To be published as HC 669-i




Environmental Audit Committee

Energy Intensive Industries Compensation Scheme

Tuesday 4 December 2012

Damien Morris, Dimitri Zenghelis, Simon Bullock and Alex Kazaglis

Dr Laura Cohen, Jeremy Nicholson, Gareth Stace and Philip Pearson

Right Hon Michael Fallon MP, Paul Drabwell and Niall MacKenzie

Evidence heard in Public Questions 1 - 70



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Oral Evidence

Taken before the Environmental Audit Committee

on Tuesday 4 December 2012

Members present:

Joan Walley (Chair)

Peter Aldous

Zac Goldsmith

Mark Lazarowicz

Caroline Lucas

Caroline Nokes

Dr Matthew Offord

Mark Spencer

Simon Wright


Examination of Witnesses

Witnesses: Damien Morris, Senior Policy Advisor, Sandbag, Dimitri Zenghelis, Senior Visiting Fellow, Grantham Research Institute on Climate Change, London School of Economics, Simon Bullock, Senior Campaigner, Policy and Research Unit, Friends of the Earth, and Alex Kazaglis, Senior Analyst - Energy Use in Buildings and Industry, Committee on Climate Change Secretariat, gave evidence.

Q1 Chair: I am very pleased to welcome all four of you before the Environmental Audit Select Committee this afternoon. We have a very full agenda because we have two more sessions following on and I think you have noted that the divisions downstairs in the Chamber have already delayed proceedings a little bit. With that said, we will get straight into the questions, if that is okay. Please do try to catch my eye if you want to add to questions that perhaps one of you may have replied to. This is a very timely inquiry and one to which we have a very small amount of time to devote, so I think these sessions will be very important this afternoon for all our witnesses.

We are really interested to know how the data gap on carbon leakage is being addressed. We are looking at the Government’s £250 million compensation scheme for the indirect costs of carbon policy on energy intensive industries. One of the things that concerns us is the extent to which the Government has or has not assessed the level of energy intensity where indirect energy policy costs represent a serious competitive risk. Do you have comments about the assessment that the Government has made in terms of where compensation will go and what needs to be done about it?

Simon Bullock: To take a very quick step back from it, the context of this is that we have seen in the last week and in the run-up with Doha just how important climate change is. A carbon price through UK climate policy is really important to help industry and the power sector decarbonise but we accept that power pricing rules are different throughout different countries and the EU vis-à-vis the rest of the world. It is important to reflect on the fact that carbon prices may be different in different regions. If there is a genuine competitiveness threat then, yes, we accept it is right to compensate industry. It is great that DECC have done this assessment of whether or not there is a genuine carbon leakage problem.

There are two issues that seem to us to be perhaps not fully addressed. The first is the extent to which this is about electricity intensity or energy intensity. In this inquiry, it seems that they are very clear that it is about electricity intensity, but the signals from the Secretary of State in the Energy Bill that was set out last week seem to suggest that it is about energy intensity rather than electricity. It is very important to be clear about the distinction between electricity and energy here. The second point is that the consultation seems to be suggesting that there are two important components, electricity and trade intensity, and yet the eligibility criteria seem to apply to electricity only and there is nothing much in there about trade intensity, which we feel is a gap.

Dimitri Zenghelis: I was going to add from a slightly broader economics point of view, because I am not an expert on the specifics of UK policy but I was the author of the competitiveness chapter in the Stern review. As part of that work, we looked at a number of studies on this important question of carbon leakage that have been undertaken across the world, including, for example, in America where, in principle, the ability to relocate across borders when you are in the same country, with the same language and same currency but in a different state provides a very rich test bed for analysis. Most of the studies found that there is very little if any evidence of so-called carbon leakage. The reason for that is partly that one needs to be very careful. You will never know the counterfactual of what would have been the case if various policies had not been applied, so it is difficult to assess definitively on the basis of what evidence you have. There are issues of aggregation, so what you might find applies for a sector does not necessarily apply to a specific firm in a specific location under specific circumstances. The issue of trade intensity, of course, is very important and applies to different sectors.

From a point of principle, you have to acknowledge that for even the most energy intensive sectors with the kind of orders of magnitude of carbon pricing that you are talking about, you are looking at changes in costs. For the most part, if you are talking about something like £30 per tonne of CO2 costs-and I am not talking about the rest of the UK policy environment, which may have very different implications-that tends to mean for almost all of the tradable energy intensive sectors cost increases of around 5% or so. When you compare that to changes in labour costs, issues related to changes in exchange rates or even just the normal fluctuations in energy costs that you get over the cycle, you can see why that, plus the fact that any policy differentials across jurisdictions would have to endure for the lifespan of an investment-so you are not just talking about a differential in policy this year but you are talking about a differential in policy you would expect to endure for five, 10, 20 years-means it does seem plausible, at least, that these kinds of location decisions will be based on a lot more than just energy costs. They will be based on access to markets, access to labour, labour costs, access to skills, access to raw materials and so on. That is why you have steel producers in Germany where labour costs, the biggest part of costs, are 10 times higher than those of steel producers in Indonesia and China and so on.

Q2 Chair: In terms of the actual carbon leakage and how that is being quantified and the basis on which DECC has sought to say that certain sectors will be affected by it and certain sectors will not, isn’t it important that that information is there at the very beginning, especially if it is going to have those long-term effects?

Dimitri Zenghelis: That is absolutely right. Once you have identified vulnerable industries, it is very important that you consider what is the best approach to helping them transition to what inevitably will become a higher fossil fuel cost economy, whether it be through policy or through the fact that Asia-China and India-are parts of the world that are industrialising so demand is outstripping supply.

Alex Kazaglis: In an assessment of how to allocate compensation, there are a couple of things that you have to know and both of them you need to know at a very detailed level so detailed data are required. The first is you need to know who is facing these costs that you are trying to compensate for. I note in the BIS consultation they look at electricity consumption and they look at it as if all of it incurs these costs whereas actually there are details you need to know. For example, a lot of industry auto-generate their electricity and in some cases they are auto-generating their electricity using fuels that are exempt from the Carbon Price Floor, such as blast furnace gas on a steel site. In many cases they are facing rates of the Carbon Price Floor that is reduced, so you have to establish if they are facing these costs and for that you need detailed information.

The second thing you need to establish if they are facing these costs is whether those costs are making them more vulnerable as a sector. If they can simply pass on the costs or there are ways that they can absorb the costs, or if there are things about the market that mean that that market can cope with these costs, then it is probably not the best place to allocate a small pot of compensation. To answer that question you need detailed information about trade intensities but you also need to know a little bit about how the market works in each of these commodities. For example, for parts of the steel sector it might make sense for the manufacturer to be close to their market and there is not a risk of their leaking overseas because of specific aspects of that market.

Chair: I think Caroline Nokes wanted to come in on that point.

Q3 Caroline Nokes: I am not sure it is specifically on that point but I have a general question with regard to the focus of this. Do you think that it is too tightly focused in on electricity and that there should be a wider recognition of those industries that are not necessarily reliant on electricity but, for example, on gas?

Alex Kazaglis: It depends on what the compensation is for. If the objective of the compensation is to compensate for indirect costs of the Carbon Price Floor, and EU ETS, as it is stated that it is, then it is right to focus on electricity and within that to focus on electricity from the grid in the main.

Q4 Chair: Damien Morris, you wanted to come in.

Damien Morris: If I could pitch in on that first point, I wanted to highlight that the European Commission has already done a carbon leakage assessment here, using its own criteria but among those criteria it applied a carbon price expectation of €30 per tonne, which is by all accounts obsolete. We are currently at a carbon price of around €6. It is not set to rise above €10 under quite optimistic expectations going forward. That list of sectors, as it has been defined, has multiplied the number of eligible sectors. It was welcome to see that the BIS consultation had applied an additional filter on companies, but we note there that it uses a 2020 carbon price against 2020 GVA when we are talking about a spending review period that ends in 2015. Again, this is multiplying the companies that would be eligible for compensation.

Q5 Simon Wright: Do you agree with the principle of compensation and what are your views on the size of the package, £250 million over two years?

Alex Kazaglis: From the perspective of the Committee on Climate Change, I think there are a number of ways. Clearly there is likely to be a competitiveness or leakage implication for a very small number of firms at the minimum, which has not been quantified yet but let’s assume that there is that risk. There is a number of ways that you could respond to it. You can respond to it by energy efficiency, which means they are not using the energy any more so they are not paying the cost. You can respond to it by switching to renewable fuels, which are not subject to these costs. You can respond to it through compensation, which is one of the means, or exemptions from the cost in the first place. I would agree with the principle of mitigating these costs but just to note that there are a number of ways you can do it. You need a full assessment of all those different routes and how far you can go, and it is different in each of these sectors.

