Do energy companies make windfall profits from emissions trading? To answer this question we briefly indicate how emissions trading works and clearly define the term windfall profits. Under the Kyoto Protocol the EU is committed to achieving an 8% reduction in greenhouse gas emissions by 2008–2012 compared to emission levels in 1990. Emissions trading is an instrument to reach that target. In the EU system, the emissions are capped and polluters are allowed to trade emissions in the form of emission rights. At least until 2012, they primarily receive those rights, called allowances, for free. If participants decide to trade, the buyer is allowed to emit more, but the seller must emit less (e.g. Dales 1968). This scheme is both effective and efficient: the environmental target is met at lowest costs (e.g. Woerdman 2005).
However, the emissions trading scheme is not without problems. Energy companies are now accused of making windfall profits. These are the profits due to the introduction of the emissions trading scheme. Windfall profits arise because producers pass on the market value of the emission rights to consumers via a mark-up on energy prices, while the producers obtained those rights for free. Should energy consumers pay for the allowances that energy producers obtained for free? The answer is yes. The crucial reason being that emission rights obtained free of charge have “opportunity costs” (e.g. Grafton and Devlin 1996; Nentjes et al. 1995).
In economics, the concept of opportunity cost must be taken into account whenever a resource can be used in alternative ways (Varian 2003). In general, when you consume more of good 1, you may have to give up some consumption of good 2. If that is the case, giving up the opportunity to consume good 2 is the economic cost of more consumption of good 1. A more concrete example is the wage rate. The wage rate is not only the price of labour, it is also the opportunity cost of leisure. If your salary is €20 per hour, then an extra hour of leisure costs you €20 in forgone income.
A similar reasoning can be applied to emission rights. Instead of using the free allowances, the firm could have sold them at the current market price. When selling its output, for instance electricity, the firm wants to recover this opportunity forgone in the product price. An emissions trading scheme puts a price on residual emissions, which means that they are no longer for free. “Consuming” the right to emit when producing output is a cost to the firm. If producers are to be motivated not to sell those rights, then the proceeds of such a sale need to be compensated via the energy prices. In other words: although an energy producer does not have to pay for the emission rights, he does employ them to cover the emissions when producing output and therefore he must pass on the value of those rights in the product price. Below, we illustrate this with a numerical example.
Let us consider the example of energy producers. They are assumed to be price-takers, which means that these producers take energy prices and allowance prices as given. Suppose that prior to the introduction of a system of tradable emission rights, at time t = 0, the cost price of, say, a unit of electricity is €65, consisting of €50 fuel costs, €10 capital costs and €5 labour costs. The normal profit is €5. In equilibrium, the market price for a unit of electricity is then €70 (excluding indirect taxes and distribution costs). The left side of Fig. 1 illustrates that with the introduction of an emissions trading scheme, at time t = 1, the market value of the free allowances is added to this price. (Note that the right side of Fig. 1 is not referred to here and will be used later on in this article). Suppose that the market value of an allowance implies a €20 mark-up on the electricity price (i.e. from the market price of an emission right per unit of CO2 producers derive a mark-up per unit of electricity). Including the normal profit, the electricity price becomes €90 per unit of electricity. The market value of the emission rights is then fully passed on to consumers. The reason being that the producer could have sold those rights. He will not sell if and only if he can earn the revenue forgone via the electricity price.
In his published yearly accounts the producer will report a total profit per unit of electricity of €25 and, second, the normal profit of €5. This is clearly a situation in which reporting the results in the yearly accounts differs from economic reality: there is only an economic profit of €5, while €20 is necessary to compensate for the opportunity costs of using the rights.
The cause of the windfall profits, that is grandfathering, is not always well understood in the climate change literature and popular press. The following quote taken from an interview with Kevin Smith, a researcher with Carbon Trade Watch, illustrates this: ‘Governments massively over allocated emissions permits to the heaviest polluting industries in the initial round. This resulted in windfall profits for some of the biggest polluters who in exaggerating their need for emissions allowances, received enormous amounts of permits that they could then profitably sell on’ (in: Cunningham 2007: 27–28). This is indeed a popular view, but it is not correct.
