Emission trading schemes belong to the most efficient and effective policy options to achieve a given emission reduction target. In an emission trading system, each source of pollution gets a certain amount allowances that give the ‘right’ to emit one unit of pollution. By reducing the amount of allowances issued, the system can achieve emission reductions among its participants. By allowing the allowances to be traded on an organized exchange, the market assures that these reductions are achieved at the least possible cost for participants.
In theory, the efficiency of the system is achieved regardless of the initial allocation method. Allocation methods most often considered are auctioning and free allocation. Because free allocation impacts less on the costs for companies, it is believed to be a better system in the context of unilateral climate policies. Through free allocation, companies face less cost disadvantages compared to producers that do not fall under a climate policy regime. Free allocation would therefore have less distortive impacts on trade and economic growth - allowing EU producers to compete at lower price levels than would be possible under an auctioning regime.
However, this belief in the benefits of free allocation crucially hinges on the assumption that companies do not pass through the opportunity costs of their freely obtained allowances in the product prices. If they would pass through the market value of the freely obtained allowances, product prices would rise and the impacts on trade and competitiveness of a system of free allocation would be similar to that of auctioning. The only effect of free allocation would then be that companies gain windfall profits through the emission trading system and income from citizens will be transferred to business. This would be a particularly unfavourable outcome in the European context, where free allocation is presented as a solution towards carbon leakage.
Economic theory tells us that companies will pass through the costs of the freely obtained allowances in most circumstances – even if this will bring them a competitive disadvantage to producers not due to climate policies. According to economic theory, companies are profit-maximizing institutions that prefer profitability on invested capital over maintaining market shares. If passing through the opportunity costs in product prices can enhance their profitability, they will do so even if this would bring them some harm in terms of loss of market shares, as long as the additional profits do outweigh the additional costs. How much the firms will be able to pass the costs on depends on market structure and on elasticity of demand and supply. Theoretical analysis shows that typically, assuming linear demand and supply curves, the firms will be able to pass from 50% of increase in marginal costs due to the EU ETS (under the monopoly) to a 100% (under perfect competition). How much the increase in marginal costs reflects the carbon price depends on elasticity of supply and demand. Assuming non-linear demand and supply curves implies different rules and a possibility to pass on more than a 100% of additional costs due to the EU ETS.
We have tested the hypothesis that energy intensive companies did not pass through the costs of their freely obtained allowances during Phase 1 and Phase 2 of the European emission trading system the EU ETS. The EU emissions trading scheme (EU ETS) was launched in 2005 to cap CO2 emissions from large industrial facilities and electricity producers. Covering over 10,000 installations, it is the largest international emission trading system in the world. During Phase 1 (from 2005-2007) and Phase 2 (from 2008 till 2012), allowances were issued for free to the energy intensive industries in all member countries. The question is whether the value of these free allowances have been forwarded in the price of EU products, signalling windfall profits, or that EU producers did not do that.
This is investigated using econometric methods stemming from the concept of co-integration and market integration. The idea is that several dependencies exist between EU and non-EU markets through the prices of inputs in production processes and the prices of outputs on the various markets. If, for instance, prices of iron ores increase in Asia, they are likely to start to increase in Europe as well. This will put an upward pressure on the price of steel in both Europe and Asia. If Asian steel prices increase due to local shortages, this will also put an upward pressure on European steel prices as a larger portion of European steel will be shipped to Asia. In this system of market dependencies, it can then be investigated if the price of an emission allowance at the European ETS market is a significant variable for the variation in prices between EU and non-EU products over time.
A standardized estimation procedure was developed (co-developed and reviewed by three independent econometricians) in order to come up with robust outcomes (and preventing data mining and spurious outcomes). This estimation procedure was subsequently applied to a few selected products from the iron and steel, refineries and (petro)-chemical industries. For these products, prices were compared between the EU and the US and it was investigated to what extent European prices were influenced by price developments on the EU ETS markets.
The outcomes of the econometric analyses show that for most products a significant influence of the EUA prices on the European product prices can be found. For products from the refineries sectors (gasoil, diesel and gasoline) a quite direct influence can be found. Within two weeks are higher prices on the EU ETS markets translated into higher prices on the German markets for diesel and gasoline. For gasoil traded in Rotterdam an immediate price increasing effect from CO2 prices can be found. For the products of the iron and steel sectors (hot and cold rolled coil), a significant influence of CO2 prices can be found after one month, while for polyethylene, polystyrene and polyvinylchloride a delayed influence from 3-8 weeks can be found.
The cost-pass-through rates from the econometric estimations show that for products of the refineries sector full cost-pass-through rates are likely. The econometric results even suggest that more than 100% of the costs were passed through, but this cannot be stated with certainty. For both steel varieties, the cost-pass-through was close to 100%. The same value was found for polyvinylchloride and polyethylene. For polystyrene the cost-pass-through rate was significant but much lower at 33%.
These results cannot be directly interpreted in amount of windfall profits, as we have no information on the individual emissions stemming from producing these products. However, if the full cost-pass-through rates would prevail for all products in the refineries and iron and steel sectors, it can be calculated that the total amount of windfall profits would equal € 14 billion between 2005 and 2008. This implies a substantial transfer of money from consumers to the energy intensive industry.
This research hence results in the conclusion that there is ample evidence that the energy intensive industry has passed through the prices of their freely obtained allowances during Phase 1 and Phase 2 of the EU ETS. This has generated windfall profits in these sectors. The cost price increase is identical as it would have been under an auctioning regime but without the possibility that governments would have to compensate consumers by recycling auction revenues. Politicians seem to have underestimated the potential of windfall profits in exposed sectors and have believed overall the claims of industry that additional costs cannot be passed through. The higher prices on the EU markets may have stimulated imports from non-EU producers but this was not quantitatively assessed in this study. The results, however, do point at the suggestion that free allocation falls short of its intentional goals: to prevent carbon leakage. Under free allocation both windfall profits and carbon leakage may be stimulated.