[Increasingly, people agree that markets for carbon permits are likely to be a major mechanism for fighting climate change. But how those permits are designed, how they're sold, and who benefits or loses from their sale -- these are all very complex-yet-pressing challenges. Here, WC allies Clark Williams-Derry and Eric de Place explain why just giving permits away both burns consumers and lets polluters rake in unearned profits. While written in the context of the U.S. Western Climate Initiative negotiations, this is the clearest explanation of the questions involved I've yet seen in any context, and is really worth a read. -- Alex]
1. Allocation Economics: A Simple Explanation
Why will energy companies raise prices even if they’re given carbon permits for free? The simplest explanation may be an analogy from Peter Barnes of the Tomales Bay Institute:
Try buying World Series tickets from a scalper. Would he charge you any less if he found the tickets on the ground? Of course he wouldn’t. Like energy, the street price of World Series tickets is based on supply and demand. The supply and demand for tickets is the same no matter how much the scalper paid for them, and so the price he charges you will also be the same no matter how he got them.Of course, the scalper would much rather get his tickets for free - and that’s precisely the point. Polluters are financially much better off if permits are given away instead of auctioned, but the cost of cutting emissions and the resulting effect on energy prices will be the same no matter how the permits are delivered.
A permit to emit carbon is like a World Series ticket. It has a value in the marketplace; and any owner of permits will attempt to sell them to the highest bidder, rather than just giving them away. That’s true regardless of how the owner acquired the permits (whether through an auction or free allocation) and regardless of who buys them (the firm’s own customers or some other entity).
2. Allocation Economics: More Detail
Let’s take a look at how the system would work if permits were given away for free:
• Let’s say that WidgetCo is given free permits, and that the market price for permits is $10 per ton. And let’s say WidgetCo releases one ton of CO2 to make each widget.
• When WidgetCo’s managers decide whether to produce a widget, they have to ask themselves: “Should we use up a permit so we can sell yet another widget? Or is it better to simply sell the permit?”
• If WidgetCo sells the permit, it nets an easy $10 profit. So the company won’t bother to make another widget unless it can make at least as much money as it can by selling a $10 permit.[0]
• So, to recoup the $10 profit they could have made by selling a permit, WidgetCo raises prices by just about $10 dollars per widget. (If they don’t raise prices, then they’d be better off just selling permits, rather than widgets.)
• In the end, WidgetCo’s sales may fall a bit from higher prices. And when its sales fall, its emissions fall too. But WidgetCo won’t mind losing a few sales because they will be making $10 more per widget.
• In fact, the only people who won’t be happy are widget consumers. They’ll be paying higher prices, while WidgetCo reaps the profits – all thanks to free permits.
In the real world, the dynamics depend on the specifics of WidgetCo’s markets. If the company competes with firms that aren’t operating under an emissions cap, it may not be able to pass on the full costs of unsold permits to consumers. Or if WidgetCo is operating in a tightly regulated market (such as the Western electricity market) then it may not be legally allowed to raise consumer prices to cover the opportunity costs of unsold permits.
But if WidgetCo has a captive market with high demand for its products (if widgets are gasoline, for example) then it will pass most of the opportunity cost of its unsold permits. Energy prices will go up, and any firm that was given free permits will reap the unearned profits.
Note that selling permits, rather than giving them out for free, does not change the underlying dynamic of price increases for consumers. No matter how permits are allocated—whether through auctioning, grandfathering, or some other form—firms will attempt to charge consumers for the market cost of the allowance. Consumer prices will go up exactly the same amount, regardless of how the permits are distributed initially.
A permit auction system, on the other hand, gets the system off to the right start. Financial incentives can spark innovation, speed least-cost efficiency measures, and encourage start-ups with smart ideas for clean energy sources. The revenue can cushion consumers from higher prices and fuel public efficiency and infrastructure investments [And provide more climate equity. - Ed.].
3. What Happened in Europe
Don’t take our word for it. Take a look at the one real-world case where cap and trade was used for carbon emissions -- Europe. Under the EU’s Emissions Trading Scheme (ETS), almost all of the permits were given to polluters for free.[1] And, as it turned out, firms reaped windfall profits from consumers based on the market value of the permits they were given.
That’s what the bipartisan National Commission on Energy Policy found in a March 2007 paper:
Recent experience with the Emission Trading System (ETS) now being implemented by the European Union (EU) suggests that the potential for windfall profits, far from being purely hypothetical, is borne out by empirical evidence, with utility companies that received free allocations under the EU program having realized substantial gains. [2]
What was the effect for consumers? The Commission’s report continues:
...an allocation approach that gives all allowances for free to directly affected industries will have the overall effect of transferring some wealth from the broad public (in this case consumers) to those industries.
The International Energy Agency independently studied Europe’s system and came to the same conclusion. In a February 2007 report the Agency said:
If any evidence is needed of the CO2 pass-through into electricity prices, it was provided by the abrupt fall of the CO2 price in May 2006, as market players were made aware of the excess quantity of EU allowances for the year 2005. The fall by EUR 10/tCO2 was immediately followed by a drop in wholesale electricity prices of EUR 5-10/MWh. This electricity price adjustment can be directly attributable to the CO2 [permit] price fall, itself not connected to other energy market movements that could also affect electricity prices.[3]
In other words, permit prices dictated the rise and fall of consumer prices, even when permits had been free for energy producers. And when an energy research group at the University of Cambridge looked at the European experience, they also agreed:
...in theory, power producers pass on the opportunity costs of freely allocated emission allowances to the price of electricity. For a variety of reasons, however, the increase in power prices on the market may be less than the increase in CO2 costs per MWh generated by the marginal production unit. This is confirmed by empirical and model findings, showing estimates of CO2 cost pass through rates varying between 60 and 100 percent for wholesale power markets in Germany and the Netherlands.[4]
That is, specific market conditions may influence price outcomes, but the not method of allocation.
At first, the European Union gave away permits for free. Now the EU is rewriting their program to correct the mistake, and to ensure that new permits are auctioned. The Western Climate Initiative can do it right the first time around, saving enormous
headaches and delays.
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For a review of the relevant literature, please see the literature review here (PDF). More information from Sightline can be found here.
notes:
0. In a competitive market, WidgetCo simply doesn’t make much money from selling an additional widget. Supply, demand, costs, and prices are all balanced so that WidgetCo’s barely profits, or possibly loses money, from selling an additional widget. (That’s what economic theory says, and it’s largely borne out in practice.)
1. Jos Sijm et al., “CO2 Cost Pass Through and Windfall Profits in the Power Sector,” Electricity Policy Research Group, University of Cambridge, May 2006, web link, page 2.
2. National Commission on Energy Policy, “Allocating Allowances in a Greenhouse Gas Trading Program,” March 2007, web link, page 11.
3. Julia Reinaud, “CO2 Allowance and Electricity Price Interaction,” International Energy Agency, February 2007, web link, page 5.
4. Op. cit. 1, page 26.
