How the EU’s CBAM will impact energy imports from countries that flare gas

• Gas flaring is increasingly recognised as a major source of economic and environmental waste.  Flaring, which sits alongside “venting” and “leaking”, leads globally to the annual loss of at least $30 billion of valuable product, plus generates 1.2 billion CO2-equivalent tonnes of greenhouse gas emissions – that’s 1.5 times those of airlines.
• However, little-discussed so far are the major importing blocks’ embedded flaring emissions associated with oil and imports.  Our analysis lifts the lid on this critical source of invisible (and largely avoidable) emissions and shows wide variation by country.  Of particular concern is that despite the excellent leadership within its borders, Europe has 40% higher embedded flaring intensity in its imported oil than the global average.  By comparison, the flaring intensity of Europe’s indigenous oil production is 82% lower than imported oil.
• As the world becomes increasingly focussed on “ESG” and consumers recognise that “not all molecules are the same”, buyers increasingly want to buy products differentiated by their quality.   Similarly, producers are starting to compete on emissions intensity.
• Embedded flaring emissions are likely to have serious financial consequences for producing countries in the years to come, especially if the EU’s proposed “Carbon Border Adjustment Mechanism” (CBAM) becomes extended to energy imports.  If this were to happen, we estimate that carbon border taxes of €3 billion per year could be levied on extra-EU oil and gas suppliers (equivalent to 1-2% of the underlying commodity price).
• The major flaring nations have many technically proven options that create commercial value and can materially reduce emissions.  Instead of paying these border taxes, countries should invest in gas flaring solutions, and a lot can be delivered with €3 billion per year.  With COP26 setting the stage and CBAM and “Fit for 55” being key elements, the time for action – supported by political and economic reform and committed leadership – is now.

By Mark Davis and John-Henry Charles | 1800 words | Reading time: 6 minutes.

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Introduction

The World Bank’s report for 2020 highlights that gas flaring (the deliberate combustion of gas associated with oil and gas production) stood at 142 Billion Cubic Metres (BCM) per year. That’s large enough that, if “gas flaring” were a country, it would be the 5th largest gas consumer worldwide.

Whilst gas flaring is modestly down versus 2019 (only due to lower oil production), it remains a major global environmental and economic challenge. Also, the fundamentals (i.e. flaring per barrel of oil produced) are heading in the wrong direction.  Not only does flaring burn gas and entrained liquids, but it also is a major source of methane emissions from incomplete combustion.   Including this so-called “methane slip”, annual emissions are probably in the range of 1.2 billion CO2-equivalent tonnes of emissions per year[1].  

But with record carbon, gas and power prices in Europe and beyond, gas flaring is also a major economic loss.  Even at very conservative prices ($3 per mmbtu and $60 per barrel), gas flaring represents an additional annual sales potential of $20-30 billion.

Whilst flaring is associated mainly with the oil supply chain (as a bi-product of production), it also comes from the gas supply chain (especially from condensate-rich fields), and so the distinction can be blurred. 

73% of the world’s oil production comes from countries that have committed to “Zero Routine Flaring“.  But concerningly, progress has been slow, and the world is off track (see our article “new data confirms we are off track to eliminate gas flaring“). 

Figure 1 shows the data at a country level.  There is a very large range not only in absolute flaring (left chart) and relative flaring (right chart, shown as “flaring intensity”, i.e. flaring per barrel of oil and condensate production).

Why imported emissions matter – a lot

Given that 56% of the world’s oil production (and at least 25% of the world’s gas production) is imported into another country, arguably a more illuminative approach is to look at the “embedded flaring” emissions associated with oil (and gas) imported by consuming countries. 

To explore this, we have analysed a range of publicly available information on volumes of traded oil and gas, including the Statistical Review of World Energy from bp, data from our research and other insights provided by commodity data and analytics company Kpler.  This work builds on, and extends, the work published by the World Bank in June on their so-called “Imported Flare Gas” (IFG) Index (and with whom we are grateful for many excellent discussions). 

