European Union moves to exempt industries such as steel, refining and cement from the cost of buying carbon permits risk handing them windfall profits and could blunt EU green investment, analysts say. Heavy industries in Europe and the United States are battling hard to avoid paying for permits to emit carbon dioxide, saying the added cost will harm their ability to compete with overseas rivals, for example in India and China.

EU leaders reached a deal in December to curb carbon dioxide emissions to a fifth below 1990 levels by 2020, but to clinch that agreement they were forced to promise some countries such as Italy and Germany opt-outs for sectors at risk from 2013.

That risk list of sectors is currently being fine-tuned in Brussels according to a complex formula that looks set to hand pollution permits from the Emissions Trading Scheme (ETS) worth billions of euros to the most polluting sectors -- steel, cement, and refining.

At stake is around 4.5 billion euros ($6.13 billion) a year for the steel industry, roughly 5 billion for cement and just under 4 billion for refining, says analyst Olivier Lejeune at New Carbon Finance in London.

Help for the cement industry in particular hangs in the balance, hovering close to the threshold for support.

WINDFALL PROFITS

But by giving manufacturers ETS permits for free, the EU risks handing them windfall profits, as it did in previous years with the power sector, analysts say.

Windfalls are generated when companies pass on the cost of the permits regardless of whether they were free or not, profiting by millions in the process.

It will not lead to the same level of windfall profits as it did in the power sector, said Susanne Droege at the German Institute for International and Security Affairs.

If they have customer relationships where the customer cannot easily shift to another supplier -- longterm contracts for example -- then they could pass through the costs of permits that were given to them for free.

Under the rules agreed by EU leaders in December, manufacturers will have to pay for 20 percent of their permits in 2013, rising to 70 percent in 2020.

But at risk sectors -- those deemed to have substantial exposure to international competition and face a 5 percent or more increase in costs from buying carbon permits -- will receive all their permits for free.

In principle there's some potential for windfall profits in any sectors that are not exposed to competition, said Lejeune. But I'd trust the Commission to look at this very carefully. They have a huge stake in the ETS being successful.

CARTEL PROBES

But Sanjeev Kumar of conservation group WWF points to numerous cartel probes in the European cement and steel sectors as proof that both industries can handle international competition, can pass on cost increases to customers and can not be trusted to give full disclosure.

Other environment campaigners in Brussels speculate the deal on exemptions was done to win the support of German Chancellor Angela Merkel and Italian Prime Minister Silvio Belusconi, and EU officials will therefore treat industry generously.

Revenues from auctioning ETS permits are seen by many as an potential source of government funding for research and development into green technology to battle climate change.

But if permits are given to companies for free, EU governments will lack the funds needed to boost R&D amid the current economic crisis, said analyst Cecile Kerebel at French think-tank Ifri.

It is possible to use these revenues for projects against climate change, and definitely there will be less money, she added.

Lejeune said there would be a relatively small impact on ETS revenues, which could be used for green R&D, but also as the source of funding to offer to poor nations at global climate talks in Copenhagen in December.

There is an impact, but it is small, he said. Auctioning will account for over 50 percent of all emissions permits in the phase from 2013, and manufacturing can only increase or decrease that by up to 15 percentage points.

The Commission's risk list is close to being formalized -- ending the uncertainty of sectors such as cement -- but it could be derailed later in the year due to a row over the methodology of cost calculations.

Kumar of WWF says the European Parliament could reject the calculations because they strayed from the legal demands of the directive agreed by EU leaders.

The deal was done in a shoddy way by heads of state, and I wouldn't be surprised if some parliamentarians are still sore about that, he said. It could be challenged legally. This issue is not dead. It's very much alive and kicking.

(Reporting by Pete Harrison; Editing by Keiron Henderson)

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