intensive industries. Comparing Denmark with seven other European countries, Denmark tops the list when looking at the overall effects of taxation of diesel oil, gas and electricity, cf. Figure 1.4, which are the main energy sources for industries with substantial energy use. Moreover, the other countries tend to have at least one source of energy with substantially lower levels of taxation, providing cheaper substitutes and thereby potential escape routes from high energy taxes.

Figure 1.4: Tax rates on energy for process use in industries (non-ETS companies), 2010

DKK/GJ

0 Denmark Sweden Norway Finland Germany France Netherlands Polen Italy

Diesel oil Natural gas Electricity

Source: Deloitte (2010)

The picture of high Danish energy taxation is confirmed when looking at some individual industrial products and processes. In Figure 1.5, we reproduce a comparison between hypo- thetical plants with plastic and malt production in nine countries and assume that their use of energy units for a given level of final production was equal. The figure shows tax payments in Denmark and eight other European countries under domestic tax rules, i.e., using national rates as well as specific provisions applying to such energy intensive industries. Es-

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sentially, only Norwegian rates for malt production exceed Danish rates while effective rates in all other cases are below Danish rates.

Figure 1.5: Tax payments for plastics and malt across nine countries, 2010 Mill. DKK 6

5.19 5

4.06 4 3.61

2.07 2 1.86

1.10 0.87 0.96 0.87 1 0.82 0.59 0.54 0.55 0.39 0.18 0.09 0.00 0.00 0 Denmark Sweden Norway Finland Germany France Netherlands Polen Italy

Plastics Malt

Note: The tax payments take into account national tax rules including possibilities for refunding and deductions. Source: Deloitte (2010)

Our conclusion is that increases in energy tax rates on energy intensive manufacturing in Denmark are likely to have only a very limited dampening impact on global emissions of CO2 for two main reasons. First , Denmark is a very open economy and, as presented above, the smaller the region with higher tax rates than competitors, the larger is the extent of leakage. Second , the fact that energy taxes are already higher in Denmark than in other countries suggests that Danish firms have already gone further than foreign competitors in exploring options for increasing efficiency in energy use in production. In chapter 5, we provide some empirical back-up for that assessment while recognising that real comparisons are difficult 2.

The study presents some model based simulations to back that assertion. We have used a relatively simple model, but the results are in line with international work in this area. In our benchmark estimate we suggest that domestic reductions of CO2 for industrial processes following the revised Tax Reform Package lead to a reduction of domestic CO2 emissions of roughly 30 percent of Danish, energy-intensive manufacturing industries, which are nearly completely offset by higher emissions in other EU countries. In fact, we estimate a leakage ratio of 88 percent, i.e. for each 100 tons reduction of CO2 emissions in Denmark they go up by 88 tons in other EU countries.

We underline that our model has the same limitations as most other models applied in this area, namely that it reviews the effects of relatively modest changes in energy taxes: if the tax rates become large enough, then firms will cease production in Denmark rather than adjust energy consumption on the margin. Moreover, we have only modelled effects on Danish

2 Even the most detailed industrial data will tend to compare apples with pears: the underlying firms are not really producing the same products and hence have inherently different energy needs.

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firm’s competition with other EU competitors, missing the effects from loss of market shares and leakage to non-EU firms.

The key point is to underline that the rate of leakage can be very substantial even when using relatively conservative model assumptions. Hence, the projected tightening of energy taxes for Danish energy intensive producers may end up providing few, if any, benefits to global climate policies, while distorting the internal market within EU by reducing the market shares of energy efficient Danish producers.

Overall conclusions: • Higher energy taxes for Danish energy intensive producers will lead to substantial amounts of carbon leakage. • Furthermore, it implies job losses in Danish firms that at the outset are at least as energy efficient as firms in other countries. • The policy conclusions from the analysis are that the use of taxes has a role to play as a cost-effective instrument to attain climate policy objectives. However, it is quite important that taxes are internationally coordinated, and as a minimum, special attention should be given to the trade exposed industries with the possibility of tax exemption or other means of alleviation. Hence, careful implementation is required to reduce the risks of industrial carbon leakage for energy intensive and trade exposed industries. • The trick is to strike the right balance: This requires a careful review of carbon leakage at a relativity detailed level, taking into account energy cost shares and trade intensity.

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Chapter 2 DRIVERS AND ESTIMATES OF CARBON LEAKAGE

The displacement of production facilities in response to higher production costs in a certain country or region is a real economic phenomenon. Classic examples are the shipbuilding industry moving from Europe to cheap-labour regions in Asia over the past 5 decades 3, the textile industry (one of the main drivers in the European industrial revolution) moving to South East Asia and Central America 4, and mining and heavy industry moving to Eastern Europe and further East in the 90’s to take advantage of energy subsidies 5. The last decades have taught us that businesses become ever more mobile through international trade and foreign direct investments, so similar stories will become more likely and will happen faster as a response to even smaller increases in local production costs.

When policy makers aim to divert economic behaviour through taxes or subsidies, the mobility of production processes becomes an issue. In this chapter, we focus on the factors that determine the degree to which imposing higher energy costs on firms within a region leads to the partial movement of such production to regions outside the region, through the process of carbon leakage that we already defined under main findings.

In this chapter, we provide a more detailed description of these effects. First , we start by looking at the possible choices for a firm confronted with high local environmental taxation (section 2.1). Second , we turn to the description of key leakage drivers (section 2.2). Finally , we discuss the size of leakage estimates from the economic literature (section 2.3).

2.1. CHOICES FACING FIRMS WITH HIGH LOCAL ENERGY AND /OR CO2 TAXES In a world with free trade and near to competitive pricing, there is no possibility of passing on tax increases to consumers. There are basically four options open to the firm:

Abate using existing technologies Make product or technology innovations Relocate part of the energy-intensive production processes outside the jurisdiction Close production entirely (leave the market to foreign competitors)

Pursuing an abatement or innovation strategy will not exclude the possibility of eventually having to give up the production site. For example, if the innovation efforts fail to produce productive results, increased costs (both from taxes and innovation) may lead to bankruptcy and closure.

Abatement using existing technologies will be a way of lowering the costs of emissions. For example, installing a Carbon Capture and Storage technology (CCS) can prevent the firm from paying CO2 taxes. Yet, the technology always comes at a cost and is therefore only a way of accommodating the tax increase; it will never remove the burden entirely.

3 Hoffmann (2004). 4 Singleton (1997). 5 UN (2003).

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Innovations have a longer and more widespread perspective. They cannot only reduce the tax burden in the future, but potentially create entirely new markets where the firm can add to its profits.

However, we stress that just as leakage rates from unilateral increases in energy taxes are higher for small regions, so are gains from innovation likely to be much smaller. Innovation is driven by the increased benefits that producers and consumers get from energy/carbon savings given higher tax rates. If firms are mainly selling to markets in other regions where industrial and private consumers are not facing the same higher energy taxes, then they face difficulties in recuperating the costs of innovation. See also box 2.1 that discuss such and other side effects of energy taxes.

Box 2.1: Effects of energy taxes on innovation and net profits from energy savings Some researchers put a lot of emphasis on the positive potentials in innovation 6, but we need to keep in mind that the level of innovation efforts will depend on the expected total value of the new technology, which is very much dependent on the geographical scope of the jurisdiction with higher tax rates. For most Danish manufacturing firms, exports account for the bulk of the value added created within the industry. Also at the domestic market, they will face competition from foreign competitors provided that the activity is exposed to competition. Hence, the gains the firm may have from innovation can be very limited as foreign and local final consumers can buy products from firms that pay less for energy consumption: the es- sential problem is then that costs of innovation cannot be recaptured. Local Danish taxation for trade exposed activities can at best be expected to induce some very incremental innovations.

Another angle put forward by some researchers 7 is that there are a lot of viable investments in energy savings not being made, for example because managers and firms do not have time and managerial resources to implement them. Hence, if higher energy prices are imposed, they will implement measures that actually have negative costs.

This is an argument, which should be treated with substantial caution. First, there is a substantial amount of literature suggesting that ex post savings from energy saving projects often fail to meet expectations.8 Second, the fact is that all investment projects in a firm are likely to be facing a hurdle represented by management resources being scarce. So if higher energy prices push more management time and investments in the direction of reaping energy savings, less time of management is devoted to other projects, re- tarding investment in these areas. There is no-free lunch. Source: Copenhagen Economics based on Andersen and Ekins (2009), Neri (2007),

The strategy of eventually leaving the production site, be it by relocation of part of the energy intensive activity to outside the jurisdiction or by total closure of the entire production is where carbon leakage comes in. Additionally, if the former location was optimal from a transportation point-of-view (which economic theory would predict), it implies that relocation leads to additional transportation and thereby additional emissions.9

The actual choices will depend on a number of factors – or drivers – which we will explain in more detail in the next section.

6 E.g., Andersen and Ekins (2009) 7 For example in Neri (2007), part of a project on the competitiveness effects of energy taxes. 8 E.g., Kunz et al (2009), Thomsen et al (2005). 9 We should here emphasise that our own calculations have not included emissions from additional transportation. This is one reason why we believe that our estimate is conservative.

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2.2. DRIVERS OF INDUSTRIAL CARBON LEAKAGE In this section, we look at the most important factors that drive the size of industrial carbon leakage:

Share of energy costs in total production and tradability of products Transportation costs Ability to split and outsource part of the production processes Time horizon Relative energy efficiency in production

Below, we describe each element at a time. First, however, we introduce the concept of a “footloose industry”. A footloose industry will be characterised by low transportation costs, low plant fixed costs (sunk costs), and standard technologies implying, e.g., few require- ments on employee skills 10 . The important lesson is that carbon leakage is not only a function of how much (fossil) energy is used in the production process of a certain good, but also of some underlying production, product, and market characteristics.

