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Comparative Assessment of Carbon Price Effects vs. Energy Price Effects in EU Industry

By Orla McAlinden

As the second most carbon-emitting sector and the largest sectoral consumer of coal, natural gas, and electricity (International Energy Agency (IEA) 2021), industry is highly exposed to variations in prices associated with both energy inputs and carbon emissions outputs. This influence is sometimes deliberately steered with policy choices, such as with the implementation of carbon pricing in the EU or establishing energy price floors and ceilings. However, unexpected market impacts also play a role and must be managed, as observed recently in natural gas markets. This paper will compare the impacts and drivers of energy and carbon prices in various industrial subsectors. Later, the contrasting strategy of Europe’s emissions trading system (ETS) with the Inflation Reduction Act (IRA) in the U.S. will be discussed.


Carbon pricing impacts
Carbon dioxide emissions from electricity and heat generation, aviation within the European Economic Area, and energy-intensive industrial sectors are covered by the EU’s Emissions Trading System (ETS). Under the cap-and-trade scheme, operators must pay for credit allowances per ton of carbon dioxide they emit. However, in order to prevent sectors from losing competitive advantages relative to international competitors, sectors classified as at risk of carbon leakage will be granted 100% of their allocations for free until 2030 (European Commission n.d.a). The industrial sectors included in this classification include production of aluminum, iron and steel, copper, cement, and more (European Commission 2019). The allocation of free allowances for iron and steel, for example, is such that the free allowances granted over the course of the program’s history have consistently exceeded the verified emissions of activity (European Environment Agency 2022).

As a trading market, the price of CO2 pollution under the ETS varies depending on demand and other market factors. Notably, the price of an allowance of one ton of CO2 emissions surpassed 100 EUR for the first time in the system’s history in February 2023, a growth in price that was likely driven by greater demand for credits in anticipation of cold weather and decreased wind production, coupled with higher emissions resulting from a return to coal use to compensate for limited gas supply (Twidale et al. 2021). Prices may be expected to continue to rise in the coming years in parallel with the implementation of stricter rules agreed to by EU lawmakers that will steadily decrease the total number of allowances in the system, as well as cutting the free allowances granted to at-risk sectors (Hodgson & Sheppard 2023). In light of these developments and despite the fact that most of European industry is currently
largely insulated from carbon price impacts, the eventual gradual phase out of free allowances and increasing prices will force the sector to face tightening pressure from carbon prices in tandem with the energy price impacts it already manages.


Energy price impacts
The European energy market has experienced multiple shocks over the past year and a half, beginning with tightening supplies in 2021 due to COVID-19 recovery and multiplied by the impacts of Russia’s invasion of Ukraine (IEA n.d.). These market developments impact the profitability of industry operations due to the energy-intensive nature of the sector. At the peak of the price crisis in August 2022, the benchmark price for European natural gas reached 300 EUR per KWh. Confronted with these rising prices and the vulnerability of their energy supply to Russian influence, the EU released the REPowerEU plan with aims to rapidly reduce the EU’s dependence on Russian gas (European Commission n.d.b). Following these measures and as of early 2023, gas prices have returned to a relative normal, dropping below 50 EUR per MWh for the first time since 2021 (Sheppard 2023).

Despite the turbulence in gas prices observed over 2022, the impact on European industry has been relatively limited. Although there was a 25 bcm,1 or 25%, reduction in gas demand from European industry during this period, the accompanying reduction in manufacturing outputs was comparatively low. Production activity from the most gas-intensive subsectors (aluminum, steel, and fertilizers) fell only 8% over 2022. The IEA (2023) attributes this disparity to the increased importing of intermediate gas-intensive goods at lower prices, enabling gas consumption to drop while maintaining final product outputs. Other avoided gas demand was due to fuel switching to oil; roughly 7 bcm of gas demand was avoided by these measures. Improvements in energy efficiency avoided 3 bcm of demand. Despite the lower impact on industrial production relative to the impact on gas demand, it is still significant that 13 bcm of avoided demand was due to curtailed production (IEA 2023).