Windfall profits should not be confused with profits arising from “over-allocation”, meaning that companies get more (in this case free) allowances then they need, which they can sell for cash on the market (provided that there is still sufficient demand). Over-allocation arises solely from leniency in the setting of the emission target; windfall profits arise solely from the allocation method of grandfathering. With stringent targets, electricity producers will still realize windfall profits, because the grandfathered allowances entail opportunity costs for them. However, with a smaller number of free allowances, the price of those rights will be higher. Therefore, a more stringent emission cap does not necessarily reduce the size of the windfall profits, but might even increase those profits.
Although over-allocation should thus not be confused with windfall profits, they are intertwined in the sense that over-allocation in principle should lead to a low (or zero) carbon price, resulting in low (or no) windfall profits. This only occurred during 2007 after data on over-allocation had been published. Forward sales in 2007 of allowances, though, did not suffer from over-allocation (with prices ranging between about €12 and €24), since those allowances are to be used in the more stringent 2008–2012 period (COM 2007).
Others question the opportunity costs reasoning all together and suspect that it is wrong to pass on the market price of free allowances to consumers in the first place. Jepma, for instance, writes: ‘Because allowances are grandfathered, and most installations seem to succeed in passing on allowance prices onto end users without being charged accordingly, they eventually capture windfall profits. […] [T]he group that eventually pays for the rent […], is the group of final end users, or consumers, who eventually pay the bill for the net windfall gain’ (Jepma 2006: 6–7). However, consumers should, as explained above, pay for the allowances that energy producers obtained for free, because the use of those allowance entails opportunity costs.
Another misunderstanding is the idea that the emission reduction costs must be subtracted from the opportunity costs. Instead of using the free allowances, the energy producer could have sold them and should thus pass on their opportunity costs to consumers. But if he would actually sell them, he must first reduce his emissions, which comes at a cost. Some seem to believe that the emission reduction costs must be subtracted from the opportunity costs, but this is wrong. In the case that a producer does not reduce pollution in a grandfathering scheme, he faces opportunity costs of the allowances and no emission reduction costs. In the case that he does reduce pollution, he not only faces emission reduction costs, but he also brings in revenues from selling the allowances. The allowances set free through emission abatement can be seen as a side product of the firm. His profit is the difference between the revenues from selling the side product, namely allowances, and its production costs, that is the emission reduction costs. If the producer still produces some emissions after the abatement, he will have to cover these remaining emissions with allowances.
About 2 or 3 years before 2005, when emissions trading started, the Council of Ministers decided to use grandfathering in the EU in order to make carbon pricing acceptable for their industries and to protect their countries’ competitiveness. Only 1 or 2 years after the start of this scheme, politicians were surprised that electricity companies made windfall profits. However, this should not have been a surprise at all. The grandfathering of emission rights generates additional cash for electricity producers, improving the financial position of shareholders. The value of a share increases, because the electricity company receives an asset with a market value for free.
What is surprising, though, is that politicians did not know, or maybe act as if they did not know, that this was going to happen. Already at the end of the 1990s, Bohm (1999: 21) wrote: ‘Gratis allocation such as grandfathering […] [implies] that these firms obtain windfall profits (as compared to not being given the permits gratis)’. More recently, Richard Douthwaite of the Foundation for the Economics of Sustainability (Feasta) stated in an interview that ‘(…) EU officials who planned the ETS [EU Emissions Trading Scheme] were aware of the windfall effect, but opposition from industry would have made it impossible to introduce the ETS if the permits had not been given away. […] It was essentially a massive bribe’ (in: Cundy 2007: 1). We are not sure as to what politicians did and did not foresee in advance, but we know for sure that the windfall effect was recognized in the economic literature several years before the start of emissions trading in the EU.