To End Windfall Profits, the EU Should Limit Free Allocation of CO2 Allowances to Industry

Tata Steel IJmuiden, Netherlands (Photo: Hendrik Ploeger)

EU member states intend to continue giving European manufacturers free CO2 allowances, even though this will hand them windfall profits, and will not motivate them to reduce CO2 emissions, writes Emil Dimantchev,  senior carbon market analyst at Thomson Reuters. Dimantchev calls on the European Commission to start a discussion with stakeholders and lawmakers from the European Parliament and member states to find a compromise ensuring that industry will pay the right price for its CO2 emissions.

EU lawmakers are currently discussing the rules that will govern the carbon market throughout the next decade (also known as “phase 4” for the carbon market). One of the main goals of the new rules is to ensure the carbon price does not harm the competitiveness of EU industry. To do so, member States have already decided to continue giving industry CO2 allowances for free. The crux for decision makers is to determine how many allowances to give industries in order to keep them competitive while prompting them to reduce CO2 emissions.

This decision will have economic and climate consequences. If the EU gives away too many allowances, it will forgo revenues that could be earned from auctioning the permits, while industries will make windfall profits, lose any kind of incentive to reduce emissions, and possibly emit more CO2. If industry receives too few allowances, its costs would rise, and if the carbon price reaches significant levels in the future, the result may be carbon leakage, whereby CO2 emissions increase outside the EU.

In the past, the EU gave industry too many free allowances, which led to windfall profits. In this article, we will explore why this happened and how lawmakers could avoid this in the future.

How many allowances do industries need?

There is a common notion, stipulated in the preamble to the EU Emission Trading Scheme (ETS) Directive), that a company needs to receive CO2 allowances for free if it is unable to pass through the cost of these allowances onto its product price without losing significant market share. This logic led member states to largely phase out free allocation to electricity producers in 2012, because utilities, which do not compete with companies outside the EU, are able to pass through 100% of any carbon costs onto the power price.

When it comes to industry, on the other hand, lawmakers have been uncertain as to whether companies can pass through CO2 costs and, if so, to what extent. Until recently, there was little research attempting to quantify cost pass-through rates across sectors. For this reason, EU lawmakers agreed to err on the side of caution when they decided the rules for phase 2 and 3 of the carbon market (2008-2012 and 2013-2020 respectively).

The Commission was effectively assuming that these industries would be unable to pass through any CO2 costs through to their customers. In retrospect, this decision resulted in a vast overallocation of allowances

In 2009, the Commission determined that all of the largest emitting industries, such as steel, cement, refining and others, were at risk of carbon leakage. These sectors accounted for 97% of industrial emissions and 43% of total emissions covered by the EU carbon market. By designating them “at risk”, the Commission made them eligible to receive free allowances equivalent to 100% of their estimated emissions. (Emissions are estimated using historical production levels and assumptions about CO2 efficiency also known as benchmarks, which are also subject of debate, but less relevant to the subject of this post.) Thus, the Commission was effectively assuming that these industries would be unable to pass through any CO2 costs through to their customers. In retrospect, this decision resulted in a vast overallocation of allowances.

How CO2 cost pass-through led to windfall profits

Recent research by CE Delft and the Oeko Institute found that heavy industries have been able to pass through a significant portion of the carbon price to their customers. The report, which was done for the European Commission, discovered that over the 2008-2014 period industries raised their product prices due to the carbon price, while they were receiving allowances for free. This way they were able to earn higher revenues at no extra cost, gaining windfall profits.

Because this idea seems counter-intuitive at first, it is worth taking a moment to consider why industry would want to pass through the carbon price even when it receives allowances for free. Think of a steel producer who receives two free allowances for every ton of steel produced (the quantities don’t matter, but I picked these because this is roughly the CO2 intensity of steel production using blast furnaces). The producer has two choices: 1) produce a ton of steel, emitting two tons of CO2 in the process, and surrender two allowances or 2) not produce a ton of steel and sell the two allowances on the market.

The evidence suggests that companies have been able to pass through CO2 costs without losing significant market share

Option 1) yields the usual profit from steel production, while option 2) gives a profit equal to the price of the two allowances. If option 2) is more profitable, a profit-maximizing company will refuse to produce steel at the original price and ask its customers for a higher price, a price where option 1) becomes at least as or more profitable. In this way, industry passes through the opportunity cost of the free CO2 allowances. This is the same well-documented mechanism, through which power producers passed through CO2 costs in the past and why most no longer receive free allowances.

