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Policy brief. The 2030 EU Climate and Energy Package: why and how? Thomas Spencer, Michel Colombier, and Teresa Ribera (IDDRI) *

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Policy brief n 16/13 DECEMBER 2013 climate The 2030 EU Climate and Energy Package: why and how? Thomas Spencer, Michel Colombier, and Teresa Ribera (IDDRI) * This article is based on research
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Policy brief n 16/13 DECEMBER 2013 climate The 2030 EU Climate and Energy Package: why and how? Thomas Spencer, Michel Colombier, and Teresa Ribera (IDDRI) * This article is based on research that has received a financial support from the French government in the framework of the prograe «Investissements d avenir», managed by ANR (French national agency for research) under the reference ANR-10-LABX Institut du développement durable et des relations internationales 27, rue Saint-Guillaume Paris cedex 07 France We still have a problem the rationale for energy and climate policy It is not surprising that in difficult economic times a long-term issue like climate policy has slipped down the agenda. However, Europe still has fundamental challenges to face in this regard. The IPCC s 5th assessment report underscored again the urgency of action on climate change. Europe will need to prepare its position for the crucial 2015 climate change negotiations hosted by France. Moreover, Europe s energy sector is in dire need of long-term orientations. Europe s fuel bill is a significant weight on its economy; the weight of evidence suggests that Europe will not replicate the US shale gas revolution. It is also important not to exaggerate the importance of the US shale revolution for competiveness and economic performance. Europe will need to develop its own collective, competitive solutions. Three thought experiments on the design of the EU climate and energy package In comparison with 2008, there is significant divergence in Member States vision for the 2030 climate and energy package. Some want renewables targets, others don t. Neither the Coission nor Member States are yet ready to address energy efficiency in the new package. And so on. This article conducts three thought experiments, thinking through three radically different designs for the 2030 package. These are a CO2 only package, an innovation package, or a subsidiarity package. These reflections lead to the conclusion that a combination of elements is needed. Firstly, carbon pricing via the EU ETS should remain a central pillar, and be reinforced. Secondly, technology deployment objectives remain necessary: the key question should be what kind of targets and how to negotiate them, not whether. Finally, there is a need to build flexibility into the new package, in order to take into account the diversity of Member States circumstances and preferences. * Thanks go to the following for their assistance and coents: Oliver Sartor, Andreas Ruedinger, Tancrede Voituriez, Damien D ly, Michael Jacobs, Mathilde Mathieu. INTRODUCTION The recent IPCC report reaffirms the existence, urgency and human origin of global climate change. In comparison to previous reports, it expresses near certainty (95%) that humans are responsible for the observed warming. 1 The EU has made a political coitment to reduce its emissions by 80-95% by France, the United Kingdom and Germany all have similar goals inscribed in domestic legislation or quasilegislative instruments. 2 Given the high degree of EU integration, these objectives can only be reached via a coordinated EU approach. At the same time, Europe is still in the midst of profound economic crisis. Europe needs to generate growth and jobs in the short-term, while pursing fiscal consolidation and aligning its economic model to long-term challenges. Finally, climate change is coming back to the international stage. The EU will be required to prepare its international position for the next major cycle of international negotiations, with the heads of state suit in 2014 and the Paris COP in THE INTERNATIONAL CONTEXT 1.1. International (geo)politics Climate change has profound implications for the global economy and global economic policy. This can only increase as its physical and policy implications become starker over time. For example, China and the USA have been strengthening their bilateral relationship on climate change at the highest level; both have been strengthening their domestic policy as well. 3 Such engagement is to be welcomed. However, Europe should ensure that it and others are not excluded from global rule-making on such an important issue. The UN climate suit in Paris provides an important occasion for Europe to be at the heart of global governance. Failure in Paris would be a 1. IPCC (2013), Working Group I Contribution to the IPCC Fifth Assessment Report, Climate Change 2013: The Physical Science Basis: Suary for Policymakers. 2. UK Climate Act (2008) in the UK; POPE (2005) in France; Energiekonzept (2010). N.B. as an unterichtung durch die Bundesregierung this does not have the force of legislation. 