Windfall profits to power generators do not mean that the Emission Trading Scheme is not working

The WWF and Point Carbon published a report (pdf) earlier this week estimating that power generators in Germany, the UK, Spain, Italy, and Poland will make a windfall profit between 23 and 71 billion Euros in Phase 2 of the EU ETS.

The windfall is made when power generators pass the market value of freely allocated allowances onto their customers. They do this because the allowances have an opportunity cost: once the allowances have been allocated, one option open to the power companies is to shut down or scale back their trading and sell the surplus. Customers must pay the generators the value of the credits to persuade them not to do so.

Point Carbon is probably right about the windfall – the calculations look as good as any – and WWF is right to feel that the windfall is unmerited. Environmental Capital calls it a “cautionary tale about how not to fight climate change” and that it “undermines the fight to curb emissions”.

Actually, the windfall problem does not damage the environmental integrity of Phase 2 – the cap remains the same. The problem is around who the cost imposed on carbon ends up with. The government is probably the best we can hope for, which is where the money will go when allowances are auctioned.

One way out of the windfall profit problem while credits are still freely allocated would be to impose a fine on companies that reduce their trading activities. The fine would be based on an estimate of the market value of EUAs that would have been required to cover the reduced trading.

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