GA No.308481
Report on market concentration
and transferable quotas
Samuel J. Okullo
Tilburg University, CentER & Tilburg Sustainability Center, TSC
FP7-ENV-2012
Executive Summary
This report describes the impact of market power on the functioning of allowance markets.
Market power can weaken the link between permit prices and abatement choices as it
introduces incentives for the strategic manipulation of allowance availabilities. Polluting firms
with market power seek to gain advantageous control of the goods market at the expense of
their rivals and consumers. We discuss these results in relation to the current state of
knowledge about the functioning of the EU ETS and provide a set of hypothesis that can be
used to test for the impacts of market power on the functioning of the EU ETS. Empirical
evidence indicates that firms are not yet fully economizing on abatement costs as there is a
weak link between permit prices and abatement fundamentals.
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Table of Contents
Executive Summary .............................................................................................................. 2
1.
Introduction .................................................................................................................... 4
2.
Summary of Work Performed ......................................................................................... 5
3.
Results and Conclusion .................................................................................................. 8
4.
References ..................................................................................................................... 9
5.
List of Abbreviations ......................................................................................................10
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1. Introduction
Emission Trading Systems (ETSs) are appealing regulative instruments since they allow
governments to control emissions efficiently across firms while possessing little to no
knowledge about firm-specific marginal abatement costs. The efficient functioning of an ETS,
however, depends on the size of firms being regulated, the risk tolerance of firms, and the
strategies that firms employ when deciding between abatement and emission choices.
Table 1: Top emitters in the EU ETS, 2011
Company
Emissions (MtCO2)
RWE (Germany, United Kingdom)
141.0 (7.4%)
E.ON (Germany, United Kingdom, Italy, France)
89.5 (4.7%)
Vattenfall (Germany, Sweden, Finland)
77.7 (4.0%)
Enel (Italy, Spain, Portugal)
76.24 (4.0%)
GDF Suez (France, Belgium, United Kingdom)
60.8 (3.1%)
Top 20 utilities
712.5 (37.4%)
In the left column, given in brackets are the countries of operations. On the right column given in
brackets are emissions as percentages relative to the 2011 total EU wide cap of 1904 MtCO2.
Calculations based on 2011 EU Transaction Log data.
For this report, we set out to understand, how market power could impair the functioning of
the EU ETS. Market power is of serious concern in the EU ETS especially, since a few large
firms are responsible for the majority of emissions. In fact, only about twenty percent of the
approximately three thousand regulated firms account for ninety seven percent of emissions.
Table 1 shows that the top five emitters, all of which happen to be utility companies, together
account for nearly twenty three percent of the EUs regulated emissions. Moreover, many of
these utilities also happen to be oligopolies in the overlapping markets in which they operate.
Their strategies and choices therefore could have substantial impacts on the efficiency of the
EU ETS and the product markets in which they operate.
We identify three main mechanisms through which market power may obstruct the proper
functioning of the EU ETS. Firstly, when some firms are capable of influencing the trade for
allowances, then the ETS is inherently inefficient as such dominant firms have the incentive
to manipulate the permit price for their own benefit. This can result in over or under
abatement of emissions depending on which side of the trade the dominant buyer is on. In
the second case, allowance markets may continue to operate efficiently, however, if some
firms choose emissions contingent on the outcome in the permit market, then such firms may
seek to hoard permits in order to drive up costs for their rivals and as consequence
strategically raise product prices. Finally, market power may impair the functioning of the
allowance markets when firms are dominant both in the goods and permit market. For this
case Chaim Fershtman and Aart de Zeeuw have managed to show that firms can coordinate
their trading activities such that permits and hence output is shifted to the high cost firms,
contrary to what regulators might desire.
Market power thus weakens the link between allowance prices and abatement choices, with
potentially quantitatively significant consequences for the performance of the ETS. Without a
clear signal of the true cost of abatement, firm incentives get distorted resulting in the
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inefficient abatement of emissions. A comprehensive review of the empirical literature
reveals that regulated energy firms under the EU ETS have, but only to a limited extent,
undertaken abatement as a result of the EU ETS. Hintermann (2013) argues that the
exercise of market power by major emitters such as RWE and Vattenfall during the first
Phase of the EU ETS significantly undermined the performance of the EU ETS.
2. Summary of Work Performed
The task of analysing the impacts of market power was broken down into two major steps. In
the first step, Aart de Zeeuw together with Chaim Fershtman have developed a theoretical
model for the performance of an ETS where firms possess market power in both the permit
market and the goods market, and where these firms can coordinate their trading activities.