3. For example, US President Obama and Chinese President Xi negotiated an important agreement on the super greenhouse gases HFCs at their suit in June Domestically, see for example Obama s Climate Plan, and the 2014 Climate Plan released by the Chinese State Council. significant setback for the multilateral approach to climate change and to domestic policies; it would also have negative repercussions beyond the climate change regime. It would be a significant setback to the multilateralism which supports EU interests in a world of multiple great powers Europe s negotiation strategy The EU s domestic policy is central to its international negotiation strategy. As the world s largest market, its domestic policies and standards exert a strong market pull. 4 The EU s policy entrepreneurship provides valuable experience for others. For example, China, South Korea, Mexico, and South Africa are all implementing carbon pricing via either trading or tax schemes. The contents and credibility of the EU s post 2020 package are therefore important internationally. Within the negotiations, the EU s positions form an important centre of gravity. But a fragmented EU cannot be an effective negotiator: hence the importance of a tie to a domestic consensus and policy basis. This strategy of a coherent EU position needs to be complemented by alliances with progressive developing countries. Large emerging countries are highly sensitive to the demands of developing countries; shifts in the positioning of emerging countries can influence the US. But building progressive alliances depends on the credibility of the EU s position and its underpinnings in domestic action. An EU political coitment is a vital signal to other countries also to come forward with their own emissions reduction offers. But the EU should not be concerned that it is going alone. Firstly, the talks in 2013 in Warsaw should launch a collective step-by-step process for formulating and submitting coitments by early This will give assurance that others are getting on board; indeed both BASIC 5 and the USA 6 have recently stated that they will be ready to coit by Secondly, it s unlikely that the EU will have a legislated package by 2015, in contrast to 2008/9 where the EU entered negotiations with legislation. 4. Morgera and Kulovesi (2013), The Role of the EU in Promoting International Standards in the Area of Climate Change, University of Edinburgh 5. Joint statement issued at the conclusion of the 16th BASIC Ministerial meeting on climate change, Foz do Iguaçu, Brazil, September 15th and 16th 2013, https:// ministerialmeeting_climatechange 6. USA (2013), U.S. Submission on the 2015 Agreement, Oct policy brief 16/2013 Iddri Figure 1. Real price indices for various resources ( ) 2005=100% Source: World Bank Data. 2. THE INTERNAL EU CONTEXT 2.1. Some global boundary conditions: increasing scarcity The world appears to be moving into a new phase of structural resource scarcity. Global supply is being stretched by unprecedented economic growth. Between 1960 and 2012 the world economy grew by 44.5 trillion USD Slightly less than one third of this growth took place in the last 12 years since If the world economy grew at 2.8% between now and 2035, it would add a further 45 trillion USD in less than half the time. In parallel, the marginal productivity of resource supply is declining. Resources are becoming more intensive to extract, in terms of other resource inputs, capital or environmental damages. The combination of these two factors can be seen in global resource price indices (figure 1). Real price indices for energy, agricultural products, fertilizers and base metals increased by 97, 74, 141 and 140 percentage points respectively from 2000 to While there are some nuances to this rather sombre supply picture (shale gas discussed further below), the overall picture is one of a robust long-term structural trend towards increasing resource scarcity. This will structure global geopolitics, trade, innovation and demand. EU climate and energy policy, and its broader economic policy, needs to be situated within this long-term context Energy security The decline of domestic sources of oil and gas pose significant risks to European energy security. EU oil and gas production is predicted to decline by more than a factor of 2 between now and Net fuel imports already equate to 3.2% of EU27 GDP in Europe s negative trade balance is largely explained not by a lack of competitiveness in manufacturing sectors, but rather by its large imports of fossil fuels from abroad, particularly oil (figure 2). Greater energy efficiency and substitution away from imported fossil fuels therefore represents an opportunity to reduce Europe s trade deficit, which may be beneficial in terms paying down both public and private debt. Europe s fuel dependency is a problem in particular for Eurozone countries, whose currencies cannot fluctuate to rebalance external trade. The pressure of adjustment must therefore fall on wages and internal prices. A link between the monetary system and the energy system is present via inflation, which determines real interest rates and thus interacts with the ECB s monetary policy. Energy policy is therefore a macroeconomic issue for the EU and the Eurozone. At the same time, the world (or more specifically, the USA) is undergoing a significant shift in the global energy landscape. US production of natural gas grew by 27% between 2005 and World Bank data. 8. EC (2011), Energy Roadmap. 