The EU ETS as an Environmental Instrument - Green Energy and Efficiency: An Economic Perspective - page 358

was believed to be easier and cheaper for installations in the electric utility sector.
Second, the electric power sector did not face any non-EU competition that would
occasion leakage. Installations in the industrial sectors were seen to be competing in
a world market, in which the prices were set outside the European Union, and the
grant of free allowances was believed to be means of allowing them to avoid raising
prices and thereby losing market share. In contrast, power stations competed in
strictly European markets and would thereby be able to pass on their added CO 2
costs

.
In a system based on free allocation, the depth of the market depends, among
other factors, on the difference between that allocation and demand for emissions.
Asymmetries between operators will cause some of them to have more allowances
than others in certain circumstances, stimulating the market.
These asymmetries are generated primarily for three reasons:

”

Non-equitable allocation. This is the case of several Member States, where more
allowances are allocated to one sector than to others.

￿

￿ Emission reductions caused by the fact that neither the legislator nor the

operator can know the marginal costs of reduction in advance. In such cases, had
the legislator taken this into account then windfall pro ts due to sales of

allowances allocated in excess would have been avoided.

Variability between production and emissions: different production situations
may arise (plant shutdowns, maintenance, etc.) inducing variability in emissions.

￿

The allocation system can either depend only on historical emissions (grandfa-
thering) or take ef ciency into account (benchmarking), but in either case demand

will be caused by the difference between the number of allowances allocated for
free and the need for emissions. This could cause distortions in the price signal.
This effect is increased by the fact that many EU ETS operators are small facilities
and are not active in the market. If allocation to such operators has caused them to
have a surplus, that surplus may never reach the market.
However, the regulator has a simpler way of avoiding distortions from asym-
metric allocation to different operators for these two systems: auctioning. This
method helps the regulator correct inef

ciencies in allocation, since all operators
have to bid for the required allowances, making the price signal more reliable as it
does not re ect differences between allocation and emission projection, but is based

only on projected emissions. A full auction would not completely eradicate price
distortions: there are still major changes in supply timing that can potentially cause
temporary surpluses in the daily supply and demand market.
Applying auctions as the only allocation method would not be a wise policy
without a global agreement against GHG emissions. Many operators which are
regulated by a carbon market compete internationally: faced with international
competitors who do not have to internalise the cost of their carbon emissions, they
will be at a clear competitive disadvantage.
In Phase III the EU ETS has opted for a mixed method of allocation, with full
auctioning for the power sector, where operators are not competing against facilities
outside the EU (captive customers). What exactly does that mean? Power operators