In the EU ETS firms are allowed to band their trading activities. Moreover, as seen in Table
1, there are just a few dominant firms in the electricity sector, which firms also happen to be
dominant in the allowance market. The Fershtman and de Zeeuw model thus provides a
transparent framework for theoretically examining the functioning of the EU ETS. To
elaborate, Fershtman and de Zeeuw integrate market power in the product market and
market power in the permit market in a single framework and consider the incentives for
abatement and production decisions. They find that only in the case of a very low pollution
standard (stringent emission ceiling), the result from competitive markets that the firms will
just economize on abatement costs holds for a duopolistic market as well. For higher
pollution standards (lax emission ceiling), however, the industry may show a strategic
decrease in total output as production is intentionally shifted from the low cost to the high
cost firm.
The above theoretical insight provides a basis for empirically analysing the impacts of market
power in the second step. This step was broken into following subtasks: (i) a comprehensive
review of the theoretical literature to identify other mechanisms and situations under which
market power may impair the functioning of allowance markets, (ii) an extensive review of the
empirical literature for current evidence on the functioning of the EU ETS, (iii) formulation of
suitable hypothesis that could be used to empirically examine the functioning of the EU ETS,
and finally (iv) testing the hypothesis against the data.
Market power can impair the functioning of permit markets when it exists either in permit
markets alone, or the goods market alone, or as analysed by Fershtman and de Zeeuw, in
both the permit market and the goods market. In the first case, firms use their dominance to
manipulate permit prices (cf. Hahn 1984, Misiolek and Elder 1989, Malueg 1990) to their own
benefit. A dominant buyer for example purchases too few permits and as a consequence
over abates while a dominant seller sells too few permits and as a consequence over
pollutes. When market power exists only in the goods market, the dominant firm may engage
in the over purchasing of permits to drive up its own costs and thus induce itself to cut
production while at the same constraining output from other firms by reducing the availability
of permits (Erhat et al, 2008). The case where market power lies in both the permit and
goods market with explicit coordination of output strategies is that analysed by Chaim
Fershtman and Aart de Zeeuw. Here, a shift in permit allocations is made to the inefficient
firms.
The evidence suggests that firms are adopting fuel switching as an abatement strategy;
however, the relationship is weak indicating that there still is no sustainable link between
abatement and allowance prices. Empirical studies assessing the impacts of the EU ETS on
firms can be placed in to two broad categories. Those that test for marginal abatement cost
pricing of CO2 permits and those that directly test for emissions abatement by regulated
firms. Some notable studies coming from the first group include: Aatola et al. (2013), Alberola
et al (2008), Hintermann (2010), Bredin and Muckley (2011), Chevallier (2011, 2012), Rickels
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et al. (2014), Lutz et al. (2013), and Creti et al. (2012). Essentially, these studies examine
whether (changes in) permit prices (the left hand variable) can be explained by a collection of
right hand side variables meant to capture underlying cost-based fundamental drivers such
as: coal prices, gas prices, oil prices, industrial and economic activity, water reservoir levels,
temperature, and precipitation variables. A strong connection between these variables would
suggest a minor role for inefficiency inducing elements such as market power, strategic
trading, and the influence of risk attitudes in the determination of allowance prices.
Alberola et al (2008) finds that unanticipated cold temperature is a significant driver of permit
prices. Hintermann (2010) focuses on emissions pricing in the first versus the second year of
Phase I of the EU ETS. He finds that allowance prices were substantially disconnected from
fundamentals during the first year of the EU ETS, that is before the first ever emission
verifications. He postulates that this disconnection was due to some producers exerting
market power, or a CO2 bubble, or some firms hedging against stochastic future emissions.
Rickels et al. (2014) focus on identifying those factors that most influenced permit pricing
during Phase II. They find that economic activity in Europe and the provision of hydropower
are the only consistent determinants of permit pricing. Their conclusion is that while indeed
permit prices may be connected to other important fundamentals, in particular gas, oil and
coal prices, the connection is still weak to warrant the conclusion that firms are abating
emissions efficiently. Creti et al. (2012) who look at Phase II versus Phase I report of a more
significant role for fundamentals in explaining permit prices in Phase II of the EU ETS.
A number of studies directly look at abatement of emissions. These form the second broad
classification of studies. Anderson and Di Maria (2011) estimate that during Phase I of the
EU ETS firms abated approximately 247 million tonnes of CO2. However, their regression
model indicates that high oil prices between 2005 and 2007, more than the EU ETS itself, is
what explains abatement. Jaraite and Di Maria (2012) who analyze the EU public power
generating sector conclude that Phase I of the EU ETS encouraged environmental efficiency.