9. EIA data. Iddri policy brief 16/2013 3 Figure 2. EU27 net trade balance by product (left axis) and fuel trade balance as a % EU27 GDP (right axis) Source: Eurostat data. Figure 3. EU gas production, demand, imports and prices Source: Data from IEA (2011), ibid, and JRC (2012), ibid. This naturally raises the question of to what extent this could be replicated for the EU. The weight of evidence points to the unlikelihood of repeating the US experience in the EU. 10 Europe is still at an early stage of exploration and test drilling. Its different geology, population density, resource availability, regulatory framework and production capacities mean that the growth of shale gas production would take time, and will be marginal compared to aggregate EU 10. Cf. Geny (2010), Can Unconventional Gas be a Game Changer on European Markets, Oxford: Oxford Institute for Energy Studies, 2010; Joint Research Centre (2012), Unconventional Gas: Potential Energy Market Impacts in the European Union ; IEA (2011), World Energy Outlook 2011 ; IEA Special Report (2011), Are We Entering a Golden Age of Gas?. demand (it may be more significant for some countries, such as Poland). EU countries face a strategic choice on shale gas, which is their prerogative. But regardless of this choice, the EU will continue to remain a significant importer of fossil fuels. It will continue to be a price taker on international markets. Figure 3 shows a reasonably consensual range for possible unconventional gas production in the EU, and a comparison between domestic conventional and unconventional gas prices. Unconventional gas may be significant for some EU countries, but for the EU as a whole its impact on domestic supply will likely be marginal. The changed energy landscape does not fundamentally put in question the current EU energy strategy, even if one were to forget about climate 4 policy brief 16/2013 Iddri The 2030 EU Climate and Energy Package: why and how? Figure 4. Gas expenditures and employers costs of health insurance in US manufacturing sectors (2010) Share of the energy bill or health expenditures in the sectoral VA Energy bill Health expenditures Share of the sectoral VA in the GDP (cumulative) Source: Data from the US Manufacturing Survey 2010/11. change for a moment. Efficiency, improving the internal market to benefit from more liquid, secure and diversified supplies, and fossil fuel substitution will still be crucial to the long-term security and affordability of EU energy supplies The changing global energy landscape: implications for EU competitiveness The unconventional revolution in the US has also raised questions in the EU about its impacts on EU manufacturing competitiveness. Natural gas prices to industry have more than doubled for a selection of EU countries from 2004 to 2012, while they have almost halved for the US.11 We argued above that a US-style shale revolution is unlikely in the EU, and that the broad contours of the EU energy strategy remain valid. Nonetheless, the potential competitiveness impacts of this situation are a separate question. Figure 4 shows energy expenditures as a share of sectoral value added for US manufacturing sectors at a highly disaggregated level. It should be noted that this is total energy expenditures, not just the share thereof that would be elastic to a carbon price or to a drop in natural gas prices. Finally, it compares these with the employers cost of health insurance, sector by sector. This is an interesting comparison, as health care is roughly twice as expensive in the US than in the EU, at around 20% of GDP versus around 10-12% in the EU.12 Around 60% of US manufacturing sectors have employers health care costs that exceed their total energy bills (this excludes all other labour costs, taxes, transport costs, etc. which may also impact on cost competitiveness between the EU and the US). This illustrates a general conclusion: energy input costs are highly concentrated in a small number of primary manufacturing sectors. 11. IEA data. EU data are for the Czech Republic, Finland, France, Germany, Hungary, Poland, and the UK. 12. Cf. Piketty (2013), Le Capital au XXIe Siècle, Seuil, ff Manufacturing competitiveness Iddri policy brief 16/2013 5 Figure 5. EU27 External trade balance in chemical, pharmaceutical and related products and machinery and transport equipment vs. energy price differences EU27 vs. USA Source: IEA industrial gas and electricity prices, Eurostat trade statistics. For the manufacturing sector in aggregate energy is not generally a significant factor of comparative advantage. For example, between 1978 and 2012 the average electricity and gas price differential between Japan and the USA was 259% and 333% respectively. 