Share of energy costs in total production and tradability of products Classic leakage industries are simply defined by having a high energy-intensity and having a high exposure to foreign trade.

There is a consensus that the key leakage industries include steel, aluminium, bulk chemical products, paper/pulp and cement. They are all characterised by huge intensity of CO2 in production, including upstream electricity producers and international tradability of essen- tial commodity products with limited product differentiation.

Estimates of the direct effects on costs from carbon pricing fall within a relatively consistent pattern for the classic leakage industries. Four studies based on detailed product based analysis gives double digit price increases for steel, cement and aluminium with carbon prices at ETS Phase II level (€20 euro per ton CO2) with cement being a class of its own, cf. Table 2.1. Two more sector based analyses with a much less detailed modelling of the characteristics of the industries and the use of more aggregated sectors provide much smaller effects. However, in both of the latter two studies there is an explicit recognition that this broader sector based approach leads to inclusion of products with lower CO2 emission and, hence, lower cost estimates than the product based studies with more narrow industry classifica- tions.

10 Also, it should not be too dependent on agglomeration / cluster economies of scale. By this is meant that producing in a particular location provides specific benefits such as access to other industries in the same field of compete- tences and access to a strong research network.

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Table 2.1: Short run impact on production costs from a carbon price of € 20 per ton

and Iron Steel, primary(%) Iron Steel, & secondary(%) Aluminium, primary(%) Aluminium, secondary(%) (%)Cement Forestry(%) Chemicals(%) and Paper (%) pulp Geographic coverage Product oriented studies IEA (2005) 27 3 11 8 35 4 EU Smale et al. (2006) 9 4 UK / EU McKinsey (2006) 17 3 1 0,5 37 10 EU Umweltbundesamt (2007) 18 14 61 23 11 Germany Climate Strategies (2007) 27 2 11 34 4 9-12 9 UK / EU Sector based studies Ho, Morgenstern and Shi (2008) 61 1-2 7 2 14 0,8 4 2-3 US CE Delft (2008) 6 3 0-4 8 0.6-0.8 Netherlands Source: Copenhagen Economics and the studies referred to.

Transportation costs Transportation costs will determine how competitive a geographically more distant producer is. If it is very costly to bring the product to the market, there is also limited geographical scope for moving production away while keeping total costs below pre-tax levels.

Transportation costs are closely related to product characteristics. Fresh milk is heavy and easily decomposed, hence expensive to move. Milk powder, on the other hand, can be stored at limited costs and is much more weight-efficient to transport. A similar example holds for cement and clinkers (see table 2.2). The point is that products with high storability and low weight/value ratio will be quite footloose as they are relatively cheap to transport.

Ability to split and outsource production processes The effect on final production costs may be mitigated by outsourcing the most energy intensive part of the production process to regions with lower pricing on green house gases emissions. Prominent examples are clinkers for the production of cement, but also other sub products can be outsourced to the same effect, cf. Table 2.2. The key point here is that leakage can occur even when high transportation costs make outsourcing of the entire product non-profitable. While cement can only profitably be moved beyond 100 kilometres by road transport if the price difference exceed roughly 20 euro per ton, which is due to its low price- to-weight ratio, that does not apply to clinkers.11 In fact, exportation of clinkers from Mo- rocco and Egypt to Spain was substantial during the construction boom in Spain.12 China also mainly exports clinkers and not final cement (see also below).

11 Climate Strategies (2007) 12 Ponssard (2006)

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Table 2.2: Splitting up the vertical value chain and tradability issues Product The most energy/GHG intensive Trade issues part of the production process The raw material input for cement is abundantly available in Cement Clinkers most parts of the world. This, combined with a low price-to- weight ratio, which leads to high transport costs, makes cement less exposed to international trade. Only 6 % of the global production is traded international. The transport costs for cement is around 15 % of the product price pr. 100 km.

Both iron and steel is widely internationally traded. 40 % of Steel Semi-finished products such as long and global production is internationally traded. flat products, ie. steel plates and rods High trade intensity. Aluminium has a high price-to-weight Aluminium Semi-finished products for cables, pro- ratio, which negligees transport costs in end prices. 77 % of fils, etc total production is internationally traded and production is most often placed near access to cheap electricity Source: CE Delft (2008), IEA (2008a) and Neuhoff et al. (2004)

Time horizon While estimates of direct costs effects from carbon pricing fall within a reasonable narrow margin, there is much more uncertainty about long term effects on costs and production.

This reflects a variety of factors. All these industries are capital intensive, so they may stay in business as long as marginal costs are below sales prices while holding back on reinvestment. However, these industries are also very much globally integrated with prices set in international markets and with the major firms disposing of plants across the globe.13 In the pres- ence of spare capacity, they may shift production more rapidly to the region with the lowest carbon costs.

Leakage materialises slowly so the time horizon is of great importance. If taxes are relatively moderate, we may have to wait several years before the new financial restraints lead to closure or outsourcing.

Relative efficiency in production The main point here is that final emissions will also depend on the difference in energy efficiency between taxed and non-taxed regions. If the high tax region is relatively more energy efficient than the low-tax region, we will see an increase in total CO2 emissions for each unit production that is moved from the tax to the non-tax region and vice-versa. Some researchers have therefore reached leakage rates exceeding 100 percent, e.g. in the case of Swedish CO2 taxes a leakage rate of 114 percent has been estimated 14 .

A related argument refers to technology transfers and their potential to reduce the level of carbon leakage abroad.15 If the region experiencing a cost increase is more technologically

13 IIEJ (2008a, 2008b) 14 Nilsson (1998) 15 Barket et al (2007)

18 Carbon leakage from Danish energy taxation

advanced, it is asserted that this (fuel-efficient) technology will be spread to the low-cost regions; not only for the specific production processes, but in general to all production. If this effect is very strong, leakage may even become negative. There are several qualifications to such conclusions. First , relocation must be driven by FDI (Foreign Direct Investment), not closure due to competitive pressures. Second , the firm must face a financial incentive in the new country to deploy its technology that may only be economically viable with high taxes. Third , there will be extra costs of educating employees in the new country in order for them to smoothly shift technology. Keeping these caveats in mind, we therefore conclude that additional technology transfers driven by higher tax rates in home country are limited. Indeed, a firm with production locations in two countries may opt to move production to the low tax country rather than spend resources on innovation in the home country.

2.3. LEAKAGES ESTIMATES From an empirical point of view there are basically two ways of assessing the degree of leakage: (1) through analysis of historical data on location of production or (2) through economic model assessments based on assumed behaviour. The first approach typically looks at imports of certain energy-intensive goods (production from outside) or the location of energy-intensive firms, e.g. in terms of FDI or asset values before and after the implementation of specific environmental policies. Below, we will look at the results from both the statistical and the model approach.

Starting with evidence based on historical data, we find statistically significant estimates of the import elasticity to increases in environmental compliance costs. 16 Thus, higher local compliance costs decreases local production and increases the level of imports. Yet, the size of these estimates may multiply by a factor 10 or more when we look at footloose industries.17 It is found that the mobility can rise by a multiple of approximately 4 for industries with low transportation costs, and similarly a multiple of 4 for processes with few fixed plant costs. 18 In other words, processes that consume only a quarter of the energy consumed by cement production can be equally exposed to carbon leakage, if transportation costs are low. If, in addition, fixed plant investments are low, the energy consumption rate could drop to just 1/16 while still being trade exposed at the same level. This evidence underlines the fact that a proper leakage discussion will not focus exclusively on cement and steel, but keep a broader scope. We should note that the EU directives considering tax differentiation for industries with significant risk of carbon leakage adopt a measure for outward mobility, although rather imprecise, which is the degree of exposure to imports.

Turning to the macro estimates of leakage rates, we conclude that carbon leakage seems to be sufficiently high that policy makers should care . Typical macro estimates with conservative assumptions lie in the range of 10-50 percent for large geographical areas. 19 These esti-

16 Ederington and Minier (2003), List and Co (2000) 17 Ederington et al (2003) 18 Ederington et al (2003) 19 Barker et al (2007), Szabo et al (2006), Demailly and Quirion (2006)

19 Carbon leakage from Danish energy taxation

mates either come from calculations based on compliance with Kyoto targets (developing countries versus Annex 1 countries 20 ) or from ETS compliance (EU countries vs. rest of the world). However, we emphasise that a large uncertainty is attached to these estimates as long run competition effects require long periods to materialise.

A second and very important conclusion is that carbon leakage is more likely the smaller the geographic scope of the tax .21 Carbon leakage will not exist if all countries of the world commit to common instruments, whereas smaller regions or countries will see large leakage rates. This is, e.g., borne out by a recent study from the OECD where different abatement regions are compared 22 with leakage rates declining from nearly 100 per cent in the case of unilateral climate policies in small EU countries to nearly 0 if all countries with formally binding reduction commitments (Annex 1 countries) jointly pursue climate policies with equal carbon prices cf. table 2.3.