Simon Bullock: I think the compensation for genuine competitive threats does deal with a real short-term problem, but I would like us to step back and look at the need for British industry in the future. It is clear that British manufacturing has to be strong and resilient in the face of global threats but also it has a crucial role to help the UK decarbonise and meet its carbon budgets. I am concerned that over the last couple of years we have had maybe six or seven occasions where climate policy has retrofitted or bolted onto it measures to help electricity intensive industries out, which is right, but I think we also need to be looking at how do we help them make that transition rather than just shielding them from the costs of carbon and energy prices as they go forward. What do we need to do to help them to invest in low-carbon technology and become energy efficient? That is the thing that is critical in the medium to long term and we can’t just have a programme based on compensation.

Dimitri Zenghelis: I would echo that. I think that is right. The question here is you want to legitimately compensate those firms that are vulnerable without over-compensating and therefore using excess resources. To distribute that compensation in the form of a lump sum should not, in principle, blunt the incentive to improve efficiency. In practice, that would need looking into. As Simon says, one might want to consider other market failures in terms of energy inefficiency and waste, so might that compensation be distributed better if it is targeted at improving energy efficiency or might it be distributed better in terms of cutting payroll taxes or national insurance, which are probably more likely to prevent leakage and dislocation to other countries than merely handing a lump sum to their profits?

Damien Morris: I wanted to highlight a couple things, both in the Commission guidelines and in the BIS consultation, that we felt were quite welcome. Naturally, there is some level of trade-off between abatement incentives and compensation but it was welcome to see that in both of these documents there was text saying that the aid must not fully compensate for the carbon price to retain some level of these incentives. The question is whether in the detail that principle is actually being fulfilled.

Q6 Simon Wright: To what extent are there already incentives for energy intensive industries to be more energy efficient? Will the compensation scheme reduce existing incentives to decarbonise?

Alex Kazaglis: There are incentives. There is a lot of incentives for energy intensive industries just by their nature that they are energy intensive and they are facing high energy costs. They are seeing electricity prices that have risen around 140% since 2004, mainly due to the rising wholesale gas price, so there is a lot of incentives there. Is it enough? A couple of weeks ago, DECC released an energy efficiency strategy and in that strategy they stated that current policy will only achieve around 14% of the potential for energy efficiency by 2020, so there is a lot there that is not going to be achieved in the current incentives but to get that extra bit is very difficult because there are very real barriers that stop it from happening. Those are things like the long lead times taken for a blast furnace at a steel factory to turn over once every 20 years; there is only a small window of opportunity to get in those energy efficiency benefits. The incentives could go a lot further. It requires something very different from what we have at the moment. The Green Investment Bank is in the right area, but it would need to be targeted very specifically at particular measures in order to get that full potential.

Q7 Zac Goldsmith: Can you describe how you would see the Green Investment Bank being useful in the context of existing infrastructure that will be replaced maybe 10, 15 years down the line which is currently energy inefficient? How specifically would the Green Investment Bank be useful there?

Alex Kazaglis: When the Committee put together the fourth carbon budget in 2010 and we spoke to industry at that time-and this may still be the case-it was difficult for parts of the energy intensive industry to access the capital to pay for energy efficiency projects. In many cases they were competing with other parts of their businesses that had more attractive investment returns for the limited capital. For example, optimising refineries, energy efficiency refineries, is difficult because the same firm is exploring oil and gas in the Arctic, which is a much more high return activity. There were lots of examples like that. What the Green Investment Bank does is provide that targeted capital for those projects so it overcomes that lack of access to capital barrier.

Q8 Mark Lazarowicz: I would like to pursue a point about how the compensation formulas would relate to the areas of activity that are most susceptible to carbon leakage. In your view, how far do the formulas succeed in targeting those activities where there is a risk of carbon leakage or how far is it effectively just a general overall electricity bill subsidy? Could the compensation formulas be improved to meet what are the desired objectives?

Chair: Who wants to come in? It is complex.

Simon Bullock: It is. It is surprising to me that the eligibility for the indirect EU ETS compensation package for companies-not for sectors but for companies-does not include a trade intensity criterion within it. It has one for electricity intensity but not for how much you compete with other countries and which countries. I think that DECC have the devil’s own job in doing this. It is very complicated and their approach of trying to mirror the EU proposals as far as possible seems to make a lot of sense. It is less bureaucratic and less complex that way. The EU say that you should have a trade intensity criterion so it is surprising that that criterion is not there in the BIS proposal.

Damien Morris: A lot of the compensation metrics have been taken directly from the European legislation and it is good to see that these have been set up in the way that they are calculated in arrears and they are set to evolve with things like the carbon price, which evolves as the emissions intensity of the grid evolves. We particularly welcome the way that the BIS consultation specifies a new grid emissions intensity factor that is a more realistic representation of what electricity consumers are expected to be paying for than the assumptions in the Commission document. We do note, however, that one factor of the Commission guidelines is that the aid given does not drop proportionally with output. So if a company’s output drops by 49%, its aid is not lowered at all; it is not until it passes the 50% threshold. Then again, if the output drops by 74%, they still receive 50% of their aid. In terms of recommendations on that point we would, as a minimum, recommend narrower bands of compensation, 10%, 15% perhaps, rather than these massive 50%, 25% goals that could perversely incentivise running uneconomic facilities. More boldly, we would perhaps recommend making the default risk of under-compensating rather than over-compensating industries in these situations. Again, that is in line with the spirit of those-

Q9 Mark Lazarowicz: Are you saying the default position is over-compensating?

Damien Morris: In this particular set of guidelines the situation is that if output drops by, say, 74% compensation only drops by 50%. If we did something like reverse the assumptions there and pay at the lower level, again probably within a narrower set of performance bands than are currently laid out-as I highlighted earlier, there is a set of principles expressed in both the BIS document and the Commission guidelines that say we should maintain some incentives and not cover all of the costs of carbon here. I think this preference for under-compensation on this particular point is in line with that.

Alex Kazaglis: I would just reiterate or put in context the points I was making before about it does not appear that in the equation it picks up on different rates of the Carbon Price Floor paid by auto-generators and therefore that is not picked up in the compensation. It also makes sense, I think, to consider trade intensity as well and other aspects of the market that might make it less of a competitiveness concern if the industry is facing these costs.

Q10 Mark Lazarowicz: Do you think that those deficiencies could be remedied by making the formula reflect that in some way? Can that be done without making it too complex?

Alex Kazaglis: Yes, I do. It sounds complicated but what we are talking about here is not a pervasive problem that is right across the industry but an isolated problem in a small number of firms. It is possible to get a handle on those things using the various sources of data and also perhaps some sort of qualitative understanding of how these sectors work.

Simon Bullock: It may not be directly related, but one final point is that BIS and DECC are very clear that there would not be any additional energy efficiency requirement to receive the compensation, and that is surprising. I note the German scheme for compensating industry for their renewable energy was renegotiated this November and in that their new scheme has committed the industry to reducing their energy demand year on year. Part of your inquiry is about the whole package but this consultation is only about the Carbon Price Floor and EU ETS. There is nothing in there about the Climate Change Levy exemption increase from 80% to 90%, so it would be interesting to know whether there are proposals for tightening the climate change agreement to compensate for the compensation.

Q11 Mark Lazarowicz: That takes me to another point I was going to ask you about. As far as I can understand it, as best I can, there is no provision in the compensation formula that would take into account the energy efficiency or the electricity usage of the actual intensive industries themselves. Am I right in assuming that?

Alex Kazaglis: I think it is contingent on meeting certain efficiency benchmarks, from my reading of the consultation. Those benchmarks are taken from the EU benchmarking of particular processes, so there is some incentive, I think.

Q12 Mark Lazarowicz: To get compensation you have to reach that benchmark in some way.

Alex Kazaglis: You will only be compensated for the bit.

Simon Bullock: As I understand it-and I will check and get back to you if I have this wrong-there is an efficiency benchmark for the compensation for indirect EU ETS costs but there is no efficiency benchmark for the Carbon Price Floor. That is my understanding of how it is set up.

Q13 Caroline Lucas: Off the back of what you were saying a moment ago about the trade intensity, have you been able to do any assessment about whether trade intensity was properly included in the calculations? Do you have any sense of how many fewer companies would need to be compensated, for example? Is there enough information in the public domain for you to be able to make that kind of an assessment or not?

Alex Kazaglis: You end up with the same sort of sectors that are already identified in the BIS consultation document. There is fairly broad agreement on what those sectors are. There are a few that maybe should be included and are not, or are and should not be, but you get to the same category if you look at trade intensity. Trade intensity data are available at a fairly aggregated level and not below that, so it gives you an indication but it is not quite what you need to know in order to allocate compensation. You would need to do a bit more than just looking at trade intensities. Also, we are compensating for a period in the future, something that has not happened yet, so trade intensities for the past carry inherent problems as well.