13 Europe s key sources of comparative advantage are increasingly based around down-stream, high-value added products, such as downstream chemical and pharmaceutical products, and transport and complex machinery. European competitiveness in these products has thus been relatively unresponsive to recent divergence in energy prices between the EU and the USA (figure 5). Manufacturing is important economically. It is important to keep a balanced economy, with a strong tradable sector: persistent current account deficits bring external vulnerabilities that were exposed during the crisis. Manufacturing is highly productive economically and is an important source of technological innovations. However, only a small sub-set of sectors are energy intensive. These are important, but it is possible to find sector-specific measures to offset policy-induced energy price increases, as is the case under the ETS and renewables policies currently. Fundamentally, however, energy prices are not significantly responsible for the current state of EU manufacturing in aggregate, nor will they be in the future The industrial implications of the lowcarbon transition In large part, the difficulties of EU industry are due to the lack of demand, in particular internal demand. The crisis has played a role, as has the lack of supply-side competitiveness in some EU countries, which has prevented them from benefiting from external demand. But more fundamentally, Europe is faced with a long-term shift in its economic structure. Between 1970 and 1990, gross fixed capital formation averaged 22% of GDP for France, the UK and Germany. The 20 year average for fell by 3 percentage points to 19% of GDP. 14 Europe achieved the reconstruction and catch-up of its capital stock, and demand shifted from primary and secondary manufacturing to other sectors (services). The demand perspective for EU industry consists of the transformation of Europe s existing capital stock to make it resilient and productive given the long-term context. The low-carbon, resource efficient transition is an investment-intensive, macro-economically significant project. Averaged over the period , the necessary capital investments equate to about 1.5% of GDP annually. The majority of these are in energy efficiency, with high co-benefits in terms of energy security and productivity, job creation and household purchasing power. Overall over the period , annual average fuel expenditures are reduced sufficiently to compensate the additional capital investments (table 1). 13. IEA data. 14. World Bank data. 6 policy brief 16/2013 Iddri Figure 6. Green patent activity since 1990 Growth in green patent index since 1990 Figure 7. World trade of climate-related single-use environmental goods (2007=100) Table 1. Capital investments and fuel savings in the low-carbon scenario for the EU27 Additional capital costs energy supply* 1990=100% Clean Energy patents % total patent activity % of total patenl activity Source: COMTRADE data. Source: OECD data. Additional energy efficiency capital investments** Total additional capital costs Savings on fuel purchases Changes energy system costs Billion 08/yr % 2008 GDP Source: Data from EC (2011), Energy Roadmap. *Energy installations such as power plants and energy infrastructure, energy using equipment, appliances and vehicles. ** House insulation, control systems, energy management, etc. In the long-term the transition thus consists of replacing external fuel imports with significant investments in domestic EU productive capacity. This would create demand for the associated primary and downstream manufacturing products (insulation materials, steel; sophisticated energy management systems). Over time, it would also have indirect effects on the domestic purchasing power of EU households Green innovation and competitiveness Inevitably, a long-term macro trend like global demand growth and increasing resource scarcity will structure global market demand, supply and technology innovation. Global markets are increasingly placing a premium on innovative, resourceefficient products. The growth of market interest in green products can be (imperfectly) captured by looking at patent applications by sector. Figure 6 shows the growth of green patenting since 1990, as well as the growth of clean energy patenting in overall patenting activity. The growth of market interest in green products can also be seen in trade flows. For climaterelated single-use environmental goods, available data shows that world trade has grown unabated since the early 2000 s. 15 World exports of climaterelated single-use environmental goods grew by 120% from 2007 to 2011, compared to 45% for all products (figure 7). This trend is also reflected in sales data from the low-carbon and environmental goods and services sectors (LCEGS). Worldwide, total sales from these sectors were an estimated 3.4 trillion in fiscal year 2011/ The EU made up the largest share of this activity (figure 8) Suary Policy makers are faced with a
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