Table 2.3: Link between size of abating region and leakage rates Region Model Leakage effect

Small European country Average of below 1,01 Denmark CECLM 0,88 Sweden GEM-E3 1,14

Europe Average of below 0,44 Europe CTC 0,7 Europe WorldScan 0,17

OECD Average of below 0,18 OECD MIT-EPPA 0,2 OECD GEM-E3 0,16

Annex I Average of below 0,10,10,1 Annex I GTAP-E 0,04 Annex I MS-MRT 0,16 Source: The estimates derive from different models (names not shown in figure): GEM-E3 and GEM-E3-SE are different versions of the same CGE model sponsored by the European Commission. CTC is a partial equilibrium model set out by Ponssard and Walker (2008). CECLM is our own Copenhagen Economics Car- bon Leakage Model. The World Scan is a dynamic CGE model developed by the CPB in the Netherlands. MIT-EPPA is a CGE developed by researchers at the MIT. GTAP-E is a CGE model based on the GTAP research project. The MS-MRT is a CGE model used in Bernstein et al (1999). H

Leakage estimates are sometimes criticised for being too low. One would suspect that the ab- sence of China and other fast growing BRIC countries in the Kyoto agreement would entail serious leakage risks given the tradability of the leakage products. Moreover, indirect leakage from lower prices of fossil fuels should have a marked effect given non-annex 1 countries future share of energy production. Yet, in a very recent OECD study, there is no effect of

20 Annex 1 countries with formal reduction targets include for example EU countries, Japan as well as some other high to medium income countries while US have no formal target. Countries with no formal abatement commitments include all emerging and developing countries. 21 See also OECD (2008) 22 OECD (2008), ECO WP 658

20 Carbon leakage from Danish energy taxation

bringing these countries into a global system with common pricing of greenhouse gas emissions as apparent from Table 2.4.23 Reading from the top, carbon leakage from an EU perspective becomes zero or even negative if Annex 1 countries (including here USA) commit to common instruments. Moving down one more line, we see that adding Brazil, India and China into a global agreement with common CO2 prices do not affect estimated leakage rates significantly.

Table 2.4: Leakage effects under alternative scenarios, 50 % reduction of GHG by 2050 Regions acting Leakage rates 2020 2050 EU 13 20 Annex I 0 1 Annex I + Brazil, India and China -1 0 Note: Energy intensive manufacturing is defined as chemicals, metallurgic, other metal, iron and steel industry, paper, and mining products Source: OECD (2008), ECO WP 658

This obviously cannot be true given the large share in manufacturing products of these countries. The fastest growing producers in the classic leakage industries of steel and cement in recent years are exactly India and China, which together accounted for roughly 35-45 percent of global production in these two areas in 2006 cf. figure 2.1.

The underlying factors behind the very low leakage rates are the typical modelling approach. They embody assumptions of relative modest external trade price elasticities and imperfect competition that fits oddly with the characteristics of these industries. 24 Moreover, they also tend, as described above, to be based on sector aggregations that miss out on the importance of the concentration of energy consumption within a few industries with very high levels of energy use.

23 OECD (2008) 24 In OECD (2009), export price elasticities for energy intensive industries in the various global regions in the range of 3 to 4 are used. It implies that a 10 percent price increase relative to competitors lead to a fall in volumes of 30 to 40 percent. While relatively high, it should be recognised that within these industries we have pure commodity production such as steel etc. where long term price elasticities are likely to be even larger. On the other end, there is a study from Cambridge Economtrics (2007) focusing on carbon leakage, where it is assumed that export price elasticities even for energy-intensive industries are below 1, so that a an increase in export prices of 10 percent lead to a fall in export volumes of below 10 percent. In fact, this price elasticity is so low that countries would benefit from implementing export tariffs as the fall in volume of sales would be more than compensated by rising prices leading to a net improvement in the current account and firm profits.

21 Carbon leakage from Danish energy taxation

Figure 2.1: Regional distribution of steel and cement production Panel A Increases in production for six major coun- Panel B Shares of production for six major countries tries and regions, 1997-2006 and regions, 2006 20 90 80 15 70 60 10 50 40 5 30 20 Japan 10 0 India USA China Russia European 0 Union Steel share of world Cement share of world -5 production, pct. 2006 production, pct. 2006

Steel Cement China EU Japan USA Russia India

Source: World Steel and Cembureau

2.4. SUMMING UP • Energy-intensive firms face various options in order to reduce the implications of environmental taxation in the region, in which it is situated. • One option is to stop producing in the region. The profitability of this strategy depends on a number of factors, which we denote leakage drivers. • Carbon leakage is a real risk and its severity is closely related to the geographical scope of the environmental policy. • Large unilateral environmental taxes in one of Europe’s smallest countries can be characterised as a highway to carbon leakage. • The risk of carbon leakages may be underestimated by the use of a too aggregated approach to industries and failure to include long term impact

22 Carbon leakage from Danish energy taxation

Chapter 3 EFFECTIVE MEASURES TO AVOID INDUS- TRIAL CARBON LEAKAGE

This chapter is devoted to a general discussion of how to prevent carbon leakage from taking place through legislative measures. We will, in section 3.1, look at how EU legislation has implemented such preventive features. In the second section 3.2, we look at the highly relevant issue of delineating products and processes correctly in order to protect the right production processes.

3.1. MEASURES TO AVOID CARBON LEAKAGE IN EU LEGISLATION One of the basic principles of EU legislation on energy taxation and CO2 allowance allocation is differentiability of mobile, internationally competitive, and energy-intensive processes versus immobile, local processes. The former is likely to be displaced – either in form of extra-European gains of market shares or firm relocation out of the EU – if end user energy prices and thereby production costs becomes too high. This production displacement obviously also causes emissions displacement. To avoid such carbon leakage several measures have been included in the relevant directives (ETS directive and Energy Tax directive), which constitute the framework for national implementation of energy and environmental taxes (see box 3.1). In this section, we try to describe how.

Box 3.1 Key features of the EU’s Emission Trading System (ETS) and Energy Tax Direc- tive The EU ETS is the largest multi-national, emissions trading scheme in the world and is a major pillar of EU’s climate policy. The ETS currently covers more than 10,000 installations with a net heat excess of 20 MW in the energy and industrial sectors, which are collectively responsible for close to half of the EU's emissions of CO2 and 40 percent of its total greenhouse gas emissions. The scheme is based on Directive 2003/87/EC, which entered into force on 25 October 2003 and covered both Phase I (2005-07) and Phase II (2008-12) of the program. New regulatory material will be introduced for Phase III (2013-20) and from 2013 an explicit carbon leakage list will be introduced.

The existing Energy Tax Directive (ETD) 2003/96/EC started as an internal market harmonisation instrument. Its main target was to eliminate fuel tank tourism, as witnessed by the fact that the only minimum tax rates foreseen were those applying to oil fuels (excluding international aviation and shipping). Coal and electricity minimum tax rates were introduced, but at rather low levels. The energy Tax Directive now stands up to a forthcoming revision. Source: European Commission and Paleokrassas (2010)

In the EU, two legislative measures have been taken to introduce costs for emitting pollut- ants. The legislation is mainly focused on CO2 and other greenhouse gases (GHG). They are (i) the “ETS Directive” 25 , setting the rules for the EU ETS, and (ii) the so called “Energy Tax Directive” 26 . Both these legislations acknowledge the risk of carbon leakage and therefore provide opportunities for exemption for sectors with high risk of carbon leakage. The two directives are linked through a paragraph 27 in the Energy Tax Directive. It states that member states may apply reduced tax rates to electricity used in sectors covered by the ETS.

25 Directive 2003/87/EC of the European parliament and of the council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community. 26 Council directive 2003/96/EC of 27 October 2003 restructuring the Community framework for the taxation of energy products and electricity 27 Paragraph 17b

23 Carbon leakage from Danish energy taxation

The exemptions or reduced burden from these directives do not eliminate the risk for carbon leakage. First of all, sectors that do not qualify for exemption or reduced burden may still be at risk for carbon leakage, only to a lesser extent than the exempted sectors. Second , receiving free allowances in the ETS will for most installations still pose a cost since the allocated allowances mirror the emissions of a very efficient installation, the rest of the allowances have to be bought in the market (or investments in abatement must be made). Third, there is no compensation for indirect effects through increased electricity prices as a consequence of the ETS. So even with free allowances and exemption from energy taxes, installations consuming electricity produced in the EU will still be worse off than before the ETS compared to installations that consume electricity produced outside of the EU.

Below, in Table 3.1, we present a simple comparison of the leakage relevant exemption criteria in the two directives. There are three different types of criteria: specific sectors, quantitative criteria, and qualitative criteria. As the ETS directive only applies to certain sectors, it is not very meaningful to list sectors that are exempted, which is why we leave this category empty. The most interesting is the comparison of quantitative criteria; here, the ETS Direc- tive attempts to include the two main leakage drivers “costs from taxation” and “foreign competition”, while the Energy Tax Directive focuses entirely on the former. Yet, both directives have different doors open. Note that the qualitative criterion (h) under the Energy Tax Directive establishes the link between the two directives. Below, we introduce the two directives in more detail.

Table 3.1: Leakage relevant exemption criteria in the ETS and the Energy Tax Directive Revised ETS Directive Energy Tax Directive Specific criteria/sectors (a) electricity and navigation on water shall be exempted (b) motors and machinery used in construction, civil engi- neering, and public works may be exempted Quantitative criteria (a) an increase of production costs of at least 5 % and the in- (c) energy costs amount to at least 3 % of the production tensity of trade with third countries is above 10 % value or or (b) an increase of production costs of at least 30 % (d) energy tax amounts to at least 0,5 % of the value added or (c) the intensity of trade with third countries is above 30 % Qualitative criteria (d) the cost of reduction (e) development of more environmentally-friendly products (e) current and projected market characteristics (f) products are made up of, e.g., biomass (f) profit margins (g) agreements are concluded (h) tradable permits and equivalent arrangements apply Source: Copenhagen Economics

The ETS directive The ETS directive dictates the functioning of EU’s cap-and-trade system, ETS. Fundamen- tally, it works through a politically decided cap on emissions and a market mechanism that should ensure that abatement takes place where it is most cost-efficient. The direct effect of the ETS directive is that emissions become associated with a cost; if you emit you must buy an allowance to emit (or forgo the opportunity to sell an allowance). This price on emissions

24 Carbon leakage from Danish energy taxation

increases production costs, while it gives incentives to cut emissions,. Hence, it increases the risk of carbon leakage.

