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«Christoph Böhringera and Victoria Alexeeva-Talebib a University of Oldenburg b Centre for European Economic Research, Mannheim Emails: ...»

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We start the interpretation of results with the marginal abatement cost for non-EITE segments of the economy. The marginal abatement cost for EITE industries then directly follow as a function of the As mentioned before, differential emissions pricing between EITE sectors and the rest of the economy corresponds to the hybrid EU climate policy legislation where energy-intensive industries covered under the EU emission trading scheme face a different emission price that the remaining segments of the EU economy.

imposed emission price ratio: For a carbon price ratio of 1, the marginal abatement cost are by definition uniform across all segments of the unilateral abating region.

Figure 2 clearly illustrates that marginal abatement cost increase towards higher emission reduction targets as carbon emission abatement options through fuel switching (inter-fuel substitution) or energy savings (either via energy efficiency improvements or the scale reduction of production and final demand activities) become more and more expensive. Under uniform emission pricing, marginal abatement cost rise from roughly 30 USD per ton of carbon at a 5% unilateral emission reduction to more than 350 USD per ton of carbon at a 30% emission reduction. When policy grants preferential treatment of EITE sectors through relatively lower emission prices it is clear that marginal abatement cost for the remaining segments of the economy must increase above the carbon value in the case of uniform emission pricing.

Figure 2: Marginal abatement cost in non-EITE segments of the EU economy (USD2004 per ton of carbon) 500,0 450,0 400,0

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The increase in the absolute carbon price for non-EITE sectors (compared to the uniform carbon value) remains relatively moderate even for the case of total EITE exemption. The reasoning behind is that the EITE sectors are only responsible for a smaller share (less than 15%) of overall carbon emissions in the domestic economy. Yet, the additional price tag on non-EITE sectors towards higher emission reduction targets becomes more and more pronounced indicating the potential for substantial increases in direct abatement cost as the gap in marginal abatement cost between EITE and non-EITE sectors widens.

We next turn to the implications of unilateral climate policy on competitiveness at the sector level.

Emission pricing has a direct impact on those sectors where emission-intensive inputs (fossil fuels) represent a significant share of direct and indirect cost. With uniform unilateral emission pricing, these sectors lose in comparative advantage not only against domestic emission-extensive industries; at the international level they are also at a disadvantage compared to competing energy-intensive industries which are not subject to emission regulation. Figures 3 and 4 depict the implications for competitiveness of EITE industries as well as for the bulk of non-EITE industries (summarised within the composite sector “Other industries and services”, OTH). Both trade-based indicators confirm competitiveness concerns for EITE sectors in the case of unilateral climate policy: EITE industries lose in competitiveness if we compare its trade performance with the average trade performance across all sectors of the unilateral abating region (RCA). Likewise, EITE industries suffer from a loss in competitiveness if we track the trade performance of this sector in the abating region compared to the performance of the same sector in other non-abating regions (RWA). The higher the emission reduction target and thus the implied emission price is, the higher are ceteris paribus the losses in EITE competitiveness. As policy discriminates emission pricing in favour of EITE industries, these losses can be ameliorated to some extent.

Figure 3: EU Sectoral competitiveness effects – revealed comparative advantage (% change from BaU)

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However, Figures 3 and 4 also illustrate that preferential policies in favour of EITE sectors go at the expense of other industries whose competitiveness decrease towards higher carbon price ratios. While the specific changes in competitiveness RCA and RWS indicators provide a useful cardinal information on competitiveness implications at the sectoral level, it becomes obvious that a balanced view calls for the simultaneous assessment across various sectors of the domestic economy rather than focusing on a very narrow segment of the economy which might be most adversely affected by policy-induced structural change. The trade-off between performances of sectors for differential emission pricing can be further visualised through the output effects in the different industries. Figure 5 indicates that EITE industries (with a BaU production share of slightly more than 10 %) suffer from substantial production losses due to emission constraints, while the rest of non-energy industries and services (OTH) industries with a much higher BaU production share may even slightly increase their output above BaU levels. The losses in EITE production can be substantially attenuated through differential emission pricing (up to roughly one-third for the extreme case of full exemption) but this works at the disadvantage of production in OTH industries.

