Anxiety prevails as windfall benefits power companies

Date: 20/01/05

Can the EU's emissions trading scheme for carbon dioxide succeed in the absence of a global climate change agreement? The ETS provides a mechanism by which emitters - factory operators, oil refineries or power plants - are obliged to accept absolute emissions ceilings. They have a choice of cutting their own emissions or paying to ensure that someone else does it for them. This ensures that the ceiling is complied with at the lowest possible cost: those who can reduce emissions at lower costs will sell their allowances to those with higher costs.

A precondition is that the system is sound and properly implemented. With this and the success of the US sulphur dioxide scheme in mind, the European Commission's leitmotiv was to keep the system "simple". The ETS - at least initially - covers only carbon dioxide emissions from large industrial and energy installations, from a limited number of energy-intensive sectors such as refineries, cement, pulp and paper, glass, steel and other metal plants, coke ovens, and power generation. Together they still cover about 45% of total EU CO2 emissions.

Member states chose to allocate almost all emissions rights for free instead of selling them, which they could have done, at least for a small portion. This was no surprise. It was also no surprise that the handing out of emissions rights, the so-called allocation for the first period (2005-07) was generous. More surprising was that member states could not agree on interpreting key concepts in a uniform way such as the definition of installations, provisions for new investment (i.e. for new entrants into the markets) or banking. This creates unnecessary complexity and extra costs. Partly, business lobbying is to blame. While publicly calling for a "simple" and "harmonised" framework, some businesses lobbied hard through the back door for exceptions and special treatment, if it suited their interests.

All this, however, should not be overstated. Such teething problems were foreseen and will be addressed in a comprehensive review in 2006. There was always going to be an element of "learning by doing" and it was generally accepted that adaptation would be necessary after the initial experiences.

The real heat came from a different corner. Having been largely silent during the run-up to adoption, energy-intensive industries suddenly discovered that they were to end up paying twice. Once for their emissions, and again through higher power prices. While they thought that they could live with the first bill, the extra invoice had not been budgeted for.

They discovered that power generators were to book some handsome windfall profits. What really caused a stir was that this was not only true for low carbon producers such as nuclear or hydro-power but also for dirty old coal plants. How so? Power prices are set on the basis of marginal costs. As most of the time the marginal producer is coal, power price increases could be substantial, since coal needs many allowances. Since power generators will find it easy to pass on additional costs, while getting their allowances for free, they make extra profits.

While early expectations from the consultants McKinsey assumed end-use price increases of 10-15%, the International Energy Agency is currently assuming an increase of between 3-5% at an allowance price of €10. But allowance prices may not remain as low as generally expected. If coal prices decrease and gas goes up, gas to coal substitution might quickly disappear. Demand for allowances would go up and with it the allowance price.

What should be done? First, energy regulators or the European Commission must monitor what happens with the power prices. Energy regulators are noticing that power price rises are increasingly justified by referring to the ETS. Second, consistent and more efficient allocation rules for new entrants are needed. Responsibility rests here mainly with the member states.

Another possibility would be to allocate allowances only to energy-intensive companies and not to power companies. Energy users would then pay for their power with both cash and allowances. Power companies would be compensated for the delivery of power by a combination of money and allowances (to cover for the allowances they have needed to produce the power). That way, there would be no windfall profits. Nevertheless, none of these options will be easy to implement.

What does this mean for the future of the ETS? Paradoxically, uncertainty about the Kyoto regime beyond 2012 might help. Unless more countries accept legally binding emissions targets, EU governments will be anxious to avoid placing too great a burden on their industries and will continue to allocate generously. By the time the world gets more serious about carbon, the EU should have sorted out the teething problems.

• Christian Egenhofer is a senior fellow, Centre for European Policy Studies (CEPS) and at the Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP) at the University of Dundee, United Kingdom.

The author, who is a senior fellow at the Centre for European Policy Studies (CEPS), analyses the EU Emissions trading scheme for carbon dioxide, launched on 1 January 2005.