Dimitri Zenghelis: Trade intensity with who matters. For most of these sectors, trade intensity falls by a factor of between three and seven when you look outside the EU. That is because many of these sectors are tradable but only over relatively short distances, or they act as intermediary products for similar industries that agglomerate in one part of Europe, for example. You need to be mindful that a firm that has strong trade with China may have a stronger case even in a world where the Carbon Price Floor provides an asymmetry within the EU vis-à-vis some of our EU competitors, versus a firm that trades with Germany, which may have similarly ambitious if rather different sets of environmental and greenhouse gas policies affecting them.

Q14 Caroline Lucas: I have a question for Sandbag specifically about the emissions trading programme in the EU. Do you feel that the amount that the energy intensive industries are gaining from the EU ETS is properly being taken into account when it comes to looking at the compensation that they are also going to be receiving?

Damien Morris: Thank you for asking that question. Certainly we don’t feel this and we really think the UK Government is in jeopardy of pouring good money after bad in terms of the compensations for carbon leakage threats that it has awarded its industries. This is an excellent opportunity to limit that. I have a few figures here. We have seen some 64 million surplus allowances awarded to industry just over the period 2008 to 2011. One critical example is that Tata’s operations just in the UK over 2008 to 2011 have accrued a surplus of 31 million allowances. The value of those is probably in excess of the whole £250 million compensation package that is being explored here. We definitely feel that these direct assets for protecting against carbon leakage that the Government has already awarded should be taken into account somehow. There are a few ways this could be done. It could somehow be factored into the eligibility criteria as to whether that 5% GVA threshold is passed, although again you would probably have to push the time horizon back within the spending review period there. Probably more realistically what you could do is withhold compensation until the cost of carbon equivalent to the surpluses that have been accrued has been passed through to that firm. Naturally if you do that, not all surpluses have been acquired, because of the recession and because production has been lowered. In some cases this has been because real abatement has taken place and if industries could prove that then those costs should be given to them.

Q15 Zac Goldsmith: Could you explain how it is that Tata managed to secure an over-allocation? You said 31 million. Can you explain how that happened and what that actually means?

Damien Morris: Yes. I think the Government had been fairly forthcoming. Before that it had the intention of basically protecting industry from all of its direct costs under the EU ETS by giving out free allowances. When it was consulting with industry it tried to determine what their emissions were going to be over the course of Phase II and essentially gave them allowances sufficient to cover that.

Q16 Zac Goldsmith: Would Tata have made an over-estimate of what kind of emissions they were likely to generate?

Damien Morris: I wouldn’t claim that necessarily, but what definitely happened is that the recession came along and blindsided everybody. The free allocations that were sufficient to protect business-as-usual emissions as expected back then never materialised and we were left with Government assets far in excess of what was awarded to most of UK industry.

Q17 Caroline Lucas: So Tata is not an exception, in a sense? Tata is always used as the example to prove the point. Are there plenty of other cases we could be looking at where there is over-allocation?

Damien Morris: Absolutely. I don’t mean to pick on Tata. It is just because they are such a large company that it is more obvious there, but the steel industry in the UK has basically doubled the allowance it needs overall. It is a similar story with ceramics. The cement industry also has not quite the same proportional oversupply. Tata is not alone, the steel sector is not alone, and we really think this should be taken into account in terms of compensation for all energy-

Caroline Lucas: Sorry, I was just scribbling. Were you saying cement and ceramics both have at least double the allocation that they would need?

Damien Morris: Ceramics has roughly double. Cement has a little less than that.

Chair: I presume you have the evidence on which you are basing that. It would be very useful to have it.

Damien Morris: Yes. I would be very happy to submit some documentation to support the numbers I have given today.

Q18 Mark Lazarowicz: I can see members of the gallery shaking their heads. No doubt we will hear something in due course. Just to put it in perspective, what has been the value of that over-allocation, as you see it, to the industries concerned? Obviously the market price will change day to day, but what kind of figure can you put on that?

Damien Morris: It is hard to put a figure because the carbon price fluctuates so much. Over the last year it has been much lower than it has been over the rest of the phase. As I said before, the market price today or recently is around €6 per tonne. It hovered around the €14 or €15 mark for a lot of Phase II. From forecast projections across the next eight years, it is not expected to go above €10.

Q19 Mark Lazarowicz: It is probably a silly question but in terms of EUA how many are we talking about or would you prefer to work out the common points after that?

Damien Morris: Yes, sorry. For Tata the specific example I gave before, that is 31 million, so if you assumed a €10 carbon price you are talking about €310 million.

Mark Lazarowicz: Over what period?

Damien Morris: Over 2008 to 2011.

Chair: I am very conscious that we have the industry representatives coming and we need to finish our next session at 6.00pm. It would be very useful if you could provide any evidence in writing to the Committee.

Q20 Caroline Lucas: Do the other people on the panel agree in principle with that rough kind of back of the envelope type of assumption that ceramics and cement, and indeed steel, will have been given significant over-allocations and therefore in principle need less compensation?

Alex Kazaglis: From the perspective of the Committee on Climate Change, yes, the free allowances are definitely there. I want to take the opportunity to trail a report that the Committee are doing that will look at this. It is coming out next February so we will be able to quantify them to some extent. Also, these could be used to offset the costs but there are reasons why they might not be able to be used to offset the costs. For example, money given a couple of years ago is not necessarily good for a business to offset costs that they are facing today. There are real competitiveness issues going forward. You would need to take into account, after you had worked out how big the free allowances were and how much the surplus allowances were, whether indeed they do offset costs that go into the future.

Q21 Caroline Nokes: It is a bit of a hypothetical, but If carbon leakage were not an issue, do you think that the Emissions Trading System and Carbon Price Floor would be effective leaders in driving decarbonisation?

Dimitri Zenghelis: I was going to chip into the last point, but this is a nice link. The question that is clearly begged over the degree to which there is over-allocation is to what extent ought the EU ETS have tightened the cap to track the slowdown in demand as a result of the global economic slowdown. To the extent that it has not, to what extent has policy been loosened in terms of emissions reductions. That also has a bearing on the relationship between the Carbon Price Floor, of course, because for those sectors that overlap with the EU ETS, the Carbon Price Floor will lead, one for one, to carbon leakage because the European cap will still hold. To the extent that UK firms reduce their demands, that reduces demand in the market as a whole so the price goes down until that cap is met, so someone somewhere else in Europe will be commensurately increasing their emissions. There are good reasons that you might argue for doing that but it is a pretty bold move and one that needs to be looked at very carefully in the context of the broader emissions reductions through the trading process.

The only other thing I would say is I think carbon pricing is a prerequisite for effective emissions reductions but of itself it is not sufficient. There are other market failures that are not price sensitive, energy efficiency and waste being a classic example. If people were fully price sensitive there would be a lot less of it. Another might be innovation and research and development. A lot of the returns to innovation and research and development at the firm level are very long term, they are very risky, they can be captured by the firms to the extent that knowledge spill-overs are free. So there is a case there for public support as well.

Finally, the public sector has a huge role to play in capturing policy risk. One of the things that puts off private investors is the very rational fear that when political parties change or the environment changes, the policy will change. You would need some kind of skin in the game-and the Green Investment Bank is one such example of an institution that provides that-that says that if the policy environment changes, the public sector stands to lose alongside the private sector, and that instils confidence that brings forth investment.

Chair: If I may, I would like to move us on to our next witnesses. Thank you for coming along this afternoon. I am sorry that it has been curtailed. Thank you very much indeed for your time.

Examination of Witnesses

Witnesses: Dr Laura Cohen, Chief Executive, British Ceramic Confederation, Jeremy Nicholson, Director, Energy Intensive Users’ Group, Gareth Stace, Head of Climate and Environmental Policy, EEF, and Philip Pearson, Senior Policy Officer, TUC, gave evidence.

Q22 Chair: Thank you very much indeed to each of you for making yourselves available this afternoon. I am really sorry that the division has curtailed our session. I am trying to allocate the reduced time fairly and we will go straight into the questions. I am very conscious that you sat through the earlier session and I would say from the outset that if there were comments made that you feel you wish to have a right of reply to, please feel free to contact the Committee, but if we may we would like to proceed with our questions now.

I will begin by asking to what extent you think the £25 million compensation package will be enough? To what extent does it suit your members or suit your interests or to what extent has it overlooked certain things that should be included? Mr Nicholson, I suspect you wish to start.

Jeremy Nicholson: Very briefly, before handing over to my colleague, the benchmark for us is what our competitors elsewhere are doing in Europe. I think Philip Pearson and his colleagues in the TUC have done some particular analysis on that, which I think is highly relevant here.

Chair: Okay. Mr Pearson.

