1

Macroeconomic Impacts ofEU Climate Policy in 2008-2012

AIECE

November 5, 2008

Olavi Rantala - Paavo SuniThe Research Institute of the Finnish Economy

ETLA

2

Macroeconomic baseline scenario

Financial crisis dampens strongly world economic growth in 2008-2012- United States falls into recession, Japanese growth is slow

- Developing countries, esp. China hit hard, but continue growing relatively rapidly

- Commodity producers’ surpluses diminish, which lags their investments

EU countries face a severe slowdown - Many EU countries going into recession as EU as a whole

Growth getting stronger in the course of 2010, but slowly- Previous 5-year period was especially strong

After the current turmoil growth rates recover back to potentialbut below the recent record strong growth

3

World economic growth by region, %

Share of total, %

2005

2002 - 2007

2007* 2008f 2009f 2009 – 2012f

World 100.0 4.6 4.5 3.3 2.4 3.4 Asia 29.0 7.6 7.5 6.1 5.4 5.7 China 9.6 11.0 11.9 10.0 9.0 8.6 Middle East 3.7 5.9 5.9 6.2 5.5 5.6 Africa 2.9 5.8 6.3 5.5 5.5 5.8 North America 24.4 2.8 1.8 1.3 0.0 1.5 United States 22.4 2.8 1.7 1.3 -0.1 1.4 Latin America 8.2 5.1 5.6 4.5 3.0 3.8 EU (baseline scenario) 23.5 2.7 2.9 1.4 0.4 1.7

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World economic growth 2002-2012

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

World Asia China Middle East Africa NorhAmerica

UnitedStates

LatinAmerica

EU (baselinescenario)

%

2002-2007 2008f 2009f 2009-2012f

5

Primary energy prices

Energy prices have peaked in 2008 at record levels- Oil: peaked at close to 150 USD/b,

by mid-October below 70 USD/b - Coal: fiscal year prices doubled in case of steam oil

- Gas: prices follow oil and oil product price decline with a lag

In the longer term, the availability of energyis one of the key risks for global growth

6

World market prices of oil and coal and gas price in Europe

10

20

30

40

50

60

70

80

90

100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008f 2010f 2012f

Year

1

2

3

4

5

6

7

8

9

10

Oil (Brent, € / barrel, lhs.) Coal (Australia, € / ton, lhs.) Gas (import price in EU, € / Mbtu, rhs.)

7

The baseline scenario of CO2 emissions

In the forecasting model the baseline scenarioof CO2 emissions is based on energy demand in four sectors:industry, transport, households and the rest of the economy

CO2 emissions reflect electricity supply generated by fossil fuels

and other consumption of fossil fuels

CO2 emissions of electricity generation are increasedby the demand for electricity in the four sectors

and decreased by the clean electricity generatedby means of renewable energy sources

and nuclear power

Recent Eurostat data indicates a reboundin electricity consumption and estimated CO2 emissions in the EU

in spring 2008

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CO2 emissions in baseline scenario

Output by sector

Electricityconsumption

Heatconsumption

Transport

Temperature

Clean electricity generation

Energy producedby fossil fuels

CO2 emissionsRainfall

Industrial processes

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Increase of CO2 emissions in the EU baseline scenario

-200

-150

-100

-50

0

50

100

150

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008f 2010f 2012f

Year

Mill

ion

to

nn

es

Electricity generation Other consumption of fossil fuels CO2 emissions

10

Recent increase of CO2 emissions in EUChanges from corresponding month of prevous year

-15

-10

-5

0

5

10

15

2005

/1 4 7 10

2006

/1 4 7 10

2007

/1 4 7 10

2008

/1 4

Year / month

%

-15

-10

-5

0

5

10

15

%

Emissions Consumption of fossil fuels

Oil consumption Electricity produced by fossil fuels

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Climate policy and the electricity market

The cornerstone of EU climate policy isthe reduction of CO2 emissions in electricity generation and industry

under the European Union Emission Trading Scheme (EU ETS)

CO2 emissions result largely from electricity generation

More than 50 % of electricity is produced by fossil fuels in the EU

There are hardly any substitutes for fossil fuelsin electricity production in the short run

