Carbon Contracts for Differences can hedge against carbon price uncertainty

OLGA CHIAPPINELLI, KARSTEN NEUHOFF, AND JÖRN RICHSTEIN

A reform of the EU ETS that creates effective carbon pricing incentives combined with Carbon Contracts for Differences (CCfDs) that shield investors against regulatory risks can form the backbone of a policy package for industrial decarbonization.

Basic industrial sectors, such as steel, cement and plastic production, are responsible for a large share of emissions, both in the EU and globally. Reaching climate neutrality by mid-century, as envisaged by the European Green Deal, requires large reductions in emission from these sectors. This will require a robust and comprehensive policy package. A high and stable carbon price is crucial It is crucial that the carbon price reaches a sufficiently high level to allow investors to recover the incremental decarbonization costs linked to climate-friendly options. This requires that the carbon cost of conventional material production is reflected in the value chain, to ensure that: 1) the incremental costs of climate-neutral production are charged to the material users; and 2) carbon savings achieved through efficient material use and choice increase profitability. This objective is currently not met by the EU ETS, since producers of materials are granted allowances for free as protection against carbon leakage and, thus, only a small and uncertain share of EU ETS carbon costs is passed on into the supply chain. In addition, uncertainty related to carbon pricing constitutes a major risk for investments in low-carbon projects.

A charge on basic materials passed along the value chain Studies conducted within the Mistra Carbon Exit program have examined policies that could address these issues. The lack of a carbon cost that is passed through to material prices can be addressed by complementing a continuation of the free allowance systems of the EU ETS with a Climate Contribution, i.e., a charge imposed on basic materials and material-intensive end-products. Such a charge would be passed along the value chain and paid upon eventual consumption of the end-product (regardless of whether the commodity is produced domestically or abroad). The charge would be tied to the weight of the material applying the same benchmark as used for free allowance allocation. The revenues from the charge could be used in part to finance climate action and in part be redistributed to citizens as a perhead reimbursement.

Such an approach would combine full carbon leakage protection with an effective carbon price signal to all actors along the value chain. Building on experiences gained with other consumption charges, implementation would be WTOcompatible and administratively feasible.

CCfDs can hedge against carbon price uncertainty Carbon Contracts for Differences, CCfDs, issued by governmental financial institutions can help investors in lowcarbon projects to hedge against carbon price uncertainty. Based on a contractually agreed strike price for emissions reductions relative to reference technologies, investors are guaranteed a fixed revenue per tonne of non-emitted CO2. As long as EU ETS prices are below the strike price, the difference is reimbursed by the government. If CO2 prices exceed the strike price investors must return the difference to avoid windfall profits. By shifting the risk associated with carbon pricing uncertainty from firms to governments, CCfDs lead to investments in clean technologies at lower expected carbon prices than for commonly discussed minimum CO2 price levels. In addition, CCfDs can substantially reduce the need for public funding to support the transition of basic materials as the state can recover part of the support costs in periods with high carbon prices.

Contracts for Differences for Renewables can provide affordable green electricity Many low-carbon technologies rely on electrification, which means that overall carbon mitigation costs are driven by electricity costs. CCfDs for Renewables issued in public auctions facilitate low-cost financing for renewable projects via the provision of stable revenue streams, thereby reducing renewable generation costs by about 30 percent. These long-term provisions can also be passed on to electricity users, enhancing the predictability of input costs for clean production processes and thereby simplifying the design of CCfDs.

Creation of low-carbon markets and practices Other policies are also needed to support the demand side by creating markets for low-carbon products and incentives for improvements in material choice and efficiency in the manufacturing and construction sectors (e.g., by developing procurement practices), as well as to break the inertia towards transformation. Literature

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