Philip Pearson: Thank you very much. The package is not adequate and the key test of this for us is what competitors are doing and that is the measure against which one would need to discuss carbon leakage. Simon Bullock used the word "retrofitting" and that is the inherent problem of the approach to industry policy that we have been faced with, not just under this Administration but previously. It does not bear comparison as an industrial-cum-energy strategy with that of our leading competitor in Europe, which is Germany. If you look at the detailed support provided by the German Government you will see that it is an integrated industrial and energy policy at the heart of which is compensation for the costs of climate change that industry has difficulty bearing in the transition. I think the word "transition" is really important. You can criticise the German scheme-and the study that we have cited is not uncritical-for a blanket-style approach, which is not really what we are advocating. What the consultant’s report that I referred to is advocating is a predictable long-term decline in support, but it is predictable, it is long term and it is known and it is a bankable policy against which long-term investment decisions can be made. So it is the short-term, piecemeal approach that is the first problem and, secondly, the scale of support. You should not exaggerate, but just the numbers appear to stand out really starkly to show that the annual package of support is around €6.5 billion across a range of climate change and energy policies in Germany. So, is £210 million enough over three years? The answer is probably not, particularly if you see what other people are doing in other countries.

Q23 Caroline Nokes: A specific question, Mr Pearson, about the German scheme. You have identified that the numbers are significantly larger but are you also aware of industries in Germany that would be eligible for compensation that simply are not going to be or are struggling to ascertain whether they are eligible in the UK?

Philip Pearson: I can answer that very quickly and then invite people on the panel to also answer. There is a schedule in the report that sets out the extraordinary range of carbon cost compensation that is available in Germany, from baking to the railway industry. Why shouldn’t they if they have intensive industries-the German railway industry competes with other railway networks because it is in the European system. This is not to say subsidise everything and turn away from the need to decarbonise, because that is not what we think. We think high energy use is not the same as energy inefficiency. What we are looking for is an underpinning of decarbonisation in that in a range of industries where there is a transitional need, the industrial security question should come to the fore.

Jeremy Nicholson: The German compensation scheme is fundamentally different in scale and scope. My colleagues may add about that in terms of the sectors that are covered but also the intensity of aid that is given. I am sure as we go through the questions there will be some issues about that and we will touch on them later.

Q24 Chair: Dr Cohen, do you want to come in on the £250 million and how adequate or inadequate it is, qualitatively as well?

Dr Cohen: As the other speakers have said, it is about getting a level playing field with our main competitors around Europe but certainly on the sectors, for example the brick and roof tile companies are going to be compensated in Germany but are not likely to be compensated in the UK. Some other tile companies and so on in the UK may be in a similar situation, so it is a much more generous scheme with different criteria, but if those criteria were applied in the UK it would include many more sectors.

Q25 Caroline Lucas: One of you said that the key thing to ask is what package is being given to our competitors and therefore to compare with that. Isn’t that immensely difficult because there are going to be so many different factors that will have a bearing on what the price of something is in Germany or China, or anywhere else come to that, versus the UK? Isn’t a better litmus test to try to get to what one of the earlier panellists called the counterfactual, which is difficult to get to, in other words what would the case have been like without this particular extra measure? It worries me if we simply say that the benchmark is what is happening in competitor countries, because that does not necessarily properly take into account trade intensity or a whole range of other issues from labour costs to whole set of other incentives and policies.

Jeremy Nicholson: You are absolutely right that other factors like trade intensity and, where relevant, labour and other taxation costs and so on need to be taken into account. We are after all talking about energy intensive industries here. The one thing that all of them have as a characteristic is that energy accounts for a high proportion of their operating costs, although even within the intensive sector there is a big range there and some are more gas or more electricity intensive and so on. You are also right that because the policy measures even within Europe for supporting renewables, for example, are radically different from one another, comparability here is not straightforward. However, I think it is right to say that there are elements of compensation that are not yet available at all to intensive industries in the UK, particularly for the impact of renewable costs specifically, which is not covered by this package. As your Committee is very well aware, the Carbon Price Floor is a unilateral, UK-only measure. I think it is right, therefore, that particular attention is paid to those costs that risk distorting trade within the single market. Obviously there are much more complex questions about how one protects against carbon leakage internationally, outside the EU altogether.

Q26 Mark Lazarowicz: What would you regard as a comparative level of expenditure on a scheme that would put you on a level playing field, say with Germany, here in the UK? How is the German scheme funded and how would it be funded in the UK if you had what would be your preferred option?

Jeremy Nicholson: The starting point is the guidelines that the Commission themselves have produced. If we look at the EU ETS component first, the eight guidelines stipulate a maximum level of aid that can be granted. In certain instances there are benchmarks for energy efficiency that apply too. They also propose a maximum carbon intensity factor. This takes into account the degree to which our generating system here is carbon intensive and the extent to which the carbon price is passed on to consumers. The principal difference in the way that the German Government is approaching this and the UK Government currently proposes to grant compensation is that the German system will apply the maximum carbon intensity factor that is allowed under the guidelines and the UK Government is proposing a much lower one. If you take into account the maximum aid intensity and the lower carbon factor that the Government intends to apply here, only about 50% of the uplift in costs caused by the EU ETS will be compensated for in the UK, even for those industries that qualify. As you will be aware, there are some electro-intensive industries that will not qualify for this aid. There are similar concerns about this being applied for the Carbon Price Floor as well.

Doubtless you will hear from the Government in due course as to why they would like this lower figure to apply. We strongly suspect, on the basis of what we have heard from a number of Government Departments, the basic reason is there is not enough money to go round. We don’t think the solution to that is to fiddle the figures. We think the Government needs to be open. If they are not in a position to adequately compensate industry in the way that the German Government and some other European countries are then they should say so.

Q27 Zac Goldsmith: I was going to ask to what extent the over-allocation of permits might have alleviated, just to respond to some of the points made in the previous session, but if that is coming up then I apologise.

Chair: Okay then. Philip?

Philip Pearson: In terms of the scale of the package, these companies pay their taxes by and large. This is not the Starbucks sector. The Building our low-carbon industries report, which we did with the Energy Intensive Users’ Group, demonstrates quite clearly there is around £13 billion of revenue to the Exchequer from these core industries alone, let alone the supply chain benefit to the economy. This is the kind of mind set that is missing from the approach to the package. Is it big enough? We don’t know but what we do know is we are trying to secure industries that contribute to the economy and regionally and locally have a great deal to offer. That is the kind of yardstick.

Dr Cohen: We have shared with the Business Department and also we have shared with this Committee previously, in confidence, some examples of electro-intensive companies that are part of the solution to a low-carbon economy. They create products that reduce energy with their users but have already relocated to other European economies and are citing, in private, electricity price as the main factor. These are countries like France where they can get access to an Exceltium contract-bills are typically a third lower at the moment-and Germany where they are getting much more compensation as a whole. These companies are the technical ceramics and refractories. They are not in EU ETS already so they don’t have any allowances. They are generally pretty small installations. There is genuine carbon leakage going on here and these companies are not going to get any of the EU ETS in direct compensation either. There is a genuine problem. The BIS officials are very sympathetic to it and we appreciate their help in working with us and our members to ensure those companies submit the right evidence.

Q28 Dr Offord: I am going to approach it from a different angle. If there wasn’t any compensation at all, I am particularly asking this to Dr Cohen and Mr Nicholson, have you estimated how much the Emissions Trading System and also the Carbon Price Floor would increase the price of electricity your members pay?

Jeremy Nicholson: I would direct you in the first instance to what I think is an extremely useful report produced by BIS in July this year, the results of which accorded very much with our own internal analysis. They assessed the impact of a number of climate policy measures in the UK and in a number of competitor economies, both now and where they will likely be, given all the uncertainties, by 2020. We understand, for example, that the EU Emissions Trading Scheme, albeit with a low price of carbon at the moment, has probably added around £5 a megawatt hour to the price of electricity paid by our members. The Carbon Price Floor will probably add around another £3, so that is around £8 a megawatt hour currently. That figure will rise very substantially by the end of the decade, largely as a result of the Carbon Price Floor. Although there are disagreements between ourselves and some Government Departments about the precise carbon intensity factor that should apply, in order of magnitude terms I don’t think there is a great disagreement about this. It is more problematic to know what that means for the business, but in terms of the calculation of the effect I think there is a fair amount of consensus there. It is already material and it is going to be very significant by the end of the decade.

To put that in context, the combined cost of the renewables subsidies of energy taxation, albeit with rebates for intensive sectors, and the Carbon Price Floor and Emissions Trading Scheme taken together, are likely to add something of the order of 40%, around £28 a megawatt hour, to large industrial users’ supply costs by the end of this decade. Plainly that is a material impact if you are an energy intensive business that is trading globally.

Dr Cohen: Our members are also talking about making dispassionate decisions about where they invest. Some are talking about should they invest in the UK or France, for example, and they have to look at the cumulative costs of all these policies both now and in the future. Again, they have shared with the Business Department some instances where they have not got the investment into the UK and it has gone overseas.

Gareth Stace: Can I add to that that we have to look at the cumulative cost but also the uncertainty going forward. If our members in the steel sector operating at a global level are going to their main board for funding for a project-and their main board won’t be based in the UK, they will be based somewhere else-how can they give the certainty to that main board that costs are going to be X going forward when the lifetime of this package that we are talking about today is two years? We have no certainty what the package will be after that. How can somebody in the UK go to a global board and say, "Please give us the money" when the guy standing next them is not subject to the costs and also has much more certainty going forward in terms of investment certainty? We are not going to get that funding; someone else will get the funding.