CE Delft’s report estimated that the steel industry, for instance, passed through 55-100% of the opportunity costs of its free allowances. In the cement sector, the rate was 20-100% according to the authors, while other sectors exhibited varying abilities to pass through costs. What this implies is that the steel sector, as an example, actually needed free allowances equivalent to at most 45% of its emissions (the portion of costs it was unable to pass through), rather than the 100% it was given. The values estimated by CE Delft are uncertain, as a study sponsored by the European steel association points out, and as the authors themselves admit. But this uncertainty does not repudiate the overarching conclusion from the report and previous research cited by the authors, that CO2 cost pass-through is real and significant.

Industry representatives have either denied they have passed through CO2 costs or refused to acknowledge it, most recently during a stakeholder hearing organized by the Commission. But for many producers passing through CO2 costs may not even be a choice. It could be the case that the marginal producer, the one setting the market price, decides to pass through costs, thus increasing the market price for steel or cement. Once the price goes up, all producers benefit.

At this point, one might ask whether EU companies lost market share to foreign competitors because they raised their prices as a result of the carbon market. CE Delft’s report did not assess this. However, other research refutes that possibility.

A paper by the Grantham Research Institute showed it is unlikely for the carbon price to have caused any significant loss of market share. The empirical analysis found that energy costs in general have a small influence on international trade. The carbon price, in turn, represents a small fraction of energy costs, so its impact on trade was found to be particularly limited. The authors estimated that a carbon price of €40-65/t would increase imports in sectors covered under the carbon market by 0.04%. This calculation assumes no free allocation. Therefore, since companies received all allowances for free and passed through only a portion of their value to customers, the effect would have been even smaller.

The approaches being discussed would award more allowances to the steel sector and fewer to cement, even though historical evidence shows steel companies were able to pass through a greater share of CO2 costs

This finding has been confirmed by yet another study from Ecofys, which found no evidence that manufacturers lost market share because of the carbon market.

Thus, the evidence suggests that companies have been able to pass through CO2 costs without losing significant market share. Based on the Directive’s definition of what industry needs, we can conclude that companies received too many allowances for free.

CE Delft tried to quantify the windfall profits earned in this process of CO2 cost pass-through in another study commissioned by the climate campaigner group Carbon Market Watch. The researchers estimated that the largest emitters in the 19 EU countries investigated earned at least 15 billion euros in the period 2008-2014.

Windfall profits may continue

There is now a real risk that industries will continue to receive more allowances than they need in phase 4 of the carbon market if lawmakers continue to underestimate their ability to pass through CO2 costs. The Commission’s official proposal for phase 4 again includes giving free allowances to steel, cement, and other heavy industry equivalent to 100% of their estimated emissions.

Discussions in the European Parliament and among member states have shown a willingness to align free allocation more closely with what companies actually need (also referred to as tiered approaches). Yet current proposals (such as the one recently put forward by rapporteur for the Parliament’s industry committee) determine the risk of carbon leakage for each sector not the basis of a transparent and explicit estimation of its ability to pass through costs, but on a combination of how CO2-intensive and exposed to international trade it is. These metrics are indirect and incomplete proxies for the ability to pass through CO2 costs. Using such proxy metrics, lawmakers will be forced to make a largely arbitrary decision about what level of CO2 intensity and trade intensity deserves what level of free allocation.

The end result will be a political compromise, but one that will be far better for the success of the carbon market than the alternative of doing nothing

This approach may benefit some industries at the expense of others. Analysis that we have done at Thomson Reuters as well as research by Ecofys shows that the approaches being discussed would award more allowances to the steel sector and fewer to cement, even though historical evidence shows steel companies were able to pass through a greater share of CO2 costs. Under all policy papers published so far, the steel sector would receive free allowances equal to 100% of its estimated emissions. The result will be significant windfall profits if the sector continues to pass through the carbon price on to its customers at historical rates. 

Conclusions about future policy

The good news is that there is some political will to fix the problem of windfall profits. In October 2014, EU heads of state agreed that in giving away allowances: “… incentives for industry to innovate will be fully preserved … The consideration to ensure affordable energy prices and avoid windfall profits will be taken into account” (emphasis mine)

These words were unanimously agreed by all member states and featured in the so called Council Conclusions – a document with no binding force, but one that expresses the will of EU member states. Such documents sketch future policy with broad strokes and leave it to the Commission to provide policy proposals that fill in the details.

In its impact assessment and during policy debates, the Commission argued that the degree of cost pass-through is so difficult to calculate precisely that it cannot be used to determine future policy. But to ignore it entirely is to continue to assume that it is zero, which we know is false.

The solution is for the Commission to bring relevant stakeholders together and guide a transparent, fact-based discussion about how cost pass-through abilities of industries can be explicitly taken into account and more accurately reflected in future policy than they have been in the past.

This process would benefit from the expertise of businesses that should be given a seat at the table and asked to share relevant data. The end result will be a political compromise, but one that will be far better for the success of the carbon market than the alternative of doing nothing.

by Emil Dimantchev

Emil Dimantchev (@EDimantchev) 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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