The above production impacts throughout the gas crisis indicate that although European industry has weathered the recent energy crisis, it has not been unscathed and the risk of vulnerability to future crises remains a threat. Experts furthermore suggest that, should untenable prices continue to be a risk in Europe, operations could lose competitiveness and transfer operations permanently to the United States, in order to benefit from secure supplies of inexpensive domestic gas (Denina and McFarlane 2022).


Sectoral comparisons
As a sector overall, industry is energy-intensive, making up nearly one quarter of Europe’s total final energy consumption in 2020 (IEA 2022a). However, due to substantial variations in energy and emissions intensity, carbon and energy prices have vastly different impacts across industrial subsectors. For example, as of 2021 the global average CO2 intensity for pulp and paper production was 0.39 tCO2/t compared to 0.59 tCO2/t for cement and 1.39 tCO2/t for steel (IEA 2022b, IEA 2022c, IEA 2022d). The variation in emissions outputs across sectors is due in part to energy intensity, but also greatly influenced by the fuel inputs relied on for production. In the pulp and paper sector, the largest global source of energy is bioenergy at 43% of total demand, compared to coal making up 75% of demand in the steel sector (IEA 2022c, IEA 2022d).2 Even within the same subsector, energy intensity depends on the processes used in production. In the iron and steel sector, relying on blast furnaces for production will result in higher energy consumption and, depending on the energy source used, correspondingly higher emissions than using electric arc furnaces (U.S. Energy Information Administration 2016).

United States industrial environment
As European legislatures strive to deploy industrial policies to simultaneously mitigate climate impacts, temper price spikes, and maintain international competitiveness, it is informative to compare their strategies with those deployed by the United States. The IRA, passed in August 2022, represented a landmark achievement for the Biden Administration’s climate goals and contains nearly 370 billion USD worth of investments in clean energy and climate measures (Senate Democrats 2022). Given the measures included in this legislation, the U.S. appears to be adopting a strategy of incentivizing rather than regulating the transformation of industrial operations and the reduction of associated emissions–a contrast with the regulatory approach of the EU ETS.


Included among the provisions aimed at supporting industrial operations is the new Advanced Industrial Facilities Deployment Program which aims to provide funding to emissions-intensive industries in order to develop projects that can reduce their emissions, the expansion of the Advanced Energy Project Credit to include industrial emissions reductions, and the extension of a tax credit for employing carbon capture and storage technologies (White House 2023). Beyond the divergent policy environments of the U.S. and the E.U., there is a significant disparity in exposure to energy prices hikes between U.S. and European industry. While European industrial operators have struggled under the recent market turbulence impacting the costs of their energy inputs due to Europe’s dependency on imported natural gas, U.S. operators have been comparatively protected from these impacts due to their access to domestic natural gas supplies. In 2021, the U.S. was a net exporter of natural gas, exporting nearly 2.4 times the gas it imported.3 In the European Union, imports were roughly 2.7 times higher than exports.4

Conclusion
The energy-intensive nature of industrial operations in addition to the continued prevalence of fossil fuels as fuel inputs means that industry is theoretically highly vulnerable to both carbon and energy prices. To-date, industry has been largely insulated from the impacts of the EU ETS due to the continued policy of free allowances. It is therefore difficult to assess the impact that carbon prices could have on their operations, although the current growth in carbon trading prices indicate that this will ultimately have a significant impact on operations. Given the immediate vulnerability of operations to energy prices, this factor is therefore a more prominent threat for the industry. Despite the ability displayed by the sector over the past year and a half to outlast energy prices spikes, European industry may remain at a competitive disadvantage compared to the United States due the relatively lower energy security and the scale of government support available to operations based in the United States.

Notes

  1. Billion cubic meters of natural gas. ↩︎
  2. It is important to note that these values may vary on a regional level, i.e. due to coal making up a smaller percentage of total final consumption in Europe relative to China (IEA 2022a). ↩︎
  3. 3,131,569 TJ gross imports compared to 7,419,057 TJ gross exports (IEA 2022a). ↩︎
  4. 20,272,910 TJ gross imports compared to 7,499,045 TJ gross exports (IEA 2022a). ↩︎

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