However, to avoid carbon leakage, sectors and subsectors with a “significant risk of carbon leakage” are given free emissions allowances 28 , while other sectors will have to buy some or all of their allowances through an auction . The ETS directive explicitly states the prerequisites for a sector or subsector to be judged as having a “significant risk of carbon leakage”. A sector that is emission-intensive, i.e. would have significant cost increases due to the ETS directive and at the same time is subject to significant trade with third countries, will be deemed as having a significant risk of carbon leakage. Sector and subsectors that are either very emission-intensive or highly exposed to trade with third parties will also receive free allowances.

The energy tax directive The energy tax directive forces member states to implement minimum tax rates on some energy products, basically motor fuels, heating fuel, and electricity. 29 The purpose of the legislation is twofold. Apart from environmental protection it is also a way of improving the functioning of the internal market. Since the directive prescribes certain minimum tax rates it also introduces certain minimum costs of using energy products and electricity. This obviously introduces a risk for carbon leakage. However, certain products and processes are exempted from the directive or may be taxed with reduced rates.

The directive does not apply at all to some products and processes. Explicitly mentioned in the directive as exempted are e.g. chemical reduction processes, mineralogical processes and metallurgic processes. The directive also sets out a condition that disqualifies products from being covered by the directive; electricity is not subject to the energy tax directive when it accounts for more than 50 percent of the cost of a product.30 The consequence of this condition is that products with high energy content are exempted; this mitigates the risk of carbon leakage.

3.2. DELINEATING PRODUCTS AND PROCESSES WITH RISK OF CARBON LEAKAGE This section is mainly concerned with the leakage driver “ability to split and outsource production processes”, and how this should have implications for the quantitative criteria in legislation. In particular, we are interested in the industry/process level of detail. Having a broad industrial classification to assess cost increases from environmental taxation implies averaging potentially very different production processes, some of them being highly energy- intensive and others not. Depending on whether the average falls below or above the relevant

28 The allowances are free but not unlimited. The number of free allowances allocated to a specific installation is based on a benchmark consisting of the top 10 percent as regards efficiency in the sector or subsector. 29 The coverage of the directive is defined in article 1 and 2. 30 Article 2(4), the concepts cost of a product and cost of electricity are defined as follows: ‘Cost of a product’ shall mean the addition of total purchases of goods and services plus personnel costs plus the consumption of fixed capital, at the level of the business, as defined in Article 11.This cost is calculated per unit on average. ‘Cost of electricity’ shall mean the actual purchase value of electricity or the cost of production of electricity if it is generated in the business,

25 Carbon leakage from Danish energy taxation

threshold from legislation, we may therefore either tax leakage exposed processes or exempt non-exposed processes.

We have tried to illustrate this point in Figure 3.1, where the paper industry is disaggregated more and more as we read from left to right. Thus, the aggregated industries are the columns to the left. Then, in order to demonstrate the effects of aggregating very diverse underlying industries, we have drawn a line from the relevant column into the more disaggregated cate- gories to the right The figure clearly demonstrates that two different production processes, although closely related in the value added chain, can have very different energy intensities and thereby very different exposure to carbon leakage.

Figure 3.1: Energy costs per value added across different paper processes

60 NACE NACE NACE NACE NACE 0 1 2 3 4 50

Source: Eurostat, Structural business indicators

We may push this point even further. Now take the highly energy-intensive NACE 3 category, “Manufacture of pulp, paper, and paperboard”, from Figure 3.1. From this, we can focus entirely on paper production. Largely speaking, the production of paper consists of 10 different steps as outlined in Figure 3.2, and the figure shows which steps are most energy consuming. Thus, to the extent that the intermediary product is not too costly to transport over the relevant geographical area, we may therefore experience a split of production with the most energy intensive processes moving away from the tax area. 31

31 Obviously, paper production is also heavily dependent on availability of inputs, in particular wood. Since wood is rather expensive to transport, this puts some restraints on the possibilities to split.

26 Carbon leakage from Danish energy taxation

Figure 3.2: Process consumption shares of energy in the production of paper

35%

30%

25%

20%

15%

10%

Note: The processes cover the entire paper production chain and the shares therefore sum to 100 percent. Source: Eurostat, Structural business indicators

The importance of getting the right level of disaggregation is not restricted to the paper industry. Rather, it applies to a number of other industries. Figure 3.3 illustrates this by looking at highly energy intensive industries, evaluated at the NACE 4 level. For each time, these industries are merged into a larger industry grouping, i.e. from NACE 3 to NACE 2 to NACE 1, the share of carbon costs in total production is reduced. This is the result of the parent headings of NACE sectors containing a wide spread of products with different manufacturing characteristics and different energy content in their production. An example: production of “enzymes” (NACE 4 level) has a share of CO2 costs exceeding 5 percent. How- ever, it is part of a wider industry group at NACE 3 level, where the cost are “only” 2 percent and being yet lower at the NACE 2 and NACE 1 level.

27 Carbon leakage from Danish energy taxation

Figure 3.3: CO2 costs share of value added for selected energy intense industries, evaluated at € 30 per tonne.

Cement Cement > 60 pct. For NACE 4

Tiles

Enzymes

Paper

Sugar and sweeteners

Starch

Mineral wool

Proteins

Fishmeal and fish oils

Industrial liquid gasses

0 1 2 3 4 5 6 7

NACE1 NACE2 NACE3 NACE4 Note: For cement data stems from selected Danish representative firms’ public reports for NACE 4 and NACE 3, as official data does not cover these due to confidentiality. Where NACE3 and NACE numbers are not shown, this is due to the fact that the product is a NACE-heading itself. Source: Copenhagen Economics based on Danmarks Statistik

The importance of delineation relative to assessment of risk of carbon leakage can also be demonstrated via the criteria for allocations in the ETS directive. Taking our point of depar- ture from the quantitative criteria in the ETS Directive, c.f. Table 3.1, we can draw up these in a two-dimensional diagram, as shown in Figure 3.4. Remember that the ETS Directive will provide free allowances to industries with high energy costs, high trade intensities, or a combination of both, so that industries to the North-East of the dashed line are eligible to free allowances. Apart from visualising the directive, the figure also demonstrates the delineation problem when comparing the top and the bottom panel. In the top panel, we find the beverage industry (highlighted) outside the scope of free allowances, but when disaggregated more narrowly some beverage products actually fall within the scope of free allowances as shown in the panel below.

28 Carbon leakage from Danish energy taxation

Figure 3.4: Selection of free allowance industries, EU ETS

35 30 euro / ton CO2 costs share of GVA

5 159 Beverages

Trade intensity 0 0 10 20 30 40 50 60 70 80 90 100

35 30 euro / ton CO2 costs share of GVA

1592 Ehtyl alcohol 1597 Malt 5

1591 Distilled portable 1598 alcoholic beverages Trade intensity 1596 0 0 10 20 30 40 50 60 70 80 90 100

Source: Eurostat, Structural business indicators and Comtrade

3.3. SUMMING UP • The risks of industrial carbon leakage are reflected in both the directive on the Emission Trading System and the Energy Tax directive. • The approaches differ, though, with ETS taking into account both trade exposure and energy cost increases from the implementation of the ETS, while the Energy Tax Directive allows for reduced national rates if they result in total energy costs exceeding some threshold levels with no regard to trade exposure. • We recommend an approach in regulation that looks at both the importance of energy costs and trade exposure as in the ETS. It has the largest success in reaching the right balance between two undesirable results: carbon taxing lead to too high

29 Carbon leakage from Danish energy taxation

levels of carbon leakage and industries with low risks of carbon leakage receiving costly transfers that has to be financed by distorting increases in taxes.

30 Carbon leakage from Danish energy taxation

Chapter 4 ENERGY TAXES IN DENMARK AND SOME OTHER EU COUNTRIES

The size of industrial leakage from energy taxation in Denmark depends inter alia on the level of Danish energy taxes relative to tax rates applied to the foreign competitors. Hence, in section 4.1, we review the changes in energy taxes facing energy intensive industries in Denmark, following the (revised) 2009 Tax Reform. Second, we compare in section 4.2 these energy tax rates with rates applying in some other European countries.

4.1. EFFECTS OF THE 2009 TAX REFORM FOR ENERGY INTENSIVE INDUSTRIES A main ambition behind the 2009 Tax Reform was to lower income taxes in order to increase labour supply as well as pursuing environmental goals.32 With the tax act of June 12 2009, the implementation of the so called Tax Reform Package 2009 (Forårspakke 2.0), saw significant cuts in marginal income taxes partly financed by higher taxes on energy.

The initiative is a historic milestone in Danish energy taxation for energy intensive industries, as summarised in table 4.1. While the table is a highly stylised representation of environmental/energy taxation for industry processes 33 , it does convey the main messages of the new taxation regime. For non-ETS companies, taxation on energy used for industrial processes (e.g. not heating, lighting or transport) basically consists of two elements: CO2 taxes and energy taxes (either fuel or electricity). Essentially, what the table tells is that energy was previously (pre 2010) taxed at 11.5 kr/GJ in total, while the current effective rate now in 2010 has increased to 16.0 kr/GJ in case of fuels; an increase of around 40 percent. In 2012, this will increase to 19.5 kr/GJ or around 70 percent increase from the initial situation.34 For electricity, the effective tax rate, including CO2 taxes, decreases from 27.5 kr/GJ in 2009 to 24.4 kr/GJ in 2010 due to a significant reduction in the CO2 tax on electricity.

32 See Skattekommissionen (2009) 33 For example, CO2 taxes are not levied at energy content (GJ), and taxation also differ according to use (heating vs. production). Moreover, there exist some relevant leakage related exemptions that may reduce the effective rates. 34 In fact, the original Tax Reform Package 2009 (Forårspakke 2.0) prescribed an even larger increase of 15.0 kr/GJ in 2015 resulting in a total fuel tax of 26.5 kr/GJ.