(For clarity, we highlight that this paper focusses only on emissions from gas flaring.  We, of course, acknowledge that there are other sources of emissions, including not only those from “methane slip” associated with gas flaring (see article “flaring’s billion-tonne secret“), but also those from “venting”, “leaking”, and others.)

Figure 2 repeats the worldwide oil production versus “flaring intensity” (left side).  We break this total down into those volumes consumed domestically (within the country of production – some 44% of the total) and those imported by another country (some 56% of the total).  European countries are highlighted in darker orange.

Both the domestically consumed and exported/imported volumes have very similar aggregated flaring intensities (5.0 and 5.2 m3 per barrel, respectively). Both datasets also have large ranges in embedded flaring intensities between countries. 

Figure 3 breaks down the aggregate figures by destination block to their respective country sources. 

Japan, for example, has the lowest embedded flaring intensity (of 2.2 m3 per barrel) because its imports are dominated by countries with low flaring intensities (Saudi Arabia, Kuwait and UAE). In contrast, India has a high flaring intensity (6.6 m3 per barrel) due to the dominance of North and West Africa plus Iraq in its supply mix. 

Europe is an interesting case (see Figure 4).  Despite all the excellent leadership on carbon within its borders, there is a problem with “carbon leakage” associated with imports. 

The “embedded flaring” intensity of imported crude oil is 40% higher than the global average, at some 7.2 m3 per barrel. By comparison, the flaring intensity of Europe’s indigenous oil production is 82% lower than imported oil (at 1.3 m3 per barrel).  Europe’s imports are also 5.5 times higher than indigenous oil production. 

Many factors drive the choice of imported energy

Countries’ choices regarding their sourcing of imported crude are constrained in part by technical, commercial and geopolitical factors, ultimately making their choices somewhat “sticky”.  Technical factors include refinery configuration (each refinery requires a particular diet of crude(s) with specific density ranges, sulphur content, etc.) and geographical proximity.  Commercial and geopolitical factors often include market pricing, discounts, broader bi-lateral trading on other products or services, or sanctions.   Specifically,

• Libya’s role in supplying high flaring intensity oil into Europe is somewhat “locked-in”, e.g., through linkages between ENI and TotalEnergies’ investments in Libya and the downstream presence of the Tamoil (which is 100% Libyan owned) in, e.g. Switzerland and Italy;
  
• India, for example, exports to Iraq significant volumes of cereals, metals, meat products, pharma and medical products and more;
  
• Beyond oil, Japan’s relationship with Saudi is driven in part by exports of cars, trucks, machinery and technology;
  
• Similarly, China, the biggest buyer of West Africa crude (mostly from Nigeria and Angola), is also one of the largest investors in the region through its oil companies CNPC, SINOPEC and CNOOC.  China is also a major investor in Iraq, through CNPC’s 46.4% share in Rumaila (which, incidentally, flared 3.8 BCM in 2020, according to FlareIntel).
  
• Russia’s dealings with OPEC are linked to its export of wheat to Saudi, and its trade with Turkey is conditional on agreements on Russian transit gas;
  
• Sanctions also play a role: those from the US on Iran have led to a major drop in exports from Iran and a shift in crude exports away from Turkey, India, Taiwan, and Japan towards China and Syria.

Impact of a carbon border tax in Europe

The issue of gas flaring in the supply chain of oil (and gas) is only likely to increase in focus as the EU and others consider implementing a proposed Carbon Border Adjustment Mechanism (CBAM, a form of carbon tax) as per the EU’s announcement in July. 

Under the current proposals, the current Emissions Trading Scheme (ETS, which has last month exceeded EUR 60 per tonne) will be extended to aviation and shipping.  A new ETS will be developed for buildings and road transport. 

