Implications

This analysis of price-setting by selected sectors across ETR countries produced plausible results with good explanatory power. Two prices were employed to represent the foreign or competing price, the world price (proxied by the US price) and the EU price (proxied by the German price). Use of the German price generally fitted the data better than the US price. In the case of the non-metallic mineral products sector, it was only the German price that had a significant 'foreign' influence on price-setting. That applied only in The Netherlands and to a very small extent in Finland, suggesting that this sector is at the least vulnerable end of the price-setting spectrum. By contrast, basic metals revealed the most influence from the foreign price and was more likely to be a price-taker and hence vulnerable to domestic cost increases that emanated from environmental tax reform.

Importantly, the results also showed that use of the EU price was in general more consistent with a stable long-run price-setting relationship. Information on trade with the EU, shown in Tables 3.4 and 3.5 above, indicated the predominance of the EU as the source and destination for the products of the selected sectors during the period over which environmental tax reform was being introduced. Therefore the indications are that environmental tax reform introduced on an EU-wide basis (or emissions trading with auctioning) would have a limited effect on the competitiveness of these sectors because all firms supplying the EU market would be affected in a consistent manner.

These time-series regression results can be further employed to rank the selected sectors according to decreasing significance of the external price, that is, in decreasing order of vulnerability or, correspondingly, in increasing order of market power. Thus ranked, the sectors are as follows, starting with the most vulnerable:

• paper and paper products;

• wood and wood products;

• food, beverages, and tobacco; and

• non-metallic mineral products.

The basic metals sector was very susceptible to international trading conditions and would be the most affected by an energy or carbon tax. This, of course, is in the absence of mitigating or other measures, such as targeted revenue recycling, technical adaptations, waivers, border tax adjustments, and the like, discussed in COMETR (2007). The sector would face a cost disadvantage compared with its non-EU trading partners (if an EU-wide carbon tax applied) and would not be in a position to mark up its price. At the other extreme, the output price of the non-metallic mineral products sector responded very closely to domestic costs (wage costs in this analysis) and appeared to be relatively insulated from international trading conditions. The study did not show any influence exerted by the world price, proxied by the US price. Of the sectors analysed, non-metallic mineral products would be best placed to absorb a cost increase, such as from carbon or energy taxes, by passing on the tax to its (mostly domestic) customers in the form of higher product prices. Meanwhile, sectors able to make worthwhile alterations to their technology would naturally be better placed still.

While we have established a hierarchy of sectors in terms of their potential vulnerability to environmental tax reform, this hierarchy only holds within a reasonable range of tax rates. It is always possible that in the event of a large rise in tax rates affecting firms' energy prices, firms that were previously price-setters might become price-takers. However, it would take a very sizable rise in tax rates to bring this about.

It is now possible to add the ranking of price-setting power to the criteria used at the outset to gauge a sector's vulnerability under

Foreign price influence decreases

Most vulnerable

Least vulnerable

Chemicals

MORE VULNERABLE

Nm mineral products

Basic metals

Wood + Paper

Food, bever. & tobacco

LESS VULNERABLE

Figure 3.1. Vulnerability with respect to energy expenditure shares and pricing power, ETR countries combined environmental tax reform. A few examples of combined rankings under various combined criteria are now shown to give a more comprehensive view of the relative vulnerability of sectors. It is noted that the criteria are what the Carbon Trust (2004) terms 'competitiveness drivers' in relation to the EU ETS.

Figure3.1 illustrates the situation when unit energy costs and pricing power are taken together as two criteria of vulnerability for the combined ETR countries. The vertical axis shows increasing energy expenditure as a share of output, and the horizontal axis shows increasing market power, that is, decreasing foreign price influence in price-setting. Vulnerability is highest in the top left-hand corner, where the energy share is highest and price-setting ability is lowest. Vulnerability is lowest in the bottom right-hand corner. On these criteria, the most vulnerable sectors are basic metals and chemicals in the top left-hand corner of the figure. The chemicals sector has the highest energy expenditure share and basic metals is the most exposed to the world price—it is the least able to pass on cost increases.

In the bottom right-hand corner of the figure are the less vulnerable sectors: food, beverages, and tobacco and non-metallic minerals products. Ranked in the middle in terms of vulnerability is the sector wood and paper.

The implications for policy are that the introduction of ETR would require most care to be paid to its effects on the competitiveness of basic metals and chemicals rather than to non-metallic mineral products, and

Table 3.7. Ranking of sectors with respect to scope for technological adjustment, UK 1995 (with NACE code)

27 24 26 15 21

Wood and wood products (least scope, most vulnerable)

Basic metals

Chemicals

Non-metallic mineral products Food and beverages

Pulp, paper and paper products (most scope, least vulnerable)

Source: Entec/Cambridge Econometrics (2003).

less again to food, beverages, and tobacco. These rankings of vulnerability apply to the combined six countries that implemented ETR.

As already flagged, another major indication of a sector's vulnerability under carbon taxes is its scope for introducing economically worthwhile energy efficiency investments. Encouragement to use and develop energy efficiency is a prime objective and benefit of carbon taxes, and information on potential technical adjustment was sought as another criterion of vulnerability. Potential technology adjustments that were available to UK energy-intensive sectors had been estimated by Entec, under the Climate Change Agreements procedures and can be used here for illustrative purposes. These adjustment potentials are measured as the sector's percentage energy saving potential at positive net present value. Again, the sectors can be ranked, by scope for adjustment, starting with those that have least scope (i.e. the most vulnerable), as shown in Table 3.7.

The sectors now ranked according to their technological potential for energy efficiency adjustments can be incorporated into a similar figure, Figure 3.2, that relates to the UK. Alongside ranked vulnerability to price competition is shown ranked vulnerability with respect to scope for technological adjustment.

At the extremes, it can be seen that in the UK the basic metals sector is again clearly in a relatively vulnerable position in the figure, now joined by wood and wood products. Food, beverages, and tobacco and the non-metallic mineral products sectors are least vulnerable—they have some modest potential for adapting technology and have some price-setting power. Chemicals and pulp and paper are in between.

These examples give relative placings of sectors and their importance lies in demonstrating that one can rank vulnerability on relevant criteria. They are useful in helping to indicate in which sectors to prioritize mitigation policies to soften any impact on competitiveness in the event of environmental tax reform.

Foreign price influence decreases

Most vulnerable

Least vulnerable le bl

Wood & products le bl

MORE VULNERABLE

Chemicals ie ci ie ci a e

Pulp &

LESS VULNERABLE

Food & beverages

Nm mineral products paper

Figure 3.2. Vulnerability with respect to scope for technology adjustments and pricing power, UK

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