Q29 Chair: In terms of the UK electricity prices that the energy intensive users are paying, do you think the comparison is fair with the amounts that domestic users pay? How do you look to see how the whole fairness issue can be incorporated into the agenda?

Jeremy Nicholson: I think there are two aspects of that. One of them is the international one in the sense that what is fair for industrial users is judged naturally by what our competitors are paying elsewhere. You raise an important point about domestic prices and there are all sorts of issues about domestic electricity supply that go well beyond what we can deal with here. I would say that prices are cost reflective to industrial users, even if we don’t necessarily like some of those costs at the moment. For all consumers, whether domestic or industrial, an element of their bills reflects the wholesale price of electricity, which is the same for everyone. Some of our members are connected directly to the National Grid and therefore don’t pay local distribution charges. Of course, there are certain fixed costs associated with supply, metering and billing and so on, which per kilowatt hour are considerably cheaper for a large industrial site using 10s or sometimes 100s of megawatts of continuous power compared with the relatively small amounts we use at a multiple number of sites in the domestic sector. It is not so much that industry gets a discount but the costs reflect the economies of scale for industrial supply.

Q30 Mark Lazarowicz: On that point, but also it relates to a question that was not fully answered earlier, if you were to get the higher level of compensation that Germany has how would that be funded in the UK? Someone will get paid, someone pays for, so where does the money come from?

Jeremy Nicholson: That remains to be seen, and doubtless the Minister and others will want to comment on that, but it is likely that unless we change our targets, if the UK remains committed to the same ends, that those costs are likely to be picked up by other energy consumers. I have to say this is not something that industry has argued for. We have not argued for these costs to be imposed in the first place and I think it is always open to Government to consider whether some or all of these costs should be spread across taxation more generally as opposed to high energy consumers. That was a decision that was made by the incoming Government with respect to the Renewable Heat Incentive, which was originally going to be funded by a levy on fuel bills, principally gas bills, which would have hit all of us as consumers, and the decision was taken to fund it out of general taxation. The scale of this compensation is a lot larger and I realise there are state aid implications that would limit what could be done. I think there is a debate to be had about the equitable balance between whether it is the taxpayer generally or electricity consumers specifically that should be footing the bill.

Q31 Caroline Lucas: Mr Stace was making a point earlier about the importance of policy certainty, which I accept is an important thing but, given the fluctuation in any case on fossil fuel prices, wouldn’t you argue that because we know that fossil fuel prices are going in an upward direction but on the way there are certainly some fluctuations, in a sense the status quo is not providing you with the policy certainty that you would want? What kind of measures would you suggest putting in place? You said before that you only have the compensation for two years. Presuming that the compensation is somehow linked to an estimation that there will be some kind of transition where energy intensive industries would start to use slightly less energy over time due to energy efficiency or switching away from more carbon intensive fuels, how are you going to get this transition with the certainty that you want at the same time as you have a backdrop of fluctuating fossil fuel prices?

Gareth Stace: There are two points there. In terms of the fluctuation, that means there is more of a level playing field because globally they are feeling those same fluctuations whereas globally they are not feeling the Carbon Price Floor and the EU ETS. To me that is not so much the uncertainty of getting investment certainty going forward. In terms of the transition, we should remember that this package only addresses electro-intensive sectors and compensates them for two elements of climate change policy here-but I would be delighted if in two years an electric arc furnace in the steel sector could dramatically reduce the energy intensity of its process. It is using very tried and tested technology and in order to change that technology so significantly would require billions of pounds of investment that is not going to happen in the next two years and it is not going to happen unilaterally here in the UK or even in the EU. It requires a global solution to make steel in a very different way.

Q32 Caroline Lucas: Can I press you on that, because that does seem to come to the crux of it? What would you put in its place? If you accept that ultimately one would like to replace processes that are very energy intensive and carbon intensive and if we are going to sit around and wait for global agreement-Doha is happening now and not much is happening out of that-being practical what would you suggest?

Gareth Stace: When you say processes, you mean what policy framework rather than what technology?

Caroline Lucas: Yes.

Gareth Stace: Yes. We are going to wait far too long for an international climate change agreement so what we believe we need in the meantime is global sector agreements for certain sectors that operate on this global level, such as the steel sector, which means that sector coming together to tackle the problem as a whole rather than individual pockets. The EU Emissions Trading Scheme does nothing to reduce global emissions from the steel sector because there is very little abatement in the steel sector so if we don’t produce the steel here it is going to be produced somewhere else, so globally it doesn’t do anything. That is a real problem because the steel sector is a significant emitter and we need desperately to reduce emissions from that sector significantly. In order to make steel in a different way, we need that global funding, that global solution, and that is what we would be calling for but that needs global co-operation with countries such as China who may not co-operate at this time. What we see is that we have developed sectors such as the steel sector in developing economies and therefore those developed sectors need to be treated on that level playing field as one moving forward. I think that could happen much quicker than a global international agreement in general.

Dr Cohen: Something very positive the UK Government could be doing is working with individual sectors on breakthrough technologies, to have technology demonstrators, perhaps by using some of the green taxes recycled into these. For example, we as a sector published our roadmap last week, identifying some of these critical breakthrough technologies and we want to use this as a starting point for our discussions with Government in the UK and in Europe to try to get things moving in a positive way.

Philip Pearson: On process, I wanted to add that the TUC really welcomes the package. It may sound like we don’t, but we think it is a really important first step and we would like the comments about package 1 resolved very quickly to get it going. But there is a much bigger debate to be had and one vehicle for that is through the Green Economy Council, which has an energy intensive task group that is bipartite with Government involved at ministerial level. We feel there are places where we can resolve these issues and develop something much more long term, much more ambitious, much more like our competitors.

Jeremy Nicholson: We would certainly much prefer to be having a conversation with your Committee and others about what can be done to support decarbonisation efforts in industry, the as yet non-existent green deal for industry, which is comparable or perhaps rather better than that proposed for the domestic sector. The Green Investment Bank is obviously a part of the solution here. But if you think of the level of taxation that is being supported by Climate Change Levy, Carbon Price Floor, EU ETS and the auctioned allowances and so on that is being directly funded through energy intensive industries, even under the maximum compensation we are likely to receive that is going to be running into billions per annum by the end of the decade. It is not unreasonable to ask how much of that is coming back to support industry decarbonising.

Q33 Simon Wright: If there was scope for adjusting the compensation scheme but sticking within the £250 million budget, what adjustments would you like to see made?

Dr Cohen: I would like to see a bit of flexibility between the split between Carbon Price Floor and the EU ETS because many more companies, potentially, can gain access to the Carbon Price Floor compensation. At the moment the carbon price is going to be higher than that of EU ETS, so it is about a fairer distribution, although it is recognising there is not probably enough to go round as it is.

Gareth Stace: I would like to see that we revisit the aim of this scheme, which is to compensate electro-intensive sectors for Carbon Price Floor and the EU ETS, and make sure that we stick to that aim rather than diluting the scheme to try to compensate more sectors but compensating everyone less. We need to stick with what was the original aim of the scheme.

Jeremy Nicholson: The only thing I would add is that one of the aims of the scheme is to keep business in business, profit-making business located here, and to avoid the threat of carbon leakage. If the compensation fund for the spending review period is inadequate and perhaps unintentionally sends a message to industry that Government is not sufficiently committed to this over the long run then that would be counterproductive. One appreciates finances are tight at the moment but given what is at stake, given the sort of job losses we have heard about in energy intensive industries in recent weeks, I don’t think that a small expansion of that fund towards a greater end would be an unreasonable thing to ask for.

Q34 Mark Lazarowicz: You probably can’t give an answer now but it would be useful to get in writing your perspectives on the issue of the effect of free allowances on industry. Obviously going forward free allowances may well become-it will depend on what happens at Doha and other things, but I think it would be useful to us if you could give some reaction in writing on that particular point. With the timing I would say you have one minute now so I don’t need your answer in one minute

Chair: We are expecting the vote very shortly. Did you want to comment on this?

Gareth Stace: Shall I quickly try to answer that from the steel sector point of view? In terms of allocation that we receive under the EU ETS, we need to remember that the scheme we are talking about today relates to indirect costs on electro-intensive sectors. The EU ETS is about direct costs on carbon intensive sectors, so let’s not mix the two up.

Q35 Mark Lazarowicz: I think the suggestion is you may get a bonus to make up for what you are seeking here, to put it in a crude term. That is perhaps the indicator and that is why value is quite useful to know.

Gareth Stace: Sorry, I thought you were talking about the issue that you had in the previous session about what was potentially called over-allocation and could that be compensated with this package.

Mark Lazarowicz: Yes.

Q36 Caroline Lucas: I think we are going to come to direct compensation, in the sense that we realise they are different things, but if you are paying out a lot under one system but gaining quite a lot under another one, why can that not be seen as a justification?