Figure 5: Output effects in the EU (% change from BaU)

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We now discuss the economy-wide implications of unilateral emission abatement. The common metric in general equilibrium analysis to report aggregate welfare changes is the Hicksian equivalent variation in income. In our analytical framework where we abstain from quantifying the (uncertain) benefits from emission reduction and keep savings demand constant, the policy-induced change in real income can be readily translated in changes of real consumption. In other words: The change in real consumption provides a consistent metric for cost-effectiveness analysis across alternative emission price ratios to reach the same level of unilateral emission abatement (for the discussion of global effectiveness incorporating leakage effects see below). Figure 6 reveals that the EU is able to achieve moderate emission reductions at negative costs as the direct costs of emission abatement are more than compensated through welfare gains from improved terms of trade. Towards higher emission reduction requirements the direct abatement costs dominate secondary terms-of-trade gains and the EU encounters non-negligible losses in real income. As climate policy deviates from uniform emission pricing in favour of EITE industries, there is an economywide excess burden of discriminatory climate policy. The latter becomes quite pronounced towards higher reduction targets where broader dispensation of cheap abatement options in the EITE sectors causes much higher abatement costs in the remaining segments of the economy. More generally, the EU experiences terms-of-trade gains from unilateral emission reductions but there is no scope for additional net welfare gains (taken as the difference between direct abatement cost and indirect terms-of-trade gains) through lower emission pricing to EITE sectors.

Figure 6: Changes in real consumption in the EU (% change from BaU) 0,1 0,0

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In this context, it is useful to distinguish international spillovers from fossil fuel markets, on the one hand, and from non-energy markets, on the other hand. Regarding spillovers on fossil fuel markets, cutbacks in international fuel demand of large open economies depress international fuel prices which in turn reduce the energy bill of the EU as a large fuel importer. The terms-of-trade effects on fossil fuel markets thereby dominate additional spillover effects on non-energy markets where emission price discrimination between EITE sectors and the remaining segments of the unilaterally abating region only has a secondary welfare impact (Böhringer et al 2010b). Taking real consumption as an appropriate economy-wide competitiveness indicator we can conclude that preferential treatment of EITE sectors rather worsens than alleviates the “national” competitiveness impact of unilateral climate policy for the EU.

Figure 7 provides supplemental information on terms-of-trade changes for the EU triggered by unilateral climate policy. There are terms-of-trade gains for the EU from unilateral emission abatement (predominantly on international fuel markets) but these gains decrease with differential emission pricing in favour of EITE industries.

It is possible to decompose the welfare implications of secondary terms-of-trade effects by applying a simple decomposition technique described in Böhringer and Rutherford (2002). The total economic effect of unilateral abatement is thereby broken down into a so-called domestic market effect (i.e. the domestic adjustment holding international prices constant) and the international spillover effect (i.e. the residual effect accounting for changes in the terms of trade). Figure 8 quantifies the primary domestic market effect at constant international prices for the EU economy.

Figure 7: Terms of trade in the EU (% change from BaU) 0,7 0,6 0,5

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Without terms-of-trade effects, unilateral emission reduction triggers overall adjustment cost for the EU economy right away. Compliance cost increase towards higher unilateral emission reduction pledges as well with differential emission pricing. Note that the difference in economy-wide adjustment cost between Figures 6 and 8 are equivalent to the welfare gains for the EU from policy-induced shifts in the terms of trade.

Figure 8: Changes in real consumption neglecting terms-of-trade changes in the EU (% change from BaU) 0,0

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So far we have not addressed the issue of emission leakage and global cost-effectiveness of unilateral climate policy design. Compliance to regional emission targets at minimum cost for the domestic economy appeals as a realistic policy objective of the unilateral abating country. However, the focus on unilateral

emission reduction neglects the different impacts of alternative policy implementations (in our case:

differential emission pricing of EITE versus non-EITE sectors) on the level of global emissions via carbon leakage. In fact, claims for preferential treatment of EITE sectors not only stem from concerns of politically influential lobbies on adverse adjustment (competitiveness) effects in these industries but may be justified as second-best strategies to reduce leakage and thereby potentially increase global cost-effectiveness of unilateral abatement. In this vein, we must investigate the question how compliance cost of the unilateral abating region change with preferential emission pricing as we consider a global emission reduction target rather than the domestic emission pledge. The global emission reduction target that goes along with unilateral abatement is thereby defined as the leakage-compensated unilateral emission reduction pledge.

To achieve this, we endogenously scale the domestic reduction target of the unilaterally abating regions in order to offset adverse leakage impacts from non-abating regions on the global emission level. While leakage compensation does not seem particularly relevant for actual policy practise of unilaterally abating regions, it provides a meaningful benchmark for judging the cost-effectiveness of unilateral action without the need for evaluating the benefits from emission reduction. Against this background, Figure 9 confirms basic economic reasoning that preferential treatment of emission-intensive and trade-exposed industries will reduce leakage which is conventionally defined as the change in foreign emissions as a share of the domestic emissions reductions.

Figure 9: Emission leakage rates (in %) in the case of unilateral leakage compensation 30,0 25,0

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