Whilst imported fossil energy is not (yet) part of the CBAM, the EU is signalling a clear direction – effectively reinforcing the process of making voluntary commitments (under the Paris agreement) to mandatory action, driven by regulation.  Groups such as Shell and the EDF last week authored a paper on the importance of the EU’s methane policy to include imported gas.

(The authors don’t believe that CBAM has been designed or is intended to be a “protectionist” measure (e.g. to preserve the competitiveness of the EU’s manufacturing base – or in the future – of its residual oil and gas industry[2]).  Instead, CBAM is a process-led approach to externalise the EU’s own internal carbon pricing, and because it is non-discriminative, it is entirely consistent with the WTO rules.  There are already suggestions that the EU’s CBAM may be replicated in the US and that Kazakhstan is considering a domestic carbon tax.)

Zooming into our analysis on Europe (Figure 4), Switzerland and Italy stand out with very high embedded flaring intensities almost two times greater than the global average, driven by the dominance of supplies from Iraq, Libya and Nigeria. 

In contrast, imports of oil into the UK are on par with the global average at 5.1 m3 per barrel, mainly due to the reliance on imports from Norway (which has had strongly enforced anti-flaring policy for decades, with a flaring tax equivalent to EUR 50 per tonne of CO2). Incidentally, the flaring intensity associated with the UK’s indigenous production is quite low at 3.1 m3 per barrel (and this may lend support for developments such as Cambo).

Figure 5 illustrates the impact of any future CBAM on energy imports on those countries that export oil into the EU (plus adjacent neighbours, most of whom are covered by a similar scheme).  We have calculated the flaring emitted at source by country (middle chart) and applied a carbon price of €50 per tonne (almost $60 per tonne).  

Our calculations show that the embedded flaring emissions are significant.

Here’s the maths.  Imports of oil and condensate are 3.5 billion barrels per year (according to bp), and with an embedded flaring intensity of 7 m3 per barrel, that’s 24 BCM of embedded flare gas.  Assuming (for now) that the flares combust with 100% combustion efficiency, we can expect 1.87 million tonnes of CO2 per BCM of gas, making 45 million tonnes of CO2, which, at €50 per tonne, is €2.2 billion per year.

To put this in perspective, a €2.2 billion penalty on imports of 3.5 billion barrels per year equates to a carbon border tax of some €0.60 per barrel ($0.70, or approximately 1.2% of the sales price, assuming $50 per barrel). 

However, this figure could be close to 3 times higher (some 4%) for Algeria or Libya due to these countries’ notably high flaring intensities.  Furthermore, the 24 BCM of wasted gas per year, embedded in the oil supplied to Europe, is also material – the equivalent to the total volume of gas consumed in Ukraine or Oman. 

But since calculations are only based on the CO2 from flaring, the figures could be considerably higher if the EU also chooses to extend their CBAM mechanism to include emissions methane from flaring on a CO2-equivalent basis.   

We believe that many flares in the supplying regions are likely to have combustion efficiencies way below the “best practice” of 98% (meaning that rates of so-called “methane slip” are likely to be significantly higher than 2%).  Indeed, depending on the level of “methane slip” associated with flares with inefficient combustion and the assumed “Global Warming Potential” (GWP) of methane vs CO2, CO2-equivalent emissions could be 2-10 times higher – and even higher if “venting” and “leaking” emissions are included.

As we argue in our recent paper, “gas flaring threatens Algeria’s energy exports to Europe“, such significant penalties should be a wake-up call to producing countries. Buyers and consumers increasingly understand that molecules are increasingly differentiate-able on their underlying quality.  Buyers have choices (backed by credible groups that certify gas to clear standards, e.g. MiQ).  Producers can act.

Europe’s gas also has a flaring problem

Whilst the above analysis has applied to emissions embedded in oil production, a similar challenge faces gas imports.  In fact, the oil and gas supply chains are fundamentally interdependent, and it can be complex to allocate emissions between supply chains. 

After all, wouldn’t it be perverse for a country to claim it had high-quality gas if its supplies from a gas field with a low carbon intensity were next to a neighbouring oil field that was abundantly flaring gas?