The price of emission allowances createsan extra marginal cost in electricity production

Increases in the price of emission allowancesare largely passed through to the price of electricity

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Supply and demand for electricity in EU

Gas

Price of emission allowance

Coal

Price of emission allowance

Nuclear powerHydro and w ind pow er

Demand curve

Producer price

Price including taxes

0

20

40

60

80

100

120

140

0 500 1000 1500 2000 2500 3000

Output 2006, TWh

Va

ria

ble

pro

du

cti

on

co

sts

an

d p

ric

e

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Channels to macroeconomic developments

The price of emission allowances has become an important determinant of the price of electricity

The price of electricity is the main channel of the impacts ofclimate policy on macroeconomic developments

The price elasticity of the demand for electricity is rather low(-0.1 for industry and -0.2 for households)

The downward adjustment of the demand for electricity and CO2 emissionsmay necessitate a large increase in the price of emission allowances

and in the the price of electricity

This leads to increasing costs in industry, higher consumer prices for householdsand decreasing macroeconomic activity

The macroeconomic adjustment finally leads tolower demand for energy and reductions in CO2 emissions

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Macroeconomic adjustment to climate policy

(+)

(–) (–)

(+)

(–) (–)(+)

(–)

(–) (+) (–)

(+)

(+)

(+) (+)

World economic growth

EU economic growth

Energyconsumption

Domestic demand Exports

CO2

emissions

Price of emission allowances

Price of electricity

Emission allowances

Industryproduction costs

Householdreal income

Consumerprices

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Baseline scenario of CO2 emissions in EU ETS

CO2 emissions in the EU emission trading sector under the EU ETS grew by about 4 per cent in 2007

According to our baseline scenariothe emissions will decrease in 2008-2012

CO2 emissions will exceed the emission allowances

on average by about 100 million tonnes annually in 2008-2012

Uncertainties in the baseline EU ETS emission scenario:- macroeconomic developments and energy demand

- clean electricity supply

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Baseline scenario of CO2 emissions

in the EU emission trading sector

2000

2100

2200

2300

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008f 2010f 2012f

Year

Mill

ion

to

nn

es

Emissions Baseline scenario Emission allowances

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Primary energy sources of EU electricity generation

0

500

1000

1500

2000

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008f 2010f 2012f

Year

TWh

Nuclear power Hydro power Wind Biomass Clean electricity Fossil fuels

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Assumptions in policy scenarios

Emission allowances for the Kyoto period 2008-2012have been cut by some 10 percent as compared to the first emission trading period 2005-2007

Our most stringent policy scenario - “maximum impact policy scenario” - assumes that the CO2 emissions of EU ETS

must be reduced to the allowed cap in 2008-2012

Emission trading and other Kyoto mechanisms (Clean Development Mechanism, CDM, and Joint Implementation, JI)

allow flexibility in the adjustment of the CO2 emissions

The other extreme policy scenario - “minimum impact policy scenario” - assumes a perfectly elastic supply of emission reduction units

(Certified Emission Reductions, CER)from developing countries at the minimum price of 10 €/t

(roughly the minimum price set by China)

Our forecast for the emissions of the EU emission trading sector in 2012 lies in the middle of the two extreme scenarios

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Adjustment of CO2 emissions in the EU emission trading sector

1800

1900

2000

2100

2200

2300

2005 2006 2007 2008f 2009f 2010f 2011f 2012f

Year

Mill

ion

to

nn

es

Possible adjustment paths Forecast Emission allowances

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Emission allowance price and electricity prices

The increase in emission allowance price will be gradually passed on to electricity prices

In the minimum impact policy scenariothe emission allowance price is assumed to be only 10 €/t

and the impact on electricity prices is rather small

The maximum impact policy scenarioimplies a sharp rise in emission allowance price

and electricity prices

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Price of emission allowances

0

50

100

150

200

2005 2006 2007 2008f 2009f 2010f 2011f 2012f

Year

€ /

t

Possible adjustment paths Forecast

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Electricity price for European industry

