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A Practical Solution to Windfall Profits in the EU Carbon Market

This is a rare moment for climate policy making in the EU, writes Emil Dimantchev, senior carbon market analyst at Thomson Reuters. Lawmakers in Europe have begun a process to redesign the EU carbon market with new rules that will take effect after 2020. According to Dimantchev, they should follow the example of California and introduce a dynamic allocation system of CO2 permits. It is the most practical and politically feasible way to end windfall profits.

In the current process to reform the carbon market, one important goal for lawmakers, unanimously embraced by EU member states, is to ensure the system does not grant polluting industries windfall profits. Lawmaker concern stems from an inconvenient fact. The current design of EU’s Emissions Trading System (EU ETS) gives companies CO2 permits for free in a way that allows them to reap bountiful profits at the expense of consumers. The question is: how could the EU fix this?

The best solution is likely to be a free allocation system similar to what has already been implemented in California – a dynamic output-based allocation of permits. In Europe, a related, but very complicated, proposal failed to gain traction in 2014. But the idea of aligning free allocation to industrial output has endured in both the Council and the Parliament. This post takes a look at a dynamic allocation system for the EU that could both end windfall profits and garner broad political support.

Redesigning CO2 permit allocation in the EU

A dynamic allocation system gives away CO2 permits to companies based on their most recent production levels. To understand exactly how it would work in the EU context, we need to briefly consider how the EU ETS currently operates.

Today, the EU calculates how many free permits each installation would receive based on how many tons of industrial product the facility is expected to make per year. Crucially, EU regulators calculate an installation’s annual production based on output data observed over some fixed historical period. For example, the Commission mainly used data up to 2010 to determine free allocation for the whole period 2013-2020. Now, it proposes to base free allocation in 2021-2025 mainly on data up to 2017.

Dynamic allocation would work differently. The assumed annual production would be equal to the most recent industrial output data. Thus, the allocation in 2021 could be based on data in 2019, the allocation in 2022 on 2020 data, and so on. In this fashion, the basis for the production level would keep rolling and free allocation would keep changing based on the latest economic developments.

Hence, dynamic allocation. For such a system to work, there should be an additional design feature: an ex-post correction. This provision would adjust future allocation to compensate for any over- or under-allocation (up to a point) in the past.

Some industries have already expressed support for dynamic allocation. It may be the most pragmatic way forward

The following example illustrates, broadly, the mechanics of dynamic allocation. Say a cement maker reduces its production level by 5% in year Y. The allocation in year Y remains unchanged. In year Y+1, member states collect verified production data for the previous year, which then forms the basis for allocation in the following year. In year Y+2, free allocation is cut by 5% of what would have been allocated (to account for the latest known production level) and by an additional 5% of the allocation in year Y (to account for the fact that the cement producer was over-allocated CO2 allowances). And vice versa in the case of higher production.

Importantly, such a system would only work well if there is a hard cap on industrial free allocation. This cap could be the same as the one proposed by the Commission, which suggested that 43% of the total EU ETS cap be available for free allocation. This cap would leave plenty of allowances available for industries that grow their production.

Our analysis at Thomson Reuters suggests current draft proposals in the Industry and Environment committees in the European Parliament would result in a significant amount of allowances from the industry cap that will be left unallocated. These can accommodate any production increases.

How dynamic allocation minimizes windfall profits

To see how dynamic allocation can serve as a solution to windfall profits, let’s recap briefly the cause behind the problem.

The reason industry can gain windfall profits from the carbon market is because the current system of free allocation incentivizes producers to raise the prices of their products, even though they get CO2 allowances for free. Revenues go up, while costs stay the same. This happens because manufacturers are driven by opportunity costs. A company that receives free permits can always choose to cut production and sell its allowances. So, to keep producing implies giving up this opportunity, which amounts to an economic cost.

As I explained earlier, a profit maximizing company will raise its product price to reflect this framework of incentives. Comprehensive empirical research shows that industrial companies have indeed engaged in such CO2 cost pass through in the past.

A dynamic allocation system would largely wipe out the incentive for companies to pass through opportunity costs. To see how, consider what would happen when a company reduces its production. It will now know that its future allocation will be cut. The company will still have surplus allowances because the allocation adjustment will occur in two years’ time. However, it will lack the option of selling these allowances because it will need them in the future. The continuous ex-post correction described above ensures that the opportunity cost will, for the most part, no longer exist. As a result, the current pernicious system of incentives that causes windfall profits will collapse.

Once the current reform process is over, the next chance to change the free allocation rules will probably fall around the mid 2020s

One downside is that the price of steel and other products will no longer reflect the CO2 price. Companies using such materials, like carmakers, will lose the incentive to use them more efficiently or switch to less carbon intensive products. This effect will be limited to industrial sectors that receive 100% of their allowances for free, which will likely be the case for steel, given the current state of the discussion in the Parliament. Other sectors, which may need to buy some of their allowances, will continue to reflect part of the CO2 price in their products.

To ensure that industrial consumers are incentivized to reduce emissions, the EU could implement a consumption charge in combination with dynamic allocation, in line with a recent proposal by Climate Strategies. Researchers have long understood how dynamic allocation curbs windfall profits, but the insights have only rarely escaped academia’s bubble. Though regulators in California recognized it, the policy’s potential has been largely absent from EU policy talks. It is time for that to change.

A politically feasible solution

Dynamic allocation would be a practical way to end windfall profits. It would be very challenging to do so without it.

The ideal solution, full auctioning combined with border levies on imports, is likely out of reach. Lawmakers and stakeholders have to accept the idea that the EU will continue to give away CO2 permits. Another proposal, put forward by Carbon Market Watch, is for lawmakers to try to adjust the future amount of free allocation by the percent of CO2 costs that they think industries can pass through to consumers without losing market share. But it is a challenge to calculate, let alone agree on, such percentages.

This difficulty is not an excuse for inaction. Yet it does complicate matters for those who would like to prevent windfall profits. What’s more, some industries have already expressed support for dynamic allocation. It may be the most pragmatic way forward. The last time the EU ETS directive was opened up for full overhaul was eight years ago. Once the current process is over, the next chance to change the free allocation rules will probably fall around the mid 2020s. Lawmakers may wish to make the most of this rare opportunity.

by

Emil Dimantchev is a senior carbon market analyst at Thomson Reuters, previously known as Point Carbon, an independent provider of analysis on global carbon markets, where he develops quantitative models and writes extensively on market developments and policy issues. The views expressed in this article do not necessarily represent those of Thomson Reuters.

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