Nevertheless, our paper from December 2020 (“Twelve things the EU should do about gas flaring“) outlined how 80% of the EU’s consumed gas is imported, and the embedded emissions associated with these gas imports are 33 times greater than the indigenous gas production[2].  Our paper offered the EU 12 specific actions it could take to reduce flaring, and we are delighted to see that the EU’s Methane Strategy paper addressed many of these.

Figure 6 shows comparable data for the gas supply chain.  Our methodology uses the “gas flaring rate” (the volume of gas flared per volume of gas produced, left) to allocate an implied flare volume to the volume of imported gas by country (middle). 

Here’s the maths. 165 BCM gas was imported to Europe in 2020, with an average embedded “flaring rate” of 3.7%, meaning that 6 BCM of gas is flared.  Assuming 100% combustion efficiency (for now, therefore multiplying by 1.87 million tonnes of CO2 per BCM), 11 million tonnes of CO2 arise from flaring, which at €50 per tonne is €580 million per year of carbon taxes (numbers are not precise due to rounding errors).

Countries supplying the EU+ with natural gas can, therefore, eventually expect to pay a penalty of €580 million a year to access these markets.  The penalty is equivalent to $0.12 per million btu[3].  Compared to an assumed market price of gas (of, say, $6 per million btu), this penalty averages at 2%, but could be as high as 20% for Libya, 5% for Nigeria or 4% for Algeria, given their high rates of flaring.

Summary and policy recommendations

The status quo will become painful for producers

The EU’s proposed CBAM mechanism is an example of the “polluter pays” principle, which would radically change the dynamics of international trade in carbon-intensity products, including in fossil fuels themselves.  When effective, CBAM could trigger a chain reaction and be replicated by other major trading blocks (e.g. the UK and USA).

Much of the details of CBAM still need to be worked out – and it needs careful design to be applied to gas flaring (and other scope 1 & 2 emissions).  However, the scale of embedded emissions in the oil plus gas supply chains from gas flaring alone is material – some €2.8 billion per year (or 1% of the cost of oil imports and 2% of gas imports). 

By country, some of the largest penalties are for Russia (€830 million), Libya (€330 million), Iraq (€330 million), Nigeria (€260 million) and Algeria (€250 million). 

Take Russia: a bill of almost €1 billion for flaring alone is already a sizable component of what Novak estimates could be an undeniably large $26 billion annual penalty.  And these figures could also be considerably higher if “methane slip” (from uncombusted gas due to inefficiencies in the flaring) are included (and considerably higher too if “venting” and “leaking” were factored in). 

At these levels of financial penalties, it is likely that high flaring producers’ market share of oil and gas sales in Europe would dramatically reduce.  Alternative sources would likely replace oil volumes with similar crude properties (e.g. density, sulphur).  Gas would likely be displaced by LNG (although care should be taken to ensure that the LNG is not associated with high flaring assets – see our paper “gas flaring within the LNG supply chain“).  Displaced oil and gas would likely end up in other major consuming centres such as China and India.

But there is an alternative narrative

What would or should the EU do with the cash raised from a CBAM on embedded flaring emissions? 

We think the best option would be to invest in emissions reductions abroad.  Therefore, rather than paying €2.8 billion in annual fines, what if this money were hypothecated for on-the-ground investments in flare capture projects – thereby creating value, reducing emissions and helping producing countries to accelerate the energy transition? 

This mechanism could bring financing for decarbonisation to countries that most need it and on terms that can make it happen – either direct to National Oil Companies or to international service companies (including companies such as Capterio). 

We appreciate that investing in fossil fuels is politically sensitive in today’s world, and many institutions have made policy decisions to exit this sector.  But equally, we think that it is folly to close off some of the best “least cost” decarbonisation options with a blanket “no fossils” policy. 