Gareth Stace: Because they are potentially two different companies that are getting this free allocation in EU ETS, and then the electro-intensives for their direct emissions might be very small, but their indirect emissions are very high, so they can’t really cross-fertilise each other because they might be two very different populations. But in terms of tackling the issue of what is considered-or some people say-over-allocation, we should remember that we didn’t ask to be in this scheme in the way it is, in the sense of we are following the rules of the scheme. Nobody could predict the recession in 2008 and nobody could predict that what we had was ex-ante allocation. We said at the time that we should have ex-post allocation that took into account changes and fluctuations in production, and therefore we wouldn’t have this problem that we have now if Government had accepted our position at the time. But Government wanted the certainty of the cap at the time and told us that is what they had to have, and that is why they had to go for ex-ante allocation and we have the problem we have.

Chair: We have a Division.

Q37 Caroline Lucas: I know, but just a really quick one. Tata is the example that was given earlier with the 31 million allowances. Would you not see that, as far public perception at any rate is concerned, if Tata, which has received that much in free allowances, is then also going cap in hand saying, "Please can we have some money from your compensation scheme" it doesn’t add up?

Gareth Stace: I think probably we would need to think about those allowances and what it has done to that company in terms of I have heard the term "windfall profits". We need to think, Tata Steel is in a sector that since 2008 has lost one in three of its employees. It is a sector that is suffering in economic terms very badly and therefore I can’t see that in those sectors-and I can’t speak for Tata at all-they are swimming around with lots of surplus allowances they don’t know what to do with. We know that many companies have sold those allowances potentially in part to keep themselves afloat, so I suspect Tata would be the same.

Chair: I am afraid I am going to have to bring the session to a close. We know it is a complicated technical issue. Please do feel free to give further evidence if you wish to. Thank you very much indeed for your attendance.

Sitting suspended for a Division in the House.

On resuming-

Examination of Witnesses

Witnesses: Right Hon Michael Fallon MP, Minister of State for Business and Enterprise, Paul Drabwell, Head of Domestic Energy and Climate Change, Department for Business, Innovation and Skills, and Niall Mackenzie, Head of Industrial Energy Efficiency, Department of Energy and Climate Change, gave evidence.

Q38 Chair: Welcome you to what is, certainly for this Committee, the third of a long series of sessions this afternoon, and I understand as well for the Minister. You are most welcome and we thank you sincerely for coming straight to our Committee from a previous committee, and also from Divisions in the Commons, which have just delayed our proceedings. With no more ado, I would like to welcome you to the Environmental Audit Select Committee this afternoon, and by way of introduction say that we wanted to race ahead with this inquiry, with this session today, because we understand how timely it is and we don’t want to be too late with any recommendations that we have.

We would like to go straight into the questions and start off by asking what your assessment is of the risk of carbon leakage among energy intensive industries. The reason for this question is that we have found that the evidence has been quite patchy in places and we have not really been convinced that there has been thorough investigation, research and scrutiny done of the extent of carbon leakage across all sectors. We would be very interested, in terms of the role that you have as Minister-and indeed the Department, and it is good to welcome the officials as well-in just how much work has been done. We understand that there have only been 48 submissions on the consultation. Does that give a basis for going ahead with compensation in the way that it is going to be structured?

Michael Fallon: Thank you very much, Madam Chairman. I am sorry that you have had a long afternoon.

Chair: We understand that you have too.

Michael Fallon: That is the way of it, and can I also apologise for the absence of the Minister at the Department of Energy and Climate Change. I am accompanied here by Paul Drabwell, who is Head of Domestic Energy and Climate Change at my Department, BIS, but also by Niall Mackenzie, who is the Deputy Director of Industrial Energy Efficiency at DECC, so I am hoping they will help me out if the questions get too technical.

On carbon leakage, yes, I think you must be right, hard data are difficult to obtain. We have drawn on the range of published carbon leakage studies, including some that have been commissioned by DECC, looking at the risks to various UK sectors and across the EU, and our own data from national statistics and we have looked at data supplied by the industry. But I accept very hard data are difficult to obtain. We have to try to understand the investment decisions that companies have made and why they have made them, and the further difficulty of course is that much of that information is commercially sensitive and they don’t want to share it with us in case it is then shared more widely. Finally, I suppose I should say that when companies finally make the decision to shift their investment or operations, it will usually be done on the basis of several factors, not just the one factor.

Chair: I suppose this is the difficulty, isn’t it?

Michael Fallon: This is the difficulty.

Q39 Chair: I think that is very much an issue for BIS and also a linked issue for DECC, because how do you quantify those other short, medium and long-term costs that businesses have when making investment decisions and not relying exclusively on the issues around carbon leakage? I think that it is because it has not been quantified to the extent it needs to be, that certain sectors particularly feel perhaps quite hard done by.

Michael Fallon: We may come to some of the specific sectors. It would be interesting to have the Committee’s view on which sectors you think have been particularly hard done by.

Q40 Chair: I would name my constituency interests possibly and declare them, but certainly the ceramics sector.

Michael Fallon: Perhaps I could say something about ceramics, but you did ask a question just before that as to whether only 48 responses really were sufficient. I think it is fair to say the call for evidence didn’t provide us with a definitive answer, but it certainly helped to steer our approach. Obviously it might have been better to have had more responses. Our intention was to try to gather evidence as to how an increase in electricity prices drives investment decisions and to explore our thoughts on how the scheme might be administered, so we did get some useful evidence but I wholly accept that it looks relatively limited.

Q41 Chair: Given that it was only 48, are there attempts being made to set up bilaterals with people who perhaps did not respond, or do you know the reasons why perhaps there was a reluctance to respond? Is it because of these other factors?

Michael Fallon: I gave the reasons of commercial sensitivity and other factors affecting investment decisions. DECC called for evidence themselves. I think DECC held a summit last year at which Greg Barker, the Minister, asked for more detailed information. That helped a bit. DECC did a report on this, and there is going to be an updated assessment accounting for some of the more recent policy decisions, like the levy control framework that is going to be published in due course. But I fully accept that the picture is not a complete one and it would have been better if it had been more complete.

Q42 Chair: It has been put to us that maybe some companies have been a bit reluctant to share that information because they might end up with a better deal. Is there any truth in that?

Michael Fallon: If they don’t give us any data at all, they are unlikely to get compensation, so that is the other side of the coin.

Do you want me to answer the question on ceramics at the moment or do you want me to deal with that later?

Q43 Chair: You did ask about specific sectors, and I mentioned that as one. I do declare a constituency interest and obviously will be impartial in all of this, but it would be interesting to hear your take on that, given that we had them before us just now.

Michael Fallon: When I first came to this, I had a look at it and I was told that in ceramics the issue is not so much the use of electricity, it is the use of gas, where prices obviously have been favourable. I am not persuaded yet that is the whole story and I would like to look a bit harder at maybe whether one of the subsets of the ceramics industry would come within the scope of the scheme, and that is something you may be considering as well. I administer some of the other funding streams and so I have also been looking at whether there are other ways of helping the industry or helping the leading companies, or indeed the leading areas in it. There were a couple of bids, I think, that were selected under a second round of the Regional Growth Fund and at least one was selected under the third round of the Regional Growth Fund that was announced on 19 October. My other responsibilities include the Local Enterprise Partnerships, and of course your particular area of Stoke is one of the candidates for the second round of City Deals.

Chair: I think I am going to be in huge trouble with my colleagues if we concentrate on Stoke, so we won’t go down that route at this stage.

Michael Fallon: But let me just say that I am aware of the issues facing the ceramics industry. I think it is worth another look, without committing to anything, but I am certainly prepared to do that.

Q44 Simon Wright: Government-commissioned international comparison of the indirect cost of energy and climate change policies shows that companies in the UK will face the highest incremental impacts of those countries reviewed. I wonder if you could comment on the limitations and assumptions made in the methodology behind this comparison?

Michael Fallon: I might ask officials to help on that, but the compensation on which we are consulting at the moment addresses the Carbon Price Floor and the ETS indirect costs only. As we develop the energy industry’s exemption from the EMR, we will obviously publish more detail on the specific impacts. Would you like to add to that?

Paul Drabwell: Yes. On the international comparison report, what that report looked at was the policy costs in the UK going forward, so that includes Carbon Price Floor, EU ETS and also the cost of renewables subsidies through both the renewables obligation and the Electricity Market Reform. It looked at those policies in the UK and it looked at similar policies in other countries, and one of the assumptions it made and one of the things it included is the exemptions that exist in other countries as well. That is why you heard some people talking earlier about Germany industries. That is why Germany looks much more favourable, because it includes the exemptions from the costs renewables that exist in Germany, hence the differential. But what you can’t do, of course, is predict what is going to happen to future policies in those countries so, like any report, it has its limitations.

Q45 Simon Wright: How much of the indirect cost impact will be offset by the compensation package? Is it possible to say what sort of percentage of costs companies will typically receive?