31 Carbon leakage from Danish energy taxation

Table 4.1: Energy tax rates, industry process energy Rates as applied in Rates as applied in Old regime Revised Tax package Tax package 2009 2009 Tax, Kr. / GJ. 2009 2010 2012 Fuel: Energy taxation, fuel 0 4.5 8 CO2 taxation, fuel 11.5 11.5 11.5 Electricity: Energy taxation, electricity 2.8 7.2 7.2 CO2 taxation, electricity 24.7 17.2 17.8 Note: The table shows effective standard rates in the relevant year of introduction. The 2012 rates are lowered in the revised tax package 2009, compared to the original planned rates in tax package 2009. Source: Danish Tax Ministry, Brøns-Petersen (2009)

The revised Tax Package 2009 still operates with rising energy taxes from 2012 onward, but at a lower rate than the original proposed Tax Package 2009. Technically, what has been introduced with respect to industry energy taxation from the Tax Package 2009, apart from the increase in fuel/electricity rates, are the following:

Duties on energy used for heat to be increased by 15 percent and application of the same rate on energy used for cooling. Yearly indexation of energy duties. Decrease in the possibility of deduction and phasing out of deductibility in line with reductions in ETS grandfathering. Duties on other greenhouse gases than CO2 are increased to the level of CO2 taxation.

In Table 4.2, we demonstrate the difference in effective CO2 taxation between the old tax regime and the new tax regime in more detail. First of all we note that the effective increases are substantial in terms of percentage changes – 10 to 15 percent for the most important energy sources – especially given the fact that Denmark already belongs to the countries taxing energy most heavily. We will demonstrate this claim in the next subsection.

32 Carbon leakage from Danish energy taxation

Table 4.2: Energy and CO2 taxation in old versus new tax regime, kr per ton CO2

Energy source CO2 taxation 2020 Tax reform Package 2009 Old tax regime (Forårspakke 2.0) Abs. change Pct. change Heat - not combined w. electricity 1,140 1,140 0 0% Heat - combined w. electricity 1,358 1,509 151 11% Natural gas 1,028 1,169 141 14% Fuel oil 820 929 109 13% Electricity - individual heat 3,200 3,594 394 12% Electricity – other 3,501 3,910 409 12% Gasoline 1,746 1,746 0 0% Diesel – transport 1,144 1,144 0 0% Diesel – agriculture 95 95 0 0% Agriculture - other GHG 0 0 0 0% CO2 allowance price 225 225 0 0% Note: The figures apply for households and industries with no possibilities for deductions. Source: Copenhagen Economics based on Danish Energy Agency and Danish Tax Ministry

4.2. COMPARISON OF ENERGY TAXATION ACROSS EUROPEAN COUNTRIES In this section, we will demonstrate that Denmark already before the introduction of the new tax regime was an outlier in terms of energy taxation. There are basically three methods of assessing energy taxation levels across countries:

Comparison of aggregate energy tax revenues Comparison of specific rates Comparison of tax payments for specific energy uses

The first method – aggregate country energy tax revenues – is on the one hand more complete as it averages out, e.g., differences among fuel types, exemptions etc. and looks at the de facto energy tax burden. On the other hand, it is typically difficult to retrieve relevant data at the industrial level. In Figure 4.1, we compare aggregate energy taxation burdens – measured as energy tax revenue relative to GDP – among OECD countries. We observe that in 2007 Denmark had by far the highest energy tax burden in the OECD and therefore (probably) also in the entire world. The problem with this measure for our purposes is that households are also included, so we cannot conclude that the industrial burden is also the highest in absolute levels. However, these things often go hand in hand, so we can use it as indirect evidence .

33 Carbon leakage from Danish energy taxation

Figure 4.1: Energy taxation revenue as percentage of GDP, 2007, OECD countries

Denmark 4.59%

EU High average (NL, PT, FI, CZ) 3.04%

Korea 2.81%

Norway 2.78%

EU Middle, average (SE, HU, LU, IE, AT, UK, DE, FR, SK) 2.50%

Iceland 2.49%

Australia 2.01%

Switzerland 1.98%

Japan 1.67%

EU Low, average (BE, GR, IT, ES, PL) 1.55%

Canada 1.12%

New Zealand 1.10%

United States 0.81%

Mexico 0.61%

0% 1% 2% 3% 4% 5%

Energy taxation revenue as pct of GDP

Source: Copenhagen Economics based on IEA data

Turning to the second method – comparing specific energy tax rates – most of the caveat consists of putting things on the same footing. Some countries may have high rates but extensive exemptions, while others may have a standard low rate applicable throughout the entire industry.

Keeping the focus on the Danish classification of energy used for industrial processes, we must start by distinguishing between fuel types. Here, we focus on diesel oil, natural gas, and electricity. Also, we should exclude sectors/-companies directly subjected to the ETS system, as they are typically exempt. With these qualifications, we can observe that Denmark ranks high in terms of applicable tax rates on all three fuel types among nine (high-tax) European countries, c.f. Figure 4.2. The figure actually reveals that Denmark is the only country where substitution between energy types does not constitute a viable way of tax avoidance. A few countries have quite high rates for specific fuel types – Germany for natural gas and Poland for diesel oil – but they typically have close to zero rates for other energy types. In Sweden, France, and Italy, there is practically no taxation of energy used for production processes. Al- together, we must therefore conclude that Danish industrial companies will face significant energy tax bills compared to their international competitors.

34 Carbon leakage from Danish energy taxation

Figure 4.2: Industry process energy tax rates, non-ETS companies, 2010

DKK/GJ

0 Denmark Sweden Norway Finland Germany France Netherlands Polen Italy

Diesel oil Natural gas Electricity

Source: Deloitte (2010)

Turning to the third method – comparison of tax payments for specific production cases - we set up two examples. One example concerns a moderately energy intensive production process (plastics) and the other example is highly energy intensive (malt production). 35 The assumptions on energy use are provided in Table 4.3. In this case, it is primarily the consumption of natural gas that distinguishes the energy intensive process (malt), as it consumes more than 10 times as much as the moderately energy intensive plastics production. Electric- ity consumption is actually slightly lower for malt.

Table 4.3: Energy consumption of specific plastics and malt processes Energy type Plastics Malt Natural gas 0.9 m Nm3 9.8 m Nm3 Electricity 22.6 m kWh 15.1 m kWh Source: Deloitte (2010)

Applying the respective country energy tax rates (including deductibility provisions) produces the picture shown in Figure 4.3. Concerning production of plastics, the Danish state will collect the (by far) highest tax revenue per unit of production in our sample of nine countries. When it comes to the more energy-intensive malt production, we are roughly in line with our Scandinavian neighbours (Norway tops ahead of Denmark), but still significantly above tax payments in other European countries.

35 Both examples are described in more detail in Deloitte (2010).

35 Carbon leakage from Danish energy taxation

Figure 4.3: Tax payments for plastics and malt across nine countries, 2010 Mill. DKK 6

5.19 5

4.06 4 3.61

2.07 2 1.86

1.10 0.87 0.96 0.87 1 0.82 0.59 0.54 0.55 0.39 0.18 0.09 0.00 0.00 0 Denmark Sweden Norway Finland Germany France Netherlands Polen Italy

Plastics Malt

Note: The tax payments take into account national tax rules including possibilities for refunding and deductions. Source: Deloitte (2010)

As can be seen, we build our analysis around current tax rates. Obviously, when we turn to leakage, the question is whether future rates are significantly higher in Denmark. Leakage materialises slowly (as explained above) and investment decisions are based on future payoffs. However, we will attempt to avoid setting up speculative scenarios of how Danish and international rates look like, and we therefore base our assessments on current rates.

4.3. SUMMING UP • The 2009 Tax Reform package, despite some roll-back, has led to increases in tax rates for energy intensive industries which may be increased further in the coming years towards 2013 • The changes will consolidate Denmark’s position as a country with high levels of effective tax rates for energy intensive industries unless corrective action is taken

36 Carbon leakage from Danish energy taxation

Chapter 5 EFFECTS FROM DANISH ENERGY TAXES

In this section, we will look into the economic and climate effects of the 2009 Tax Reform. In particular, we will estimate the impact on energy-intensive industries both in Denmark and the rest of the world. First , we provide some basic information about the energy intensive industry in Denmark and compare it with the same industries in other EU countries, focusing on energy and trade intensity as well as CO2 intensity in production (section 5.1). Second , we provide some estimates of the global effects of CO2 emissions from higher Dan- ish energy taxes on these industries, taking into account carbon leakage (section 5.2).

5.1. ENERGY -INTENSIVE PRODUCTS IN DENMARK AND EU We focus our interest on energy intensive manufacturing production, because that is where carbon leakage is highest due to high cost shares for CO2 and high foreign trade exposure, as explained in chapter 2. Indeed, energy intensive industries account for 3.5 percent of total emissions but only 0.9 percent of value added. By contrast, they account for roughly 3½ percent of total CO2 emissions in Denmark cf. Table 5.1. The high ratio of emissions to value added for the energy intensive industry is reflected in a high CO2 cost share: the CO2 cost share for the energy intensive industries is 4 percent compared to 1 percent for the rest of the economy. At the same time, trade exposure for these industries, as measured by trade intensity, exceeds 100 percent while it is below 50 percent of the economy as a whole.

Table 5.1: The energy intensive industries in perspective Structural importance Leakage drivers Share of CO2 emis- Share of value Cost share of CO2 Trade intensity (%) sions (%) added (%) (%) Energy intensive in- 4 1 4 107 dustries Rest of economy 96 99 1 45 Note: The energy intensive industries are defined from the product list in the appendix and includes enzymes , industrial gasses, plant protection products, proteins, bread, sugar and sweeteners, mineral wool, tiles, plastic, paper, chipboard, flour, fishmeal and fish oil, and cement. "Rest of economy" covers CO2-emissions from businesses. For trade intensity "Rest of Economy" covers the entire economy. Trade intensity is calculated as "(Import + export) / Production + import)" Source: Copenhagen Economics based on Danmarks Statistik

While CO2 intensity in production is high for these sectors, it is none-the-less smaller than in the same industries in other EU countries. For 6 of out of 13 industries, the costs shares of CO2 measured at a common price of carbon are substantially lower in Denmark, cf. Fig- ure 5.1. For the remaining 7 groups, they are roughly equal for 5, with EU competitor firms being only significantly more efficient for two groups. As a whole, the data indicate that Danish firms within these industries are 18 percent more efficient in using fossil fuels than their competitors.