Environmental efficiency is defined as economizing on both CO2 and SO2 emissions. The
authors also define CO2 and SO2 efficiency which are defined as economizing on only one
type of pollutant, that is, either CO2 or SO2, respectively. While they do not perform
regressions for CO2 or SO2 efficiency separately, they do plot time series for these two
types of efficiency. During Phase I, SO2 efficiency improves drastically while CO2 efficiency
declines, suggesting that any explanations for improving environmental efficiency that the
authors arrive at are due to the former and not the latter, especially since the latter actually
worsened in the initial years of the EU ETS.
Other studies looking at abatement include: Jaraite and Di Maria (2014), Anger and
Oberndorfer (2008), Löfgren et al. (2013), Zachmann et al. (2011), and Mikael et al.(2013).
These studies are unique in that the employ firm level data sets. Jaraite and Di Maria (2014)
find that as of 2007, the EU ETS had not induced abatement or cut emissions among
regulated Lithuanian firms. However, they suggest caution in interpreting their results since
Lithuanian firms were over allocated with allowances during Phase I of the EU ETS. Anger
and Oberndorfer (2008), examine the performance of German firms with regard to profits
earned and employment under the EU ETS. They find no evidence that the EU ETS
significantly influenced firms’ profits and employment behaviour. Löfgren et al. (2013) find
that for Swedish firms, being regulated under the EU ETS slightly increases a firm’s
likelihood to invest in carbon reducing technology; this likelihood, however, does not
materialize into actual investments in green technology. Zachmann et al. (2011) tests the
impact of the transition from Phase I to Phase II. They find that this transition induced firms to
abate, especially firms that were initially under allocated allowances in 2005, and firms
operating in the electricity and heat, paper and paper products, and non-metalic minerals
sectors. Their results warrant caution, however, since they do not control for explicit drivers
of this abatement. Accordingly, it is difficult to say whether their observed abatement was
due to the EU ETS or to non-permit input costs that were likely to have been in a bubble at
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the time. Of the referenced articles that directly tests permit prices as a driver for abatement,
only Mikael et al.(2013) find evidence of abatement, through short term fuel switching
between wood biomass and fossil fuels for Finnish energy plants.
To isolate the impacts of market power, a firm level analysis is warranted. The goal in this
case would be to examine how firm market shares shift with changing permit prices. While
such an exercise is data intensive, it can provide a clear indication of the extent to which
firms are strategically manipulating output using permits allocations. A set of hypothesis have
been developed.
Following Ehrhart et al. (2008), the first hypothesis that indicates possible manipulation of the
permit markets would be observed when dirty firms hold excess allowance relative to their
clean counterparts. The motive for holding excess allowances is to drive up prices in the
goods market. It is important that the holding of permits in this context is explained by more
than just prudence or precautionary behaviour. Moreover, the supply of permits has to be
relatively inelastic, for example, set ex ante by the regulator as in the EU ETS. When
allowance markets are operating efficiently there will be no significant relationship between
the production technology employed by the firm and the extent of permit holding/banking.
Inefficiency would thus be observed if permit holding is proportional to firm CO2 intensities.
Hypothesis 1: In the case of an inefficiency, firms with higher CO2 intensity are over
allocated vis-a-vis their cleaner counterparts.
Hintermann (2013) tests a similar hypothesis. His approach relies on a forecast of expected
future emissions. He compares the forecast emissions to actual realized emissions and tests
for the probability that realized emissions could exceed emission forecasts. He finds that for
most energy generating firms in the EU ETS, the probability that firms emit more than their
allowance holdings was near zero in 2007, an indication that excess permit holding that were
observed for Vattenfall, RWE, and to some extent EdF could have been for strategic
purposes. The shortcoming of Hintermann’s approach is that his conclusions depend on the
quality of his forecasts. In our case conclusions are based on the regressions avoiding
further complexities and assumptions arising from the need to forecast.