Michael Fallon: We think that the combined steps of the price floor, ETS and the EMR will probably remove about 50% of the policy cost by 2020. That would certainly bring the costs more into line with other countries but, as Paul has said, we can’t predict what policy changes those other countries are likely to make between now and 2020.

Q46 Simon Wright: DECC has said that they will exempt energy intensive industries from the costs arising from Electricity Market Reform. Have you looked at how much an average domestic electricity bill will increase as a result of this exemption?

Michael Fallon: No. As we develop the proposal for the exemption, we are trying to be clearer about the details of the potential impact on consumer bills but I think they are going to be relatively small. We will certainly be looking at the impact, but we have not done that yet.

Chair: At what stage would you be looking to fill in some of the detail of that?

Michael Fallon: As we develop the proposal for the exemption, and that will be in the next few months, there are lots of pieces to put together, not least your own report.

Q47 Dr Offord: How did you determine the overall size of the spending envelope for the compensation?

Michael Fallon: We drew on the evidence we had from the various carbon leakage studies, we looked at data, national statistics, and we looked at data that has been supplied direct to us from the industry. We made an estimate of various costs based on the price floor trajectory and we made an early assessment of which sectors were most likely to be in need, based on the early draft Commission proposals. It was an estimate, £250 million, and we may be right or we may be wrong but we think it should be roughly around there.

Q48 Dr Offord: In the consultation document, it says that you will consider compensating additional sectors. If that is the case, and let us presume that the £250 million is fully committed, where is that money going to come from?

Michael Fallon: We don’t know yet exactly how the money will be spent. We are not anticipating any significant under or overspend. It is a two-year package and we cannot again commit to anything beyond that, but there is logic to the package and there may well be logic to that package continuing after that. But we think if we have to add anything, any particular subsector, I think I would rather rest it on rather than a whole new sector. If we have to add a new subsector and there is a case for doing that, we think we can accommodate that within the £250 million ceiling.

Q49 Dr Offord: I do have a third question. The Autumn Statement showed there was £100 million worth of savings that were to be found in 2013-14 and 2014-15 to fund the compensation, but previously when Greg Barker had spoke to this Committee he said that savings were from underspends from 2011-12 and no future budgets would be used. Which would be the correct assumption?

Michael Fallon: I think he made it clear that DECC’s financial contribution for the CSR period was paid from one financial year. I think he has subsequently written to you confirming that DECC funded this package from a combination of contingency funds and additional energy efficiency loan repayments in excess of the amounts originally included in our plans, but perhaps DECC might like to say something about that.

Niall Mackenzie: I think what the Minister has said covers it in terms of what DECC’s contribution was, and obviously BIS and the Treasury’s funding is spread over the two years, so there is no sleight of hand or massaging of figures here.

Dr Offord: I wouldn’t expect there to be.

Niall Mackenzie: It is just the way that Government has found the money to put the package together that we have agreed between the Departments how to get the £250 million spread across the two years.

Chair: Thank you. Just moving on then to the actual compensation calculation itself and how complex it is, Peter, you were-

Q50 Peter Aldous: Yes, I would like to put this one, Chair, if that is all right. Thank you. With regard to the compensation calculation, which is complex, have you piloted the scheme with business to see how it works and to test the verification procedures?

Paul Drabwell: I can talk to that, because the first thing to say about the formula for both Carbon Price Floor and ETS compensation-and indeed the eligibility-is that it comes from largely the Commission, so we mirror what the Commission has done on this and we mirror the Commission’s work, and hence why the formula is the way it is. If it was to be any different, it would be very difficult to get state aid clear on this. We are testing it with companies. My team have met with a number of sectors and a number of companies to work this through since we published the consultation to try to work out whether there are any significant issues with the way we have gone about it.

Q51 Peter Aldous: Thanks for that. You say you have very much copied the Commission, but the Commission criticised your scheme a little bit. You used a lower carbon emission effect than they allow. Is this going to disadvantage UK companies compared to European competitors?

Paul Drabwell: Firstly, it is not the Commission that have criticised us on that. There are a number of energy intensive industries that are concerned about us using that emissions effect because it would lower the amount of aid that goes to those energy intensive industries. It is based on the fact that what often sets the wholesale price of electricity in the UK is the marginal plant, that is the last piece of technology generation that comes on the grid, and that is often gas. Gas has a lower carbon intensity and therefore the argument runs that that could be the amount of carbon price or ETS costs that are passed through to business. For example, we think it reflects what domestic consumers and industrial consumers may face. However, there are arguments counter to that. We are listening, and that is why it is a consultation question. As I say, we are open and listening to that.

Q52 Peter Aldous: Do you think UK companies will be disadvantaged compared to their European competitors or not?

Paul Drabwell: All I can say is we are listening to the evidence. It depends what you believe in terms of whether that is reflective of the costs.

Niall Mackenzie: I think the issue is, are we compensating people for the costs they face or is it some other kind of metric? If the electricity price they pay is set on the marginal price set by gas, then the compensation or the taxation of gas through the EU ETS or the Carbon Price Floor is what they need to be compensated for, not for other issues. That is the issue that we are very keen to discuss with industry. A number of companies and sectors have said they dispute the assumptions we have made about the way they set the price or the price they pay, so if they can give us the evidence for that obviously we will listen to it and understand it fully to make sure they are compensated for the costs that they are facing, not some arbitrary figure that is plucked out of the air.

Q53 Peter Aldous: Thank you for that. On a technical point, we have been told that you have your carbon emissions factor wrong, because the emissions value is already the marginal cost. How would you respond to that criticism?

Niall Mackenzie: The Commission’s figure is based on the average cost across the average carbon content of the whole grid in the UK and, as Paul explained, what we are saying is that the value that the companies need compensation for is the carbon cost in the electricity would set the market price. I think a figure of something like 0.41. We are saying that that is what is reflected in the prices companies pay, the market price, not an average of annual carbon content of grid consumed by UK companies.

Q54 Peter Aldous: Thank you. Large cement and steel companies are benefiting from large stocks of Emissions Trading System allowances. Is it possible to add further criteria to your compensation scheme so that this is taken into account and you avoid compensating firms when they are profiting from the emissions allowances?

Michael Fallon: I think we need to be careful to distinguish here that they are profiting-if they are profiting-from free allowances to cover their direct carbon emissions not their electricity costs. I don’t think there is a direct correlation between what they are gaining on ETS and what they might well gain from our particular scheme. Do you want to add to that, Niall?

Niall Mackenzie: Entirely right, Minister. I think that is the point that sectors and individual companies may have a lot of surplus allowances, quite often from their own efforts as well as from the recession-although I would not dispute the broad figures that Sandbag were quoting earlier-but that is for their direct emissions, whereas we are looking at the compensation for the indirect costs that are coming through the electricity price. So there are two separate things. If we try to make a link between the two, first of all we would be taking away property rights that these companies legitimately have for these allowances and we would also run the risk of being very unfair and arbitrary in trying to make a link between electricity use and direct emissions.

Q55 Caroline Lucas: How do you have property rights on the emissions that were not paid for, which were given away for free for the permits?

Niall Mackenzie: As you know, the EU Emissions Trading System was set up as a market-based instrument to give companies certainty of investment, and taking away allowances that-

Q56 Caroline Lucas: If you are given a free allocation, I don’t see why that gives you a property right over it, and if you look at it more broadly around what we are doing with public money, then I think there would legitimately be question marks raised about a company that on the one hand is making significant windfall profits as a result of free allocation of the permits and at the same time is then also being compensated under this scheme. I appreciate there is a difference between direct emissions and indirect emissions, but nonetheless, if there is a case where you can demonstrate it is exactly the same company that is benefiting from both, it seems perverse.

Michael Fallon: But they may have legitimately benefited from the first one and their excess may be due directly to their own carbon reduction efforts. Is that not legitimate?

Q57 Caroline Lucas: If you have £31 million, as the case of Tata in the UK, we were told earlier £31 million free allowances essentially that are not being used, then that seems to me to be-

Michael Fallon: But they might be used because of their own success in reducing carbon.

Q58 Caroline Lucas: Why aren’t they selling them then?

Michael Fallon: They may be holding an excess and they choose to hold them, but should they be penalised for that?

Q59 Caroline Lucas: I would be fascinated to see some demonstration of evidence that that £31 million allowance was as a direct result of Tata’s energy efficiency. If you can demonstrate that, I would be delighted, but I suspect it is more to do with the fact that the ETS system simply isn’t working, but that these allowances were given as free allocation rather than being auctioned and therefore we have given a windfall profit to energy-efficient companies.

Michael Fallon: I think we are probably going to disagree on the principle, and I want to be clear I am not commenting on whether Tata’s excess was due to their own carbon reduction efforts at all. I simply said that might be a reason why a company had an excess, and I don’t think they should be penalised for that. Do you want to add to that, Niall?

