…environmental economics and the implications of environmental policy

An Over Allocation of Holiday Cheer…

with 17 comments

Now that I am back from enjoying an over allocation of wealth that is the Holiday Season, my mind turns back to all things climate policy. I have long thought that a majour gap in the current climate policy debate in Canada is allocations — how the large final emitters will be granted emission rights. One can’t help but wonder how it will all shake out given the maturations in Europe over allocations during the first trading period. As many economists predicted, if firms can pass on the costs of the permits to consumers then firms could be better off. This is indeed happening in Europe as the electrical utilities simply pass all costs on to consumers. The result is windfall gains:

Electric utilities are passing on the costs of emission rights directly to the price of electricity, even though they get most of the emission rights for free, and even if the electricity is generated in ways that do not produce greenhouse gas emissions, such as nuclear energy and hydroelectric power.
The extra dividend has boosted both the price of electricity and the profits enjoyed by electric utilities.

The “cost pass through” is a tricky concept to get one’s head around, but essentially it is about opportunity cost. Although the permits are freely allocated, they have a value in the trading market and thus using them to emit a tonne involves a loss in potential earnings. This loss is like a cost of production, and hence firms, especially regulated utilities, add this to production costs and voila, a price increase for consumers. Now, in competitive markets, this value may not be passed on if market share is to be retained, but in markets that are less than competitive, it is likely that the consumer will see some portion of this cost. But, since there is not really a cost here given permits are freely allocated, firms are better off and profits rise to the extent the cost can be passed on.

This is what is happening in Europe and this could happen in Canada. Carolyn Fischer and I did some allocations work on the Ontario electrical market a few years ago and found that under free allocations and a regulated market, electricity producers could be better off under trading—even with abatement costs accounted. On average with free allocations in a monopolistic market, utility profits increased more than a little with the high emission intensity generating sources showing the highest increase. Perverse I know, but a reality nevertheless. The solution of course is to auction the rights, like we do with telecommunications, and capture some of that allocation rent. This is what is now proposed in Europe.

So, in the wake of all our collective holiday over allocation, we should be asking if Santa will be giving our wealth to some of the large emitters and leaving us to pay for that hypothetical cost embodied in that lump of coal.

Written by Dave Sawyer

January 4th, 2008 at 3:46 pm

17 Responses to 'An Over Allocation of Holiday Cheer…'

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  1. I’m not quite sure on how a regulated electric utility would make excess profits with the implementation of an emission trading scheme in Canada. As far as I know, regulated utilities in Canada (in BC anyway) submit a revenue requirement application each year to determine how to set their electric rates in a way that doesn’t generate excess profits. If they experienced a reduction in costs resulting from generous allocation of emission permits, the regulator would force them to lower emission rates so that revenue from sales of electricity exactly covered cost of service.

    I know Ontario’s electricity system is a little different to the one here, but aren’t rates still regulated at cost of service? If so, how would utilities experience windfall profits?



    4 Jan 08 at 4:16 pm

  2. Good point Nic…Regulated utilities, such as Nova Scotia Power (Emerra) have a regulated fixed profit rate, say 21% on expenditures. But it seems that in Ontario the regulated utilities are quasi regulated, and thus can have profits in excess of a fixed rate. See here for an example: http://www.ontariotenants.ca/electricity/articles/2003/ts-03d02.phtml

    And this quote:

    In 2003 the (Ontario) government introduced “Designated Customers” and “Non-Designated Customers”. Based on size and type of business those customers that were “Designated” were eligible to purchase commodity at a fixed flat rate of 4.3 cents per kwh. Designated customers included residential and small users, as well as a host of other named users including farmers, charitable organizations, etc. The balance of customers were Non-Designated and subject to fluctuating market prices.

    Also I think a case could be made that permit retirement represents a cost to the utility and thus a case could be made to the regulator that a cost was incurred. In this event, then consumer costs could rise and in the absence of a regulated profit level, the utility would be better off. Perhaps I should dust off that allocations paper and take a closer look.

    Dave Sawyer

    5 Jan 08 at 11:58 pm

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