Concerns about the impact of carbon policies (including pricing, regulation, subsidies, and standards) on competitiveness and carbon leakage particularly affect energy-intensive, trade-exposed (EITE) industries. EITE industries are constrained in their ability to pass through carbon policy costs due to actual or potential international competition.

In light of Net Zero ambitions, this poses a unique challenge for carbon policy design. Measures aimed at mitigating these concerns are often a trade-off between preserving competitiveness and incentivising emissions reduction.

Net Zero Carbon Policy is a new Energy Systems Catapult thought leadership project, focusing on how the UK can build an innovation-friendly, economy-wide framework for Net Zero.

Key Industrial Decarbonisation Points

In this report for the Climate Change Committee and their Sixth Carbon Budget advice, we focus on:

• The UK context of international competitiveness impacts that arise directly from carbon policies
• Evaluating their ability to enable deep decarbonisation of industry in line with Net Zero pathways
• Whilst simultaneously mitigating carbon leakage and competitiveness impacts, including the potential timings and phasing of implementation.

Carbon Policies to Mitigate Carbon Leakage & Competitiveness Impacts

The fundamental role of carbon policy is to require or incentivise action to reduce or remove greenhouse gas emissions. In addition, for EITE industries carbon policies can be designed to also mitigate carbon leakage and competitiveness impacts. The choice of which mechanism is used depends on the nature of the base carbon policy being applied (e.g. free allocation of allowances is only suitable where there is an emissions trading system).

In addition, a single carbon policy is unlikely to completely mitigate competitiveness impacts without significantly diluting the incentive to reduce emissions. Therefore, policies are often combined, including with complementary policies, to form policy packages.

Figure 1 provides an overview of the evaluated carbon policy mechanisms that can be used to mitigate carbon leakage and competitiveness impacts.

Timings and Phasing of Carbon Policies

Our evaluation broadly suggests a transition from subsidy-based support in the near-term to the longer-term use of standards, including at the border, to both mitigate carbon leakage and enable deep decarbonisation of industry in line with Net Zero. These should also be considered as part of wider policy packages, including a market for negative emissions. Figure 2 illustrates an example of overall timings and of phasing of carbon policies between now and 2050:

• Immediate steps can be taken to realise benefits in the near-term, including continuing to provide direct funding and by improving the methodology for allocation of free allowances under a UK ETS. These can build on existing policies, which is important for business continuity in the context of Brexit and impacts of COVID-19.
• Alongside these, design and implementation of additional support measures such as low carbon public procurement practices and carbon contracts for difference (i.e. setting a strike price for carbon for a project) can play an important role for beginning to develop low carbon markets.
• In the interim, a border carbon adjustment mechanism could be developed as part of a longer-term pathway, which could be integrated with a UK ETS and form the basis for wider coverage of standards on producers.
• Over time, these could be phased down as longer-term policies are fully implemented, including standards on carbon for both purchasers and producers, with border standards eventually used for the latter.
• The phasing of these will enable industry to adjust, with a UK ETS and the wider set of standards tightening over time in line with carbon budgets.

Decarbonisation Policy Recommendations for Policymakers

The following recommendations are intended to provide the direction for an overall approach to industrial decarbonisation that would most effectively mitigate carbon leakage and competitiveness impacts in line with the Committee on Climate Change’s Sixth Carbon Budget Pathways:

1. Study the policy pathways required for industrial sectors, in particular, where competitiveness impacts affect investment decisions, including differences between cluster and non-cluster based firms.
2. In the near-term, continue to provide support to industry through direct funding and explore alternative policy measures, for example, carbon contracts for difference for low-regret projects.
3. During Phase I of a UK ETS, implement improvements in the methodology for allocation of free allowances, for example, by using output-based allocation. These should be phased down during the 2020s and potentially replaced with a targeted border carbon adjustment mechanism calibrated to align with the UK ETS price and phased in from 2025.
4. Explore the use of standards on both producers and purchasers as part of the long-term policy framework to enable industrial decarbonisation. To begin, standards on producers could employ a form of flexible compliance, for example, tradable performance standards. Standards on purchasers could be initiated through a low carbon public procurement programme providing initial demand for low carbon products, before expanding to cover other sectors.
5. In the long-term, to ensure that the implementation of standards are aligned with Net Zero levels of ambition while mitigating competitiveness impact, explore options to impose standards on producers at the border on imported products.