37 Carbon leakage from Danish energy taxation

Figure 5.1: Danish vs. EU, CO2 cost shares of value added with 30 € CO2 tax Pct.

Enzymes Industiral liquid gasses Plant protection products Proteins Bread Sugar and sweeteners Mineral wool Tiles Plastic Paper Chipboard Flour Fishmeal and fish oils

0 2 4 6 8 10 12 14 16 DK CO2 Costs EU CO2 Costs

Note: This is a NACE 4 level comparison. The figure shows the tax induced cost increase with a 30 € CO2 tax as a share of gross value added in the industry. Source: Copenhagen Economics based on Statistics Denmark and EC (2010)

We have excluded cement from figure 5.2, as comparable data for “CO2-efficiency” do not exist at the EU. For Denmark, this is a highly important sector constituting nearly 17 percent of total CO2 related emissions from manufacturing and just above 50 percent of the energy intensive industries (as defined in appendix B). Available evidence suggests that Dan- ish and EU production are equally effective in producing grey 36 cement as regards CO2 emissions, cf. Box 5.1.

Box 5.1: Cement - another example of the importance of a disaggregated view Cement is not included in the above figure based on NACE statistics: both white and grey cement is covered under the same NACE code while CO2 emissions from white cement are 45 percent higher than from gray cement. As Denmark has a share of 33 percent for white cement against 4 percent in the EU, comparing average CO2 emissions would lead to a bias in the relative efficiency measures to the detriment of Danish relative performance. In fact, Denmark has very substantial exports of white cement to other EU countries.

For a fair and even comparison, we can look at the CO2 intensity in comparable gray cement products: for both Danish and EU firms, the costs of carbon price of € 30 per ton equals 61 percent of value added. Source: Copenhagen Economics based on Cembureau.

Moreover, trade intensity for Danish energy intensive producers is generally at the high end compared to EU competitors. As a rule, the smaller the country the larger the share of products being sold outside the domestic market and the larger the share of domestic consumption is being imported, c.f. Figure 5.237 . For large countries such as Germany, Spain, Italy and UK, trade intensity ratios are in the range of 0.5-0.8 while it is between 0.9 and 1.4 in Denmark, Sweden, Finland etc.

36 Grey and white cement are alike by all properties, except colour, where grey cement is less CO2-intense in its production. 37 The trade intensity is defined as (Imports + Exports)/(Production + Imports).

38 Carbon leakage from Danish energy taxation

Figure 5.2: Ratio of trade intensities for energy-intensive products for EU countries

0,5-0,9 0,9-1,4 > 1,4

Note: Energy-intensive products have been selected according to the list in Appendix 1, although correspondence was not perfect between NACE and GTAP. Trade intensities are defined as (Imports + Exports) / (Imports + Production). Source: Copenhagen Economics based on GTAP 6.0.

5.2. GLOBAL CLIMATE EFFECTS AND HIGHER DANISH ENERGY TAXES Given the structural characteristics of the Danish energy intensive industries as described above, higher energy taxes on these firms are likely to result in substantial carbon leakage. First , effects on costs are likely to be high given high energy intensity in production. Second , with very high trade exposure they will find it difficult to pass-on cost rises to domestic and foreign consumers due to foreign competition without substantial losses of market shares in global markets. As a consequence, we will see a lot of production moving out of Denmark, as opposed to reduced CO2 intensity in domestic production, driven by the higher energy costs. Third , as Danish producers tend to be more efficient in using energy, each unit of production moved outside Denmark leads to a net increase in global emissions. This is the whole discussion we had in chapter 2 about leakage drivers.

To analyse this more formally, we have set up a small leakage model that allows us to make an estimates of the degree of carbon leakage resulting from higher energy costs for energy intensive industries. Box 5.2 contains a short description of the model while appendix A provides full documentation.

Box 5.2: Main features of Copenhagen Economics Carbon Leakage Model (CECLM) The CECLM is a model particularly designed at estimating carbon leakage impacts. Our leakage estimate is based on a simple, partial representation of the European economy. We consider two composite goods, a

39 Carbon leakage from Danish energy taxation

final energy-intensive (manufacturing) consumer good and a composite fossil fuel good (leading to CO2 emissions). The consumer good is differentiated according to origin – Denmark or the rest of EU27 – while the fossil fuel good is homogenous. Thus, the price of fossil fuels is common across countries, but taxation may differ. Both goods are described by a supply and demand relation, and the interaction between the two goods markets comes from fossil fuel demand by the producers of energy intensive goods.

In our calculations of leakage rates, we treat demand, supply, and substitution elasticities equally across the two regions. Thus, there is no “bias” in our estimates due to, e.g., differential demand elasticities for Danish and EU goods. However, we utilise our knowledge of differential CO2 intensities in production. A full description of the model is provided in the appendix. 38

Based on the extensive information about CO2 intensities for different energy intensive products, we can form model based estimates of the leakage rate. The leakage rate is defined as the percentage of a local (Danish) CO2 reduction being substituted by foreign CO2 increases. Note therefore that there are two forces at work: (i) the size of an environmental tax decides how much is reduced, while (ii) the leakage rate quanti- fies the degree of substitution.

To check the robustness of our model we have checked results against Official Danish estimates of reductions of CO2 emissions on Danish soil. We find that results are comparable and that differences can be explained (see appendix A). The overall degree of leakage rates are comparable with results from other models reviewing carbon leakage for small, open economies for example Sweden, as shown in chapter 2.

Our model results confirm that carbon leakage can be substantial, as illustrated in figure 5.3. Here, we show the estimated effects on CO2 emissions both inside and outside Denmark of a 39 percent energy tax increase on energy intensive industries. We see a fall in domestic CO2 of roughly 30 percent of the emissions from Danish manufacturing industries. This is as such a rather large figure and actually exceeds the estimate from the Tax Ministry on domestic abatement. 39 Most of this results from a fall in worldwide demand for the products that are now more expensive due to higher Danish taxation, and a smaller part results from improved energy efficiency within the energy intensive industry; the two “abatement” effects in figure 5.3. However, the abatement in Denmark is almost completely offset by higher emissions outside Denmark as production is moving out and as foreign producers use more CO2 per unit of production than Danish producers; the two “leakage” effects in figure 5.3. The resulting leakage rate equals 88 percent: for every 100 tons of CO2 emissions being reduced in Denmark, they are increased by 88 tons outside Denmark.

38 Gerlagh and Kuik (2007) survey the carbon leakage literature and suggest that the model components used here provide the best representation of leakage dynamics. Furthermore, they survey the size of deep parameters, and we attempt to calibrate the model according to “median” values from their survey. 39 See appendix B.

40 Carbon leakage from Danish energy taxation

Figure 5.3: Emission effect of a 39 percent energy tax increase, manufacturing industries, Denmark and the EU27 Percentage change of total CO2 emissions from CECLM industries 40%

30% Higher CO2 intensity per unit output

20% Moving out of production

10%

Fall in worldwide demand for Net domestic products -10%

-20% Higher energy efficiency

-30%

-40% Note: CECLM industries consist of most energy-intensive industries together with a subset of more standard manufacturing industries. See Appendix B for further details. Source: Copenhagen Economics based on CECLM

Our model shows that total effect on Danish CO 2-emissions in the CELM-covered sectors is a 32 per cent decrease, cf. figure 5.3. This effect is due to a 19 per cent decrease in produc-

tion and the remaining 13% stems from increased CO 2 efficiency. The loss of production constitutes a 374 mio. Euros drop in Danish value added. The analysed sectors employs 33,000 people, so a 19 per cent decrease in production can be expected to result in 6,200 lost jobs in Denmark, cf. table

Table 5.2 Effect on production and employment from increased energy taxation DK effects

Change in CO2-emissions under CELM covered sectors -32%

Decomposition

Change in CO2-CO2 -efficiency--efficiency in CELM covered sectors 131313%13 %%%

Pct. Change in production under CELM covered sectorssectors ---19-191919%%%%

Loss in DK value added from production decrease -374 mio.

Loss of jobs in DK from production decrease 6200 Source: Copenhagen Economics based on CELM

To check robustness of results, we conduct model runs for two additional scenarios. In the first scenario we assume that Danish and EU producers have the same efficiency . Thus, carbon leakage only stems from the two standard economic mechanisms: competition in product markets and energy price reductions. In the second scenario, we make the assumption

41 Carbon leakage from Danish energy taxation

that all Danish producers are 25 percent more efficient rather than the estimated 18 per cent.

The results from the base and these two additional scenarios are shown in Figure 5.4. The baseline estimate – calculated on actual efficiency differences as retrieved from available statistics – was 88 per cent. The estimate drops to 85 per cent if we assume equal efficiency, and increases slightly to almost 89 per cent under the assumption of 25 per cent higher efficiency.

We have shown above that Danish energy taxation belongs in the higher end of the international spectrum. This should imply that Danish companies have incentives to streamline production towards higher efficiency. Thus, it is not unreasonable to assume that Danish companies are on average somewhere between 0 and 25 percent more CO2 efficient than their European counterparts.

