Environmental Engineering Reference
In-Depth Information
constraint economy. At first glance, the producer
surplus shrinks when considering the emissions
uptick on the supply side. But the actual rent
seeking and revenue distribution in an emissions
constraint economy is, inter alias, dependent on
the primary market allocation method, i.e. the
choice for governments to sell the constraint
amounts of emission allowances into the market
at competitive prices or to allocate allowances
for free to the relevant industry sectors. We will
shed some light on this issue in the following
considerations on primary market allocations and
secondary market trading.
been purchased for a price or received for free,
the owner of the marginal electricity generation
plant is always facing the choice between (1)
generating electricity and incurring the fuel cost
and disposing the respective amount of allowances
and (2) staying away from generating electricity
and selling both the fuel and the allowances in
the respective markets for a competitive price.
So, in either case - be it the primary market
purchase through a government auction or sale,
be it the secondary market purchase, or be it the
free primary market allocation - the opportunity
cost of disposing allowances for production is the
same.
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Therefore, in the context of competitive
liberalized markets it is economically rational for
the electricity generator to either pass-through the
opportunity cost of allowances disposed in the
wholesale and retail electricity price or to sell the
allowances into the secondary trading market for
a competitive price.
However, against the background of free pri-
mary market allocations in the initial two trading
phases of the EU ETS, the free allocation led to
massive
windfall profits
for the electricity sector.
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There seems to be more than a grain of truth in
the provocative judgement delivered in Hepburn
(2007) where he says that “free allocation is a
regressive transfer of wealth from (relatively
poor) citizens to (relatively wealthy) sharehold-
ers.” Many others have also expressed their
concerns about those particular gains. Moreover,
with respect to defining the national caps, EU
Member States have been generous in allocating
the emission rights, at least for the period 2005-
2007 (Ellerman and Buchner, 2006; Böhringer,
Hoffmann, Lange, Löschel, Moslener, 2005). As
a consequence, the call for mitigating windfall
profits from free primary market allocations was
clearly and precisely raised early on in the debate
on advancing the EU ETS (Grubb and Neuhoff,
2006; Whitehead, 2005).
Windfall profits should not be confused with
profits arising from over-allocation, meaning that
Primary Market Allocations and
Secondary Market Trading
Most cap-and-trade regimes start off with free
allocations to emitters subject to the cap. Alloca-
tions are either based on their historical emissions,
so-called grandfathering, or based on hypotheti-
cal emissions derived from efficiency factors,
so-called benchmarking. For example, Article
10 of the EU Directive (EC, 2003) leading to the
establishment of the EU ETS in 2005 specified
that for the period 2005-2007 at least 95% of the
allowances should be allocated free of charge and
at least 90% for the current period 2008-2012.
The energy industry is the largest sector in the
scheme, responsible for more than half of total
covered emissions (Christiansen, Arvanitakis,
Tangen and Hasselknippe, 2005). However, this
particular institutional design feature of free of
charge primary market allocations and the setting
and break down of the Member States' emission
caps is discussed controversially because electric-
ity producers partly pass on for costing purposes
the market value of freely obtained emission
allowances to electricity consumers (Neuhoff et
al., 2006; Ellerman and Buchner, 2006).
Indeed, emission allowances are supposed to
be scarce and, hence, valuable assets with a traded
market price - no matter how they are initially