To avoid doubt, we fully agree that the world must transition quickly to a low carbon society.  But we also recognise that many oil states that flare also have some of the lowest cost of supply.  These countries will probably produce oil for as long as there is demand. 

Therefore, we must support – rather than ignore, or shun – gas flaring investment opportunities if they also deliver material decarbonisation.  Fatih Birol and Ali Allawi’s article “without help for oil-producing countries, net-zero is a distant dream” supports this argument. 

There could be a few ways this investment could happen.  Countries could invest themselves in capturing the value and avoiding the penalties.  Or the EU (or member countries) could use the funds raised to create a “sovereign wealth fund by proxy” and make its own investments in the supplying country’s flare capture projects.

There is real value at stake.  As shown in our article “celebrating successful flare capture projects“, many projects are technically deliverable and make commercial sense.  We have evaluated many attractive flare capture investments which require around €2-4 million of capital per million scf/day of flaring abatement.  Scaling this up, €2.8 billion per year of investment has the potential – in the conservative case, to reduce emissions by 5+ BCM per year. That’s material.

Stepping back, we have three recommendations that could lower embedded flaring:

• Firstly, importing countries may seek to switch supply sources to lower flaring countries – although this only displaces the problem to other markets.  Beyond switching, the EU also has a clear role in setting flaring and methane standards, driving measurement and introducing certification.  See our paper “12 things the EU should do about gas flaring” for more detail.

• Secondly, importing countries could partner (via its multilateral and institutional investors) with their supplying countries to reduce flaring by promoting better operational practices, better measurement, and support investment in flare capture projects by providing capital and expertise.   Key actors could include the EIB and EBRD, and progress could be accelerated if the carbon offset markets were deepened (potentially to include methane reduction – but only with clear offset accounting and full disclosure).  Arguably, partnering is a more responsible course of action; indeed, the World Bank has argued that the “burden of responsibility to reduce flaring should be shared” between producers and consumers.

• Thirdly, exporting countries should implement reform to promote initiatives that reduce flaring.  To avoid a significant “shock” from loss of market access, governments can consider: (a) greater top-down focus on flare reduction, supported by: (b) improved commercial incentives for flare capture initiatives (e.g. removing subsidies on electricity), (c) improved and empowered regulators with greater enforcement of flaring penalties, and: (d) promotion of new commercial and operating models to bring in new players with specific expertise and capital.

Much can be done to reduce gas flaring relatively quickly.  With COP26 setting the stage and CBAM and “Fit for 55” being key elements, the time for action – supported by political and economic reform and committed leadership – is now.

Capterio would like to thank many people within the EU Commission, the World Bank GGFR programme, the IEA, the OGCI, the Oxford Institute for Energy Studies and many of its member companies, plus Kpler and Jefferies, for many discussions around this topic.  Any errors or omissions are, however, our own.

[1] We assume that 90% combustion efficiency is a representative global average. Whilst there is no “right answer”, we evaluate the potency of methane vs CO2 over a 20-year period (with an 82.5x multiplier) as opposed to over a 20-year period (with a 29.8x multiplier) since we believe the shorter time-period is more relevant to the urgency of our climate crisis.  The longer time-period arguably underestimates the urgency of solving the methane challenge.

[2] We are basing this calculation on the “gas flaring rate”, which we define as the flared gas as a percentage of total gas produced.  We therefore are trying to be oil vs gas agnostic, and deliberately not trying to allocate emissions between oil and gas supply chains (which is complex to do).

[3] We can cross-check this by noting that €50 per tonne of CO2 is equivalent to $3.1 per mmbtu for each mmbtu of embedded flaring.  And at an embedded flaring rate of 3.7%, the tax amounts to 3.1 x 3.7% = $0.1 per mmbtu.

[4] Noting that with Norway and (now) the UK being outside the EU, the remaining oil and gas production is relatively low, sourced from Denmark, Germany, Italy, the Netherlands, Poland and Romania.

[5] Incidentally, it may well not be a coincidence that Switzerland also is the home commodity traders.