Figure 5.4: Carbon leakage rates under different assumptions on efficiency Carbon leakage rate

0.89

0.88

0.87

0.86

0.85

0.84

0.83 Base Equal efficiency Denmark 25 pct more efficient

Source: Copenhagen Economics based on CECLM

Given the rather rough character of the model set-up, some qualifying remarks are required. First , we have not modelled derived consequences for changes in the demand for transport. As noted in chapter two, once CO2 costs exceed a certain level, it becomes profitable to transport cement from neighbouring countries rather than producing it locally with shorter travelling distances. So, if the final destination for the energy intensive products is Denmark, then increases in transportation related CO2 emissions should be added. Second , the model has relatively large effects on total worldwide demand for the energy intensive products concerned. This reflects that we have assumed that foreign products cannot fully substitute Danish products. We would argue that in the longer term most products can be entirely produced outside of Denmark. Hence, higher Danish energy taxes may have zero long term

42 Carbon leakage from Danish energy taxation

effects on global demand for the products and very limited effects on energy efficiency in Denmark, just causing carbon leakage. Third , our results hold only for marginal increases in energy taxes: both of the two above arguments suggest that substantial further increases in energy tax rates will lead to substantial increases in leakage rates.

Futhermore it should be noted, that even though the analysed sector is defined by energy intense industries, the effects may not be evenly distributed among the industries. Some of the industries are atomistic in nature, with high trade intensities and low Danish market shares. Such industries might be in risk of closing completely in Denmark, as a response to an increased energy taxation, if this results in prices going above a certain threshold value. Several of the analysed industries have high trade intensities, as seen in table 5.3, which renders them vulnerable to such effects. The Danish market shares 40 in these industries are typical small, around 0.5 – 2 per cent, which means that other European manufactures are in a position to absorb the decrease in Danish production.

Table 5.3 European trade intensities for selected industries, 2008 Trade in- NACE Code NACE tensity

1520 Fishmeal and fish oils 49.7

1541 Vegetable oils and fats 49.4

2414 Enzymes 46.3

2420 Plant protection products 41.1

1597 Malt 30.9

2416 Plastic 27.1

2112 Paper 25.7

2613 Glass packaging 24.3

2020 Chipboard 23.8

1583 Sugar and sweeteners 19.5

2682 Mineral wool 17.9

1561 Flour 7.9

2651 Cement 6.8 Industrial liquid gas- 2411 ses 4.2

1571 Proteins 2.8

2640 Tiles 2.7

1581 Bread 0.9 Source: Copenhagen Economics on basis of Eurostat

40 Danish production value in share of total EU production value

43 Carbon leakage from Danish energy taxation

5.3. SUMMING UP We conclude that • The rate of leakage resulting from the 2009 Tax Reform Package may reach 90 percent, in line with other empirical work for very small open economies. • The high rate of leakage is also driven by higher than average energy efficiency of Danish industries. • Over the longer term and including other effects such as transportation related CO2 emissions, the leakage rate may exceed 100 percent. • Our results are based upon modelling of effects from changes in energy tax rates. The model works with continuous effects, i.e. it does not capture, that for given levels of foreign carbon prices, each further increase in Danish tax rates will drive up the leakage rate, and may at some fixed point lead to closure of existing plants and a complete stop to new investments in Denmark.

44 Carbon leakage from Danish energy taxation

REFERENCES

Andersen, M.S., and P. Ekins (2009), “Carbon-Energy Taxation: Lessons from Europe”, Oxford University Press, Oxford.

Babiker, Mustafa (2005), “Climate change policy, market structure, and carbon leakage,” Journal of International Economics , No. 65, pp. 421-445.

Brøns-Petersen, Otto (2009), “Forårspakke 2.0: Afgifter på energi i erhverv,” Skatteministe- riet.

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Climate Strategies (2007), “Differentiation and dynamics of EU ETS industrial competitiveness impacts ”

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Demailly, and P. Quirion (2006), “CO2 abatement, competitiveness and leakage in the European cement industry under the EU ETS: grandfathering versus output-based allocation,” Climate Policy , Vol. 6, pp. 93–113.

Ederington, J., and J. Minier (2003), “Is Environmental Policy a Trade Barrier: A Cross- Country Empirical analysis,” Canadian Journal of Economics , No. 36, pp. 137-154.

Ederington, J., Levinson, A., and J. Minier (2003), “Footloose and Pollution-Free,” mimeo.

Hanna, R., 2006, “US Environmental Regulation and FDI: Evidence from a Panel of US Based Multinational Firms,” mimeo.

Hoffmann, Jan (2004), “Asian countries’ specialization in different maritime businesses: Challenges and opportunities arising from the process of concentration in shipping,” UNCTAD Working Paper.

IEA (2007), “Tracking industrial energy efficiency and CO2 emissions ”

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IEA (2008c), “International energy outlook 2008 ”

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IEEJ (2008a), “Chinese policies on climate change and environment ”

IEEJ (2008b), “G8 Hokkaido Toyako Summit 2008 and the global warming issue ”

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Neri (2007),”The impact of Energy Taxes on Competiveness, Output and Exports, a panel regions study of 56 European industry sectors”, project funded by EU Commission

OECD (2008b), “The economics of climate change mitigation: policies and options for the future ”, ECO working paper

OECD (2009), “The economics of Climate Change Mitigation: policies and options for global action beyond 2012”

OECD (2009), Mail from mr. Jean-Marc Burniaux,

Paleokrassos (2010), “Greening the Energy Tax Directive,” Policy Paper for Green Budget Europe.

Ponsard (2008), “Carbon leakage and capacity decisions framework and application to cement ,” Workshop presentation

46 Carbon leakage from Danish energy taxation

Regeringen (2009), “Forårspakke 2.0 – Vækst, klima, lavere skat,” available at http://www.stm.dk/publikationer/foraarspakke/index.htm

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UN (2003), “Energy Subsidies: Lessons Learned in Assessing their Impact and Designing Policy Reform”, UNEP/ETB/2003/1.

47 Carbon leakage from Danish energy taxation

APPENDIX

APPENDIX A: DOCUMENTATION OF DATA RETRIEVAL AND ADJUSTMENTS The method for calculation CO2-costs in Danish manufacturing is taken from the EU commissions work on identifying sectors and subsectors that are exposed to a significant risk of carbon leakage 41 . The European averages are taken from the referred document, while the Danish numbers are calculated on data from Danmarks Statistik. Danmarks Statistik has provided data for total CO2-emissions and gross value added pr. Sector on a NACE4-level.

Following the method from the commission, the CO2-costs are calculated as

2 ∗ 30 / ∗ 100

thereby calculating the CO2-costs as percent of value added. In the commission document CO2-emissions are split up in direct and indirect emissions. Direct emissions stems from combustion of fossil fuels, while indirect emissions are emissions related to the use of electricity. The commission uses an EU average of 0.465 kg of CO2 pr. KWh, while Danmarks Statisik uses 0.427 kg of CO2 pr. KWh.

Due to discretion the commission only lists the interval of CO2-emissions for certain sectors. Those are b for “below 5 %”, m for “middle, between 5 % and 30 %” and u for “upper, above 30 %”. For Denmark this grouping cannot be provided, which leaves no data for some sectors, i.e., sectors that have confidential figures due to small number of firms. We have covered these sectors with data from representative data on firm-level, where public available. The sectors and representative firms are shown in the table below.

Sectors and representative firms Sector Representative firm Chipboard Novopan Cement Aalborg Portland Sugar and sweetener Nordic Sugar Company Plant protection products (Pesticides Cheminova and other agro-chemical products) Enzymes Novozymes

Below is listed the EU averages and Danish figures, for the products and the associated sector as described in the report, including the value added for the relevant sector / representative firm.

41 EU Commissions, ”Document accompanying the Commission Decision determining a list of sectors and subsectors which are deemed to be exposed to a significant risk of carbon leakage pusuant to Article 10a (13) of Directive 2003(87/ECC”

48 Carbon leakage from Danish energy taxation

Energy intensive industries, CO2 costs and value added, 2007

DK CO2 EU Average CO2- costs, per- DK Value NACE4 costs, percent of cent of added, mio. Product code NACE code description value added value added euro Salt 1440 Production of salt u - -

Fishmeal and 1520 Processing and preserving of fish 1.60 2.58 246 fish oils and fish products

Vegetable oils 1541 Manufacture of crude oils and fats 3.60 - - and fats Flour 1561 Manufacture of grain mill products 1.73 1.40 69

Chipboard 2020 Manufacture of veneer sheets 4.93 1.64 manufacture of plywood, lamin- board, particle board, fibre board and other panels and boards Paper 2112 Manufacture of paper and paper- 13.60 4.81 47 board Plastic 2416 Manufacture of plastics in primary 4.00 1.55 23 forms Glass packagin 2613 Manufacture of hollow glass 9.73 - -

Tiles 2640 Manufacture of bricks, tiles and con- 13.07 5.82 67 struction products, in baked clay

Cement 2651 Manufacture of cement 60.67 60.88 71

Mineral wool 2682 Manufacture of other non-metallic 2.27 3.85 337 mineral products n.e.c.

Glass wool 2682 Manufacture of other non-metallic 2.27 3.85 337 mineral products n.e.c.

Malt 1597 Manufacture of malt 7.87 - -

Sugar and swee- 1583 Manufacture of sugar 7.20 4.71 teners

Bread 1581 Manufacture of bread manufacture 0.53 0.53 502 of fresh pastry goods and cakes

Proteins 1571 Manufacture of prepared feeds for 2.00 2.65 201 farm animals

Plant protection 2420 Manufacture of pesticides and other 2.13 2.28 products agro-chemical products

Industrial liquid 2411 Manufacture of industrial gases 11.87 2.50 71 gasses Enzymes 2414 Manufacture of other organic basic 7.20 5.69 chemicals Asphalt 2682 Manufacture of other non-metallic 2.27 3.85 337 mineral products n.e.c.