0

100

200

300

400

2005 2006 2007 2008f 2009f 2010f 2011f 2012f

Year

€ /

MW

h

Possible adjustment paths Forecast

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Electricity price for European households

0

200

400

600

800

2005 2006 2007 2008f 2009f 2010f 2011f 2012f

Year

€ /

MW

h

Possible adjustment paths Forecast

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Macroeconomic impacts of EU climate policy

The increase in emission allowance and electricity priceswill weaken export competitiveness and export performance

especially in export markets outside the EU area

Rising electricity prices will also raise consumer pricesand slow down household real income and consumption growth

The negative impact on exports and domestic demand will be reflected on GDP and employment

Macroeconomic impacts may be strongerin the small open energy-intensive EU countries

than in the major EU countries

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Macroeconomic impacts of climate policy in the EU area in 2012 as compared to the baseline scenario, %

Policy impact in 2012, %

Baseline scenario in 2012,

2007=100

Minimum impact

Forecast Maximum impact

Industry: Price of electricity 153 20 75 157 Output costs 120 0.5 2.3 5.1 Households: Price of electricity 172 20 75 157 Consumer prices 113 0.3 1.0 1.8 Macro economy: Exports 117 -0.2 -0.8 -1.5 Industrial production 109 -0.2 -0.7 -1.3 Domestic demand 110 -0.2 -0.5 -0.8 GDP 108 -0.2 -0.6 -1.0 Employment 104 -0.1 -0.3 -0.5

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Differences in the macroeconomic impactsbetween countries

Exports in relation to GDP, especially exports outside EU

Energy-intensity of industry

Impact of temperature on energy demand

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Exports / GDP in 2005

0

20

40

60

80

100

120

140

160

Slova

kia

Luxem

bourg

Sweden

Belgiu

m

Finla

nd

Nether

lands

Irela

nd

Czech

Rep

ublic

Slove

nia

Unite

d Kin

gdom

Austri

a

Hungar

y

Denm

ark

Estoni

a

Bulgar

ia

Polan

d

Cypru

s

France

Lithuan

ia

Germ

any

Latvi

aM

alta EU

Portu

gal

Roman

iaIta

ly

Spain

Greec

e

%

Exports outside EU Exports to EU

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Manufacturing industry electricity consumption / output volumein 2005

0

100

200

300

400

500

Luxem

bourg

Finla

nd

Sweden

Latvi

a

Eston

ia

Portu

gal

Austri

a

Lithua

nia

Slova

kia

Spain

Belgi

um

Unite

d Kin

gdom EU

Nethe

rlands

Franc

e

Polan

d

Ger

man

yIta

ly

Czech

Rep

ublic

Denm

ark

MW

h /

mill

. €

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Household electricity consumption and temperaturein EU countries 1990-2000

Austria

Latvia

Belgium

France

Germany

Romania

Denmark

EstoniaSpain

Italy Greece

PortugalCyprus

Malta

Sweden

Finland

0

1

2

3

4

5

0 2 4 6 8 10 12 14 16 18 20 22

Annual mean temperature, oC

An

nu

al c

on

su

mp

tio

n p

er

ca

pit

a, M

Wh

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Greenhouse gas developments in EU

EU total greenhouse gas emissions meetthe Kyoto commitment target in 2008-2012

according to our baseline scenario

Emissions will fall clearly below the Kyoto targetaccording to our policy scenario

EU climate policy seems to beunnecessarily stringent in 2008-2012

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Greenhouse gas emissions in EU

4800

5000

5200

5400

5600

5800

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008f 2010f 2012f

Year

Mill

ion

to

nn

es

Emissions Baseline scenario Forecast Kyoto Protocol target

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Conclusions

EU climate policy dampens the medium-termeconomic growth in the EU area

EU climate policy seems to beunnecessarily stringent in 2008-2012

in terms of the Kyoto commitment targeton greenhouse gas reductions

Uncertainties in the scenarios:- The baseline macroeconomic scenario

- The flexibility in CO2 emissions allowed by the Kyoto mechanisms,especially the supply of clean development (CDM) credits

from China and other developing countries