CO 2 cost pass-through and windfall profits in the power sector

“Within a structural framework that is commonly used in the electricity auctions literature (see Wolak (2000) and Hortaçsu and Puller (2008), among others), we first test if firms’ behavior is consistent with full internalization of permit prices.”

“But a study involving Germany and The Netherlands (Sijm et al., 2006) found pricing patterns consistent with the incorporation of the opportunity cost of the free permits being fed into prices.”

“Of all market participants in the EU ETS, large power producers exhibit the greatest potential for market power, and, as it happens, they also reaped large profits from the initially high EUA price due to a combination of free allocation and cost pass-through [8, 9, 45, 46, 47].”

“Sijim et al. (2006) explore the impact of the EU ETS on the power sector in Germany and the Netherlands,”

“However, partly in response to the large windfall profits estimated to have been earned by power companies, the plan is to transition to full allowance auctions by 2020, with the decision on how to use revenues largely left to the member states (Sijm et al. 2006; CEC 2008).”

“Because of those phenomena, the ETS has been suspected of generating windfall profits for many companies covered (Sijm et al., 2006).”

“In an ex-ante study, Smale et al. (2006) have similar findings where most UK participating sectors would be expected to profit in general, although with a modest loss of market share in the case of steel and cement, and closures in the case of aluminum. While it is imperative that the econometric estimation give resul…”

“The major rationale for an auction was to avoid the windfall profits that would generally result from free allocation of allowances in deregulated electricity markets (Sijm, Neuhoff, and Chen 2006).”

“The result was some emissions abatement, but due to the free allocation of permits firms enjoyed windfall profits by passing compliance costs on to consumers, who were the losers (Sijm et al., 2006; Ellerman et al., 2010).”

“Power generators with emitting plants reaped windfall profits (Sijm et al., 2006), and firms investing in new emitting plants benefitted from a large subsidy effect (Ellerman and Buchner, 2007), leading to a positive perception by many firms.”

“Sijm, Neuhoff, and Chen (2006) examine the implications specifically for electricity prices in the Netherlands and Germany and find substantial pass-through of carbon cost.”

“For example, Sijm et al. (2006) found that the power sector is estimated to pass-through about 60–100% of CO2 to cost by increasing electricity prices.”

“2005, Sijm et al. (2006) estimated that emissions costs have been almost fully (60-100%) passed”

“…emerges from the markets, these allowances reflect new liquid assets (some critics argue that polluters have been given windfall profits in the short term), and thus their consumption (eg. to produce power) involves the opportunity cost of carbon at the market price (see also Sijm et al. 2006).”

“Sijm et al. (2006) calculate empirical PTRs between 60% and 117% for 2005 for Germany.”

“Even though the EU Emission Trading Scheme (ETS) is the world's largestmarket-based environmental regulation, only a few studies have so far tried to quantify its economic effects (e. g. Sijm et al., 2006; Smale et al., 2006; Demailly and Quirion, 2008).”

“19 and cost pass-through led to a situation where firms’ profits increased due to the introduction of the EU ETS, an issue which has become known under the label of “windfall profits” (Sijm et al., 2006; Lise et al, 2010).”

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“[2] has pointed out that where 28 companies pass on the opportunity costs of pollution licenses into consumer prices, 100% free 29 allocation leads to windfall profits for polluting industry.”

“…Although the number of studies on the impact of the EU ETS on the power sector has grown rapidly over the past 2 years, except for a few studies, empirical evidence on the impact of the EU ETS on electricity prices is still limited (e.g., Levy 2005; Honkatukia et al. 2006; Sijm et al. 2006a).”

“Some authors argue for a full (or almost) full pass through (Sijm et al., 2006; Honkatukia et al., 2006) while others only see a partial pass through or none at all to wholesale prices (Levy, 2005).”

“In other words, ‘grandfathering’ is likely to have regressive effects (Shammin and Bullard, 2009; Sijm et al., 2006).”

“Further, evidence of positive pass-through rate of the carbon price provided by econometric studies (mostly in the power sector (Sijm et al., 2006), but also in some manufacturing sectors (Alexeeva-Talebi, 2011; De Bruyn et al., 2010)) was an indirect proof that companies took into account the full…”

“…concerns in cases of high trade exposure and very price-sensitive demand, in aggregate, most sectors, including cement, iron and steel, refining, and pulp and paper, have the potential to profit from free allocation on aggregate sector levels, by adjusting output and pricing (Smale et al., 2006).”

“…to auction a significant share of allowances, and the proposals by the European Commission for trading post 2012.5 Jos Sijm and Karsten Neuhoff have been the leaders in quantifying the extent of the pass-through in these deregulated markets (see Sijm et al. 2005; Sijm, Neuhoff, and Chen 2006).”

“Examples include Sijm et al. (2006, 2008), Fell (2010), Fezzi and Bunn (2010), Honkatukia et al. (2013), and Fell et al. (2015).”

