Free allowances vs compensation of indirect carbon costs: what is the best choice for power sector in EU ETS?

The main achievement of EU ETS is market approach to carbon pricing. EU ETS is the oldest emissions trading scheme in the world, which is obligatory for main carbon emitting sectors. EU ETS was initially based on “economic efficiency” idea which suppose that all companies should pay equal price for CO2 emissions, so market, not government, would decide which sectors could be decarbonized first.

But in fact, idea of equal carbon price for each sector was not implemented in EU ETS because of carbon leakage concerns and potential damage to international competitiveness of sectors with high carbon intensity. During first two phases of EU ETS all sectors get free carbon allowances, which soften negative impact of carbon prices on economy.

Till 2012 energy sector also received free allowances, but then rules were changed. Since 2013, according to general regulation, all power stations should buy carbon allowances on market. At the same time compensations of indirect carbon costs were introduced to maintain competitiveness of major energy consumers which faced rising electricity prices. As a result, EU ETS was further complicated with unobvious consequences, which we will try to analyze.

Free allowances soften carbon burden on companies, so companies can pay less for carbon emissions. Free allowances restrain increases of product price because of rising carbon costs. Free allowances are distributed in the beginning of year and their amounts are well-known in advance. As free allowances are received by producer, they could have uniform impact on market without privileges for specific consumers.

The main reason why free allowances were cancelled for energy sector was conclusion that this sector was able to pass all carbon costs through to its customers even when power stations received all carbon allowances for free. So, there was no risk of carbon leakage in power sector.

Proponents of this position assume that from an economic optimization standpoint, it is incorrect to say that spot CO2 price will not influence electricity price if all carbon allowances are provided free. CO2 price is opportunity cost for generator, and it influence on deciding to generate electricity. Generators will generate electricity only if the revenue from selling electricity exceeds the potential revenue from selling their fuel and carbon allowances. So, electricity market needs to provide a higher level of remuneration for generators to secure power supplies. That is why electricity prices cover carbon costs, while the free allocations are the source of windfall profits for energy companies.

I would notice that it is not possible to derive actual data on pass-through opportunities and windfall profits. Existing calculations are based on theoretical assumptions. From my point of view, arguments about windfall profits are unconvincing. Business model of energy companies supposes electricity generation. For this purpose, energy companies employ staff, maintain equipment, buy fuel. Possibility to sell fuel and carbon allowances instead of generating electricity is too theoretical.

Conditions for windfall profits in energy sector with free carbon allocations

Opponents of free allowances for energy sector also noticed other disadvantages of this instrument. In particularly, free allowances could be considered as subsidy for generation based on fossil fuels. So, free allowances for such generation could endanger or slow down “green” transition of the economy. Free allocations were also distributed selectively to power producers, and such approach could distort energy market. Giving free allocations for energy sector led to decreasing possibilities to finance decarbonization measures as free allocations negatively impacted on potential auctioning revenues in EU ETS.

Cancellation of free allowances for energy sector was rather political decision, as energy sector was the biggest emitter of CO2. From this point of view, it was good idea to make all power stations to pay fully for their emissions. Nevertheless, 10 low-income countries remained possibility to allocate some allowances for energy sector for free. According to recent data, only 3 of them (Bulgaria, Hungary, Romania) continue using this right now.

Cancellation of free allowances for energy companies led to introduction of new instrument counteracting “carbon leakage” – compensations of indirect carbon costs. In fact, we could say that “free allowances” remain, only their recipient has changed: if earlier electricity producers received free allowances, now consumers of electricity receive them.

If we suppose that “combustion installations with a rated thermal input exceeding 20 MW” relate to energy sector, we could get next data from European Union Transaction Log and European Commission:

• in 2012 energy sector received 88.1 mln free allowances;
• now market value of these allowances is about €7 bln, which is almost 3 times higher than compensations of indirect carbon costs paid in 2021 (€2.4 bln).

So, from a financial point of view, the abolition of free allowances looks like a beneficial solution.

At the same time, compensations of indirect carbon costs are provided to large consumers of electricity, so impact on market is not uniform. For example, this instrument does not influence on electricity prices for citizens or small industrial consumers.

Compensations is more complicated instrument that free allowances, as each country which wants to provide compensations should develop its own scheme for such payments. The scheme must be also agreed with the European Commission. In 2021, 14 EU member states were providing compensation for indirect carbon costs. So, not all countries participating in EU ETS provide such compensations and this could distort competitiveness of companies.

Compensations are provided with delay: in the current year, the compensation is paid for the previous year. If CO2 and electricity prices rise significantly, as happened last autumn and winter, consumers of electricity will again face problems concerning their competitiveness. There is a risk that EU ETS would not be able to mitigate negative effects promptly.

Compensations of indirect carbon costs are also criticized because they distort incentives for green transition. There is an opinion that compensation should also be abolished as free allowances for energy sector. In such case we could expect rising energy costs, increasing prices of other products. It will have a negative impact on the competitive positions of European producers and purchasing power of European consumers.

In fact, EU ETS and any other ETS can exist in any configuration: with free allocations, with compensations of indirect costs or without these instruments. Emissions trading scheme is only carbon pricing mechanism. Carbon pricing can increase competitiveness of low-carbon products, making carbon intensive ones more expensive. But carbon pricing can not solve all problems of green transition without other economic instruments.

In EU high carbon price was not the main reason for decreasing electricity generation from fossil fuels. Structure of energy capacities has changed due to administrative decisions to close coal-based plants and investments into renewables. So, EU ETS is complemented by other measures and policies, which facilitate further green transition. These additional instruments greatly define speed and specifics of green transformation.