Source: Copenhagen Economics

49 Carbon leakage from Danish energy taxation

APPENDIX B: DOCUMENTATION OF CARBON LEAKAGE MODEL This section is concerned with a technical description of the applied carbon leakage model. There are three subsections: In the first, we provide a mathematical description of the model; in the second, we discuss calibration; and in the third subsection, we present sensitivity analysis with respect to parameter values. In the box below, we discuss some pros and cons of the model approach.

Pros and cons of partial equilibrium model approach The Copenhagen Economics Carbon Leakage Model is a partial representation of the European economy with focus on energy-intensive industrial products and carbon energy products. All other parts of the economy have been left out as these are assumed to matter only for second order effects. Further, we assume rather simple constant elasticity relations between the relevant products, their substitutes, and energy use. Thus, along several dimensions, we have the potentially simplest possible model (based on microeconomic theory) to estimate the carbon leakage effects. Below, we provide the most relevant pros and cons of the partial approach compared to a full-scale computable general equilibrium model.

The pros are: Simplicity implies very few parameters and thus more clarity of calibration The economic mechanisms are clearly represented by simple equations The model is flexible and easy to maintain

The cons are: We cannot capture all leakage relevant mechanisms (e.g., exchange rate effects) Microeconomic consistency is not assured (e.g., there is no representative agent with a utility function and a budget constraint) We cannot control country specific flows (e.g., where does Danish production end?)

Since we are interested in relatively simple questions concerning only part of the economy, we believe that our partial equilibrium approach has a comparative advantage altogether. Source: Copenhagen Economics

Mathematical description The model is based on n different industries. The corresponding index will be i=1,…,n . There are two different regions, Denmark and the (rest of) EU27, denoted by l=EU,DK .

Each industry in each country produces a unique commodity, and we let pil denote the

change in the logarithm of commodity i in region l, while qil is the corresponding change in the logarithm of output. It is a general convention here that all variables are measured in changes of the logarithmic value, i.e., approximately by percentage changes. We assume constant demand elasticity, εil , such that demand will be given by

= − + ,

where is size-corrected cross-price elasticity. Supply is competitive and we assume that capital and labour costs are fixed. This implies that pricing will only depend on the common carbon carbon price, p , plus carbon taxes, τl:

= ( + )

where αil is the CO2 intensity.

50 Carbon leakage from Danish energy taxation

The demand for CO2 (products) is given by production changes corrected for substitution

possibilities. Let σil denote the substitution elasticity between CO2 products and other energy sources. The actual level of substitution will depend on the wedge between changes in output prices and input costs, i.e., the difference . Thus, we can write − − CO2 demand in country l as:

= [ + ( − − )]

Note that we need to scale the industry changes by measuring the industry share of country CO2 demand. The model is closed by specifying a supply-equals-demand relation for CO2. We assume a fixed elasticity of supply, φ:

+ =

where δl is the country share of total CO2 emissions.

Finally, we just need to state how the carbon leakage rate will be calculated. Carbon leakage in this study will be given by the quantity increase in CO2 in Europe as a response to a tax induced CO2 decrease in Denmark. However, we must remember that we have chosen to measure everything in changes of logarithmic values which implies a need for size correc- tions. We can write the leakage rate as

This completes the formal model description.

Calibration The model is calibrated for all sectors with complete and reliable information on CO2 intensities, c.f. the table below.

NACE industries used for calibration NACE Label

1110 Extraction of crude petroleum and natural gas

1513 Production of meat and poultrymeat products

1520 Processing and preserving of fish and fish products

1531 Processing and preserving of potatoes

1533 Processing and preserving of fruit and vegetables n.e.c.

1543 Manufacture of margarine and similar edible fats

1561 Manufacture of grain mill products

1562 Manufacture of starches and starch products

51 Carbon leakage from Danish energy taxation

1571 Manufacture of prepared feeds for farm animals

1581 Manufacture of bread; manufacture of fresh pastry goods and cakes

1584 Manufacture of cocoa; chocolate and sugar confectionery

1589 Manufacture of other food products n.e.c.

1730 Finishing of textiles

1740 Manufacture of made-up textile articles, except apparel

1751 Manufacture of carpets and rugs

1754 Manufacture of other textiles n.e.c.

1822 Manufacture of other outerwear

1930 Manufacture of footwear

2010 Sawmilling and planing of wood; impregnation of wood

2112 Manufacture of paper and paperboard

2121 Manufacture of corrugated paper and paperboard and of containers of paper and paperboard

2125 Manufacture of other articles of paper and paperboard n.e.c.

2222 Printing n.e.c.

2411 Manufacture of industrial gases

2416 Manufacture of plastics in primary forms

2441 Manufacture of basic pharmaceutical products

2466 Manufacture of other chemical products n.e.c.

2521 Manufacture of plastic plates, sheets, tubes and profiles

2522 Manufacture of plastic packing goods

2523 Manufacture of builders' ware of plastic

2524 Manufacture of other plastic products

2640 Manufacture of bricks, tiles and construction products, in baked clay

2651 Manufacture of cement

2664 Manufacture of mortars

2682 Manufacture of other non-metallic mineral products n.e.c.

2722 Manufacture of steel tubes

2742 Aluminium production

2812 Manufacture of builders' carpentry and joinery of metal

2862 Manufacture of tools

2914 Manufacture of bearings, gears, gearing and driving elements

2923 Manufacture of non-domestic cooling and ventilation equipment

2952 Manufacture of machinery for mining, quarrying and construction

2953 Manufacture of machinery for food, beverage and tobacco processing

2956 Manufacture of other special purpose machinery n.e.c.

3002 Manufacture of computers and other information processing equipment

3130 Manufacture of insulated wire and cable

3162 Manufacture of other electrical equipment n.e.c.

3210 Manufacture of electronic valves and tubes and other electronic components

3220 Manufacture of television and radio transmitters and apparatus for line telephony

52 Carbon leakage from Danish energy taxation

3310 Manufacture of medical and surgical equipment and orthopaedic appliances

3320 Manufacture of instruments and appliances for measuring, checking, testing, navigating, etc.

3340 Manufacture of optical instruments and photographic equipment

3663 Other manufacturing n.e.c. Source: Copenhagen Economics

The exogenous parameters of the model can be divided into two classes: (i) deep parameters and (ii) data-defined parameters. Deep parameters are characterised by governing behaviour, e.g., the quantity response to price changes. Data-defined parameters are more closely related to differences in CO2 use between sectors and countries.

In the first group we find , , and . In the study by Gerlagh and Kuik (2007), we find a survey of values for all three parameters and we choose to reasonable mean values in the model. However, we choose to set price- and cross-price elasticities relatively high as we are considering a relatively small country (Denmark) and rather standardised products. Specifi- cally we set

= 4.5

= 4.0

= 0.5 = 0.3

In the sensitivity analysis below, we will investigate what happens when these values are al- tered.

The data-defined values will be calculated on the basis of the data retrieval from Appendix A. For example, the country CO2 share, , will be calculated as total Danish CO2 emisisons divided by total EU27 emissions. The CO2 intensities, αil , are calculated as CO2 emissions divided by gross value added.

The model is calibrated in the GAMS programming environment.

Comparing results against Tax Ministry results We have have compared our model based estimates (CECLM) with estimates from the Dan- ish Ministry of Taxation. If we take our results assuming relatively low price elasticity for Danish production of 1½ which is close to standard price elasticities used in macro models for Danish industry exports, the results are roughly similar 42 . However, if we use a higher estimate of 4 ½ which can be justified for high commodity based productions such as energy intensive industries then the reduction will be roughly 3 times larger (1,714 compared to

42 One may, at first sight, question the fact that the CECLM estimate of CO2 reductions are higher despite the fact that the model is only calibrated on a small part of the economy. However, we should emphasise that this small part is by far the largest emitter in the Danish economy such that the actual difference between estimates becomes negli- gible.

53 Carbon leakage from Danish energy taxation

500). Baring in mind that OECD in a recent study 43 used export price elasticities for EUs energy intensive industries in the order of 3 to 4, we will use our upper case estimate as our base case. For a comparison with actual emissions, we can draw on figures from Statistics Denmark. Total Danish emissions amount to 106,694 thousand tonnes, whereas manufacturing and mining industries emit 10,879 thousand tonnes. The model specific industries a priori emit 5,342 thousand tonnes.

Estimates of effects of Tax Reform Package 2009 on domestic CO reductions Tax ministry CECLM Scope of estimate Economy-wide Part of manufacturing (100 %) (9 % of economy) Implied energy tax increase 39 pct 39 pct Tax burden on industry (mio kr) 2735 2234 Elasticity Low High CO2 reduction in DK (1000 t) 500 795 1714 Note: Observe that there are not only differences in scope, but also in underlying tax rates. *Based on common weighting. Source: Copenhagen Economics and Danish Tax Ministry

Sensitivity analysis The main output from the model is the leakage rate. In the results section above, we have presented scenarios that addressed the sensitivity of results with respect to uncertainty of the underlying efficiency data. Thus, in this section we focus exclusively on parameter uncertainty. We have conducted a small Monte Carlo study drawing parameter values around the chosen baseline values and recalibrating and rerunning the model for each draw. The resulting carbon leakage rates can be found in the histogram below. Not surprisingly, the mean value is around 0.88 – our baseline estimate. According to the Monte Carlo study, the vast majority of estimates must be found in the interval 0.78-0.99. Thus, on a large scale, there is not much uncertainty to the estimate stemming from parameter uncertainty.

Histogram of leakage rates from Monte Carlo study Histogram 70 60 50 40 30 20 10 0 0.91 0.77 0.81 0.72 0.73 0.75 0.76 0.76 0.79 0.97 0.74 0.78 0.87 0.95 0.92 0.93 0.95 0.96 0.99 0.82 0.83 0.85 0.86 0.86 0.89 0.94 0.98 0.90 0.88 0.84 0.80 More Note: Based on 1000 draws. Source: Copenhagen Economics

43 OECD(2009)