Niall Mackenzie: I think the only thing to add is that there may an issue about the supply of allowances in the EU ETS, and this Committee may want to look at that in future proposals from the Commission. I think all I am saying is that I would question whether it is sensible to take things away from a company to fix a problem with the system when maybe you want to adjust the free allocation going forward or there are changes to the system.

Caroline Lucas: I want to do that too, don’t worry.

Niall Mackenzie: But I think that is the correct way of doing it rather than arbitrarily stepping in with windfall taxes or taking allowances away, but obviously that is an issue for Ministers.

Q60 Caroline Lucas: I wanted to ask about why you decided to particularly use the mechanism of a rebate, and in particular what consideration you might have given to using the money instead, for example, to provide loans for energy efficiency improvements or investing in innovation. Unless those things happen, we are going to be having a blank cheque to energy intensive companies for many years, which doesn’t seem very sensible. What consideration was given to using the money for-

Michael Fallon: Last year we explored a number of options on this after it was announced by the Chancellor, but the compensation is for the indirect pass-through costs of both the ETS and the CPF, so we have limited options for addressing those costs. The Commission published its own guidelines for how member states could compensate for the indirect costs of ETS and to minimise the burden on industry and support the state aid case, because all this has to be approved in the end by Brussels, and we decided to follow a similar approach for CPF compensation. Do you want to add to that, Niall?

Niall Mackenzie: Again, I think it is worth making clear-and there is a section in the consultation document about whether we should have had additional environmental requirements with the compensation package-this is compensation for costs industry face. It is not a grant, it is not free money. It is the fact that they are facing these increased costs.

Q61 Caroline Lucas: Presumably you want them to make, over time, a transition to less carbon-intensive forms of energy generation, otherwise why would you even have a Carbon Price Floor? It is not there to-

Niall Mackenzie: But I think that is why we have this in the context of a lot of waiver policies. Virtually all the industries that will be eligible for compensation under the proposals we have made already have climate change agreements with the Department, with DECC, where they are signing up to energy efficiency improvement targets until 2020 in return for discounts on the Climate Change Levy. A lot of sectors are making some quite big commitments, which shows there is still a potential for energy efficiency and they are committed to do their utmost to meet those energy efficiency improvements. So we certainly did not feel it was necessary to put extra burdens on companies who are getting compensation for costs that they are facing because of the EU ETS price and the Carbon Price Floor in addition to the commitments many of these industries are already making.

Q62 Caroline Lucas: What about the bits of the industry that are not already making those efforts through the existing mechanism that you were describing with DECC and the-

Niall Mackenzie: I think one of the interesting things to do when we have started funding sectors is to see whether there are any who are in that position who aren’t already committed.

Caroline Lucas: You don’t think there are?

Niall Mackenzie: I would doubt it. I never say never, but one of the things that we would look at in terms of future spending reviews and continuing the shape of the package is whether there are people who are making no effort. But remember these are energy-intensives or electricity-intensives that are using an awful lot of electricity, so we would expect them to be doing their utmost to improve energy efficiency. As some of the previous witnesses said, the issue now from any of these sectors is what innovation and what technology game changer there is, and that is something on which we are very keen to work with industry to see what more they can do.

Q63 Caroline Lucas: I guess on that point, and if you were listening to the earlier sessions, you will have heard that there was a question on the Green Investment Bank and the role that the Green Investment Bank might play as it evolves in terms of assisting industrial energy efficiency.

Michael Fallon: As you know, it was set up finally last month, fully operational, and I hope you welcome that. It will be investing in industrial energy efficiency projects. That is a priority area for the bank, as you might expect, and I think it has set aside roughly £100 million for investment in that particular area, so it will be a variety.

Q64 Caroline Lucas: The last question is I understand the CBI has made some recommendations, for example about energy intensive industries being helped to form collective purchasing agreements to get better prices or indeed about whether or not the Government has explored how energy intensive industries could reduce their power consumption at certain times to help balance demand in the electricity network. Has any consideration been given to those options?

Michael Fallon: We certainly would encourage collective purchasing of energy by industry, but that would be additional to the compensation through the TF and CPF. Do you want to add to that?

Niall Mackenzie: Yes. Reference was made by the previous witnesses to the Exceltium process in France, where there is a deal between a nuclear generator and a collection of industry companies. We have been talking in DECC directly with a wide range of the energy intensive users, helpfully with the auspices of Jeremy Nicholson’s Energy Intensive Users’ Group and through the Green Economy Council, to see the level of interest. Tim Stone from our Office of Nuclear Development has been trying to give details of who industry could talk to. We can’t step in and do the negotiation because it is a commercial negotiation, but we are very happy to try to help facilitate this. Thus far, I think competitive tensions between industries has prevented them from signing up to a collective agreement, because some of the larger users feel that they can get a better deal with their larger purchasing power, but if a consortium of industry could be formed I am sure the Department will do what it can to help them get the right people on the other side of the table to do a deal.

Q65 Chair: Finally, in terms of the dangerous climate change that we wish to avoid and have legislated to avoid, given that we don’t have the Energy Minister here with us as well, I wonder how much there is a joined-up approach between the two Departments, not least in respect of the Treasury as well. Given that industry is looking for certainty in terms of long-term investments and also looking for transitional arrangements, I am interested to know what co-operation or common ground or, if you like, problem solving there has been between the two Departments and with the Treasury to make sure that we are on course with the carbon reductions that need to be made.

Michael Fallon: We do co-ordinate these things. Obviously, our responsibility in BIS is to look at it from the industry point of view and the Department of Energy looks at it from the energy point of view. We have just inherited in my Department a Minister from the Department of Energy and Climate Change, Lord Marland, who brings his particular expertise and policy experience from that Department, and I think we are working even more closely together. For example, the Nuclear Industry Working Group is now to be co-chaired by the Secretary of State for Energy and Climate Change and myself from Business, and we are looking together at, for example, the technological developments in the supply chain side of offshore wind investment and so on. So we are increasingly working together with the Departments. Are we working successfully with the Treasury? I would like to think we are, but you can always be more joined up.

Q66 Chair: In terms of how policy is translated with support for industry-I am looking now particularly at your own Department and looking at BIS-it seems to me that there is going to have to be decarbonisation within the energy intensive industries at some stage so therefore the issue is how we get to where we need to be. We have heard earlier on about the transitional arrangements and the particular issues that certain sectors have. How is the Government intending to start to go down that route of decarbonisation of intensive users of the energy sector?

Michael Fallon: I think you are assuming we are at the start of this process. A lot of industries are already making enormous efforts to decarbonise their processes to become more energy efficient, and there comes a point beyond which they can’t reduce further, and we also have to make sure they remain competitive. Do you want to add anything, Paul?

Paul Drabwell: No, exactly, I think that is a key point. The other point I would make is that electrification is one of the key ways in which these industries can decarbonise. For example, in steel, electric furnace, if you move across to that, most of your carbon emissions are tied up in the grid so it depends how clean your grid is. That is why we need to be careful not to put too much pressure on the price of electricity and why this exists. The other point is we did do some work jointly with DECC on looking at some energy intensive sectors and looking at what they might need to do in the future.

Q67 Chair: What has happened to that?

Paul Drabwell: We did that, but when the Carbon Price Floor was announced and the EU ETS compensation was brought forward by the Commission, we very much focused our efforts on that because we realised how important that was. There is now some work being done in DECC, with my team in BIS, looking at sector roadmaps for energy efficiency in particular sectors. Niall may want to talk a little bit more about that.

Q68 Chair: Does that come under the energy intensive industry strategy?

Paul Drabwell: Basically, the thing I referred to earlier was the energy intensive industry strategy, but that work can feed into this decarbonisation work. We will be working with the Green Economy Council, Energy Intensive Industries Group to work out what that thing should look like.

Chair: Just so I am clear, is that energy intensive industry strategy still ongoing?

Paul Drabwell: What I am saying is some work was done and it will feed into-

Q69 Chair: So has it finished? No.

Paul Drabwell: No, it hasn’t finished at all. We intend to do something with DECC in the New Year, and whether it is called an energy intensive-

Q70 Chair: Right, and who is leading on that?

Paul Drabwell: The DECC team are leading on that, but it is not necessarily going to be called an energy intensive industry-

Niall Mackenzie: To reassure the Committee, we see a lot of scope in particular in decarbonising heat. As Paul said, moving to electricity is long term, but there is scope for a lot of decarbonising heat. Our heat strategy was published in March and we will have to follow that up, but we recognise, not least from talking to the sectors a lot, that we need to work out how we get from 2030 to 2050 for these sectors. Our carbon plan published in December set out the range of scenarios. We need to colour that in in a lot more detail and help industry get there. It is not about our standing back in Government and saying, "You should do this". It is, "How can we help you do it?"

Chair: I am mindful that the Division is being called yet again, so I do need to bring this session to an end. Thank you to all three of you for coming along and I apologise again for a shortened session. I hope that the conclusions that we have will contribute, as you suggested, Minister, to the long-term policy that the Government comes up with.

Prepared 7th December 2012