Misiolek and Elder (1989), von der Fehr (1993), and Fershtman and de Zeeuw’s model
provides another indicator for a possible inefficiency: when the market share of net permit
buyers is growing faster than that of other firms. Fershtman and de Zeeuw have shown that
that when regulated firms coordinate their strategies, they will find it profitable to transfer
permits to the firm that has higher marginal costs of production as this results in the most cut
in industry output. von der Fehr (1993) shows that when acquiring more permits reduces
marginal costs, and the goods between competitors are highly substitutable, then the
industry can move towards high concentration as those firms experiencing the most cost
reductions from acquiring permits gain market share. These firms are not necessarily the
most efficient firms in the industry. Misiolek and Elder (1989) shows that even firms that
would ideally be net permit sellers will tend to be become net buyers instead as they seek to
gain more access to the goods market. Our second testable hypothesis is:
Hypothesis 2: In the case of an inefficiency, the market share for net permit buyers increases
faster than that for net permit sellers.
Following on the above hypothesis it may be possible to pin down which firms exactly are
benefiting from net permit purchases. Following Chaim Fershtman and Aart de Zeeuw when
firms invest in emission equipment with the possibility to coordinate permit trades later, these
firms may find it profitable to choose the technology option that drives up the price in the
goods market the most. That is, when choosing between low versus high emission-output
ratio technologies, firms can prefer the latter. Such a technology increases the demand and
hence price for permits. High permit prices imply higher marginal costs of production, helping
curb production in the goods market, but at the same time increases profitability through
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higher good prices. In practice, energy firms may diversify their options by choosing a high
marginal abatement cost technology that cuts emissions, but at the same time, still invest in
cheap technologies with high emission-output ratio. Inefficiencies in the permit trading
system would therefore be observed if the market share of dirty output is increasing faster
than that for clean output.
Hypothesis 3: In the case of an inefficiency the market share for polluting installations
increases faster versus that of their less polluting counterparts.
Finally, permit trading is expected to have an impact on the profitability of polluting versus
less polluting firms. More specifically, polluting firms would be expected to be less profitable
than polluting firms. Nonetheless, if polluting firms can employ the above strategies to
counter the impacts of emissions trading, then their profitability should in theory not be
affected by the EU ETS.
Hypothesis 4: In the case of an inefficiency, polluting installations are equally or even more
profitable than their less polluting counterparts.
While current evidence clearly indicates that allowance markets are not functioning as
regulators might have intended. It remains interesting to empirically disentangle the
contribution of market power based on the above hypothesis. For this a firm level data is
required. This step of the analysis will proceed as soon as the data collection on
production/market share, allowance holdings by firms, and appropriate firm level controls is
completed.
3. Results and Conclusion
There is some empirical evidence, albeit small that indicates a role for allowance prices in
driving abatement choices among EU ETS firms. A strong and sustainable link between
allowance prices and abatement choices, however, does not exist as yet, suggesting that
firms are not fully economizing on abatement costs. Chaim Fershtman and Aart de Zeeuw
have theoretically shown that even in the case of oligopolistic markets, it is still possible for
firms to just economize on emissions and as such, permit markets may continue to operate
efficiently even with dominant firms in the permit market. This, however, only arises if the
emission ceiling is stringent enough. When the ceiling is lax, firms may coordinate their
trading activities such that production is shifted to the high cost firm. This gives rise to a
strategic decrease in industry output above and beyond what the regulator seeks to achieve.
There are multiple other channels through which market power may impair the functioning of
permit markets even when firms are not able to coordinate. This mainly arises through the
hoarding or over acquisition of permits, which can result in an expansion of market share for
the dominant and likely dirtier firms at the expense of the relatively cleaner firms. Where firm
level data is available, the empirical literature reveals limited evidence for investments in
long-term abatement equipment by regulated firms. While the literature assessing fuel
switching as an abatement measure presents relatively stronger evidence for the connection
of the EU ETS allowance price to abatement choices, the analysis is conducted at an
aggregate EU-wide level, ignoring firm specific factors that can either enunciate or mask any
connection that may exist between allowance price and abatement.
Focusing on permit prices as one of the many drivers for abatement, rather than as a
variable whose price is explained by industry fundamentals generates even weaker evidence
for the connection between abatement choices to the allowance price. Rising coal and oil
prices, more than allowance price movements, seem to be important drivers for abatement in
the energy sector. Chaim Fershtman and Aart de Zeeuw’s model provide one seemingly
important explanation for why EU ETS allowance prices are not driving abatement:
allowance prices that have been observed in the recent past might be too low to encourage
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the appropriate abatement incentives. Hintermann (2013) has shown for Phase I that some
large utilities are likely to have acquired allowances for a strategic purposes. Analysis of
Phase II versus Phase I is the natural follow-up step.
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5. List of Abbreviations
EU
European Union
ETS
Emission Trading System
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