Opportunity: supercharging industrial competitiveness

This current commentary will focus more specifically on the potential to boost industrial competitiveness through being on the front foot in taking regulatory action at the final-product end of key business chains.  In other words, smart policy that can stimulate smart business practices and investments.

The limits of ETS and CBAM

Regulatory intervention by leading authorities, like the EU, has largely focused on large point-sources of greenhouse gas emissions within their jurisdiction. As well as the aviation and marine sectors, the EU ETS legislation applies to electricity/heat generation and energy-intensive industry sectors, including oil refineries, steel works, and the production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals.

Problematically, these are commodity sectors which are price-sensitive and exposed to competition from imports from outside the jurisdiction where the production costs arising from the ETS do not apply. Similarly, this makes EU production less competitive in serving other markets. Together, these pressures generate incentives for manufacturers to shift production outside the EU.

To try to address this, the EU is introducing the Carbon Border Adjustment Mechanism (CBAM). This covers some of these commodity areas like iron, steel, cement, fertiliser, aluminium, hydrogen and electricity generation, with importers having to purchase CBAM certificates corresponding to the embedded emissions in their products.

The ETS/CBAM combination is a positive step towards addressing both emissions and at least part of the related industrial competitiveness challenge in the EU, as well as extending the influence of emissions regulation beyond EU borders. However, key problems remain.

First of all, by being understandably targeted at a limited number of sectors where emissions are produced and where significant investments need to be made to address these, the approach generates substantial "costs" for these businesses. These cannot easily be recouped in price-sensitive commodity markets. For example, green steel may cost up to twice as much to make as traditional steel. As with all "taxes", high relative costs targeted at a relatively small base stimulate resistance and avoidance. Industrial and political pressure lead to continually moderating the implications of the scheme, reducing and delaying the incentives to actually make the investments that are necessary to reduce emissions.

In addition, manufacturing and retail businesses outside the jurisdiction can continue to access the relatively cheaper commodities produced outside the authority, giving them a competitive cost advantage for importing their products into the market. So the competitiveness concerns should not only be at the level of the targeted commodities themselves (supposedly addressed by CBAM) but all the way down business chains to intermediates and end-use products.

A business-chain perspective

If regulators could take a full business-chain perspective, however, then both these key problems might be substantially addressed.

First of all, there is a need to recognise that the so-called green premium is substantially diluted by value added down the business chain. Hence, for example, using green steel may add only a few percent to the cost of purchasing a car. Analyses of all the key business chains with the highest emissions footprints (food, electronics, fashion, automotives, construction, FMCG, professional services, and other freight) show that the end-use cost impact of providing low-emissions-footprint versions is only a few percent at most (and often less than a single percent). This is affordable for most people and within normal consumer discretionary ranges (e.g. choosing different seat materials or colours for cars, or preferred breakfast cereal brands).

If regulatory standards could be applied at the final-use end of business chains, this would massively expand the effective base of incentives and funding for addressing emissions at low cost to individual consumers. This would tackle the resistance and avoidance problems at the upstream commodity end of the business chain because economic incentives would be directed up the chain to motivate the large individual investments required at particular upstream points to reduce emissions. End-use standards would stimulate incentives all the way up those specific business chain links within the jurisdiction, and they would also incentivise investments outside the jurisdiction by those that wish to continue participating in the large market.

To have an effect, however, the end-use market would need to be large enough that businesses still consider it important to serve, otherwise they would simply shift attention elsewhere rather than complying with the new standards. So one of the large markets/jurisdictions like the EU, US, China, or India would need to take a lead.

Making emissions footprints classifiable

Of course, this all depends on being able to classify credibly the emissions footprints of end-products. This seems a very complex challenge given the complexity of business chains. However, three factors generate optimism that this could be achieved in the near future if given appropriate attention.

First of all, there is the explosive emergence of data management and AI capabilities. We already have examples of how some incredibly complex data gathering and analysis tasks can be accomplished successfully. Just think of, for example, Google Maps. Besides governments, the Hyperscaler companies behind the current explosion in data centre construction have access to huge resources and capabilities that could be invested in this area. Secondly, there are already data trails to build upon as every link in a business chain involves a financial transaction. Thirdly, there is already a feasible governance framework for this type of activity emerging in the EU, namely Digital Product Passport requirements.

Where the advantage lies

The advantage to substantial end-markets in taking steps like these ultimately derives from the combination of massively diluted green premia at the final-use end of business chains and the very low likelihood of end-consumers uprooting their lives to move outside a jurisdiction simply to avoid a couple of percent of living costs. This contrasts with the situation of upstream commodity producers who, without secure demand for low-emissions material, may indeed shift location to avoid significant competitive disadvantage from the high percentage costs they face related to the significant investments they need to make. Instead, the downstream standards and related end-user demand and revenue progressively fund the green premia facing suppliers up the business chain, ultimately motivating investments in upstream decarbonisation where necessary.

Domestic competitive advantage should also accrue as lower-emissions domestic businesses can preferentially access internal markets while there is a standards barrier to external businesses until they invest. In addition, they will become more attractive suppliers for external businesses that wish to import their products into the jurisdiction. They can also still serve external markets without standards, potentially using cheaper external supply chains like their competitors.

Hence domestic businesses can avoid market disadvantage, access more markets, and potentially benefit from being both early movers and early learners in the "standards game" and "decarbonisation game". As asserted by one of my predecessor leaders of Shell scenario activities, Arie de Geus, "the ability to learn faster than competitors may be the only sustainable competitive advantage".

Thoughtfully applied by a large jurisdiction like the EU, the combination of emissions footprint standards at the final-use product end of selected business chains with ETS/CBAM acting upstream could be a powerful tool for supporting industrial competitiveness, with emissions reduction almost as a by-product.

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