“Some theoretical analyses use two-period models to address the distortion that arises if decisions in one period affect emissions allocations in the next period, as in the first two phases of the EU ETS.”

“The “pass-through” literature estimates how much of CO 2 price shock generators pass on to electricity prices (Sijm et al. 2006”

“This interaction argument has been put forward by numerous authors on a verbal level (del Rio, 2009; Fischer and Preonas, 2010; Frondel et al., 2008, 2010; McGuinness and Ellerman, 2008, p. 28; Philibert, 2011; Sijm, 2005; Sinn, 2008, p. 177; Sorrell and Sijm, 2003; Weimann, 2008, p. 55; 2009).”

“In 2005, prices in Germany and the Netherlands rose by between 60% and 117% of carbon costs (Sijm et al , 2006).”

“According to Sijm et al. (2006), the pass-through rates vary between 60% and 100%, depending on the country, market EU emissions trading: an early analysis of national allocation plans for 2008–2012 375 © 2006 Earthscan Climate Policy 6 (2006) 361–394 structure, demand elasticity and CO 2 price…”

“A well-known result is that in the case of grandfathering large windfall profits for producers occur that are paid by consumers, for example reported by Bode (2006) and Sijm et al. (2006).”

“…and consumers, so the compensation required to cover the losses of upstream firms turns out to be a relatively small fraction of the revenue which would be raised through auctioning all CO2 emissions allowances (Hepburn et al., 2006; Goulder, 2002; Grubb and Neuhoff, 2006; Sijm et al., 2006).”

“Researchers analyzing the CO2 emissions trading system in Europe that began in 2005 have reached a similar conclusion (Sijm et al. 2006; UK House of Commons 2005).”

“Profits related to free distribution of permits have been identified as an issue in permit markets in general (Vollebergh et al. 1997; Bovenberg and Goulder 2000), and in particular in the EU ETS (Grubb and Neuhoff 2006; Hepburn et al. 2006; Neuhoff et al. 2006; Sijm et al. 2006; Smale et al. 2006).”

“Making all permits free however, as the EU-ETS and many other carbon markets did in their first days, is likely to result in overcompensation, that is in windfall profits for the owners of polluting capital (Sijm et al., 2006; Woerdman et al., 2009), and may even reduce efficiency (Goulder et al.”

“The latter has been discussed under the label of “windfall profits” in the EU ETS (Sijm et al. 2006; Neuhoff et al. 2006).”

“For the infra-marginal unit (i.e., units that are not price-setting), the impact of emissions trading on profits depends on whether it is more or less carbon intensive than the marginal unit (Sijm et al. 2006: 52).”

“4 have access to previously unexplored windfall profits in the electricity derivatives market (see Linares et al., 2006; Smale et al., 2006; Sijm et al., 2006).”

“Our article can be seen as part of the emerging literature on the interactions between climate policy and energy policy (e.g. Bonacina and Gullı̀ 2007; Sijm et al. 2006).”

“Full cost pass-through of EU-ETS costs has been observed in some electricity generation markets (Sijm et al., 2006) and in oil refining (Alexeeva-Talebi, 2011).”

“Problem perceptions and framing are fundamental to the handling of a policy problem (Majone 1989; Schön and Rein 1994).”

“In this setting, an equilibrium analysis confirms the existence of the so-called windfall profits (see [21]) and provides quantitative tools to analyze alternative market designs, which are applied in [4] to optimize a cap-and-trade mechanism for a proposed Japanese emission trading scheme.”

“Grandfathered allowances used for covering the emissions of the allowance owner have an ‘opportunity cost’ (e.g. Sijm et al., 2006; Hargrave, 2000; Koutstaal, 1997; Grafton and Devlin, 1996; Nentjes et al., 1995).”

“Sijm et al. (2006) estimated that the level of passthrough of CO2 costs in the relatively liberalized wholesale electricity markets in the Netherlands and Germany was 60–100%.”

“E.g. Sijm et al. 2006.”

“Sijm et al. (2005, 2006a, 2006b) provided initial empirical evidence of passing-through opportunity costs of EUAs to power prices for, among others, Germany, the Netherlands, France, Belgium.”

“In competitive markets companies will pass on the opportunity costs of using allowances to final consumers irrespective of the allocation method (Sijm et al., 2006).”

“According to the models run by Sijm et al (2006) the rate of cost pass-through depends on the country, market structure, demand elasticity, load period and the CO2 price.”

“Sijm et al. (2006) estimate rates between 60% (off-peak) and 100% (peak) for 2005 using power exchange data.”

“In the first two phases, respectively covering the periods 2005–2007 and 2008–2012, allowances were mostly grandfathered to the involved sectors, but this created some economic distortions as indicated in Reinaud (2009) and Sijm et al. (2006).”