The implementation of the European Union Emission Trading Scheme (EU ETS, hereafter) puts a price on CO2 emissions and internalizes its social cost. CO2 emitters have to cover their emissions with the necessary amount of allowances. As a result, CO2 emitting electricity generators experience an increase in their variable costs. In a competitive electricity market this cost increase is pass-through into electricity offers and sales. Hence the increase in generators' variable costs leads to an increase in electricity prices.
By causing the increase in electricity prices, EU ETS stimulates consumers to reduce their electricity consumption. Of course, the net impact of the price increase depends on the technology used by the electricity generators. The electricity generators using technologies with no or low CO2 emissions enjoy higher short-run profits while CO2 intensive technologies have lower short-run profits. In other terms, technologies with no or low CO2 emissions become relatively more profitable. All in all, by internalizing the CO2 social costs, EU ETS incentivizes generators to increase the capacity of no or low CO2-emitting technologies and electricity consumers to save energy and use it efficiently. Thus, the increase in electricity price is the intended effect to ensure the environmental effectiveness while maintaining cost-efficiency of the climate policy.
Nevertheless, the increase in electricity prices has raised controversial debates on the legitimacy of costs pass-through of freely allocated allowances and whether – and to what extent – the supposed passing through of these costs has led to additional profits for power producers (the so-called "windfall profits"). This debate often reflects a misunderstanding of the fundamental principles of the functioning of electricity and CO2 markets and their interaction. Windfall profits are often confused with short-run profits, long-run profits and CO2 scarcity rents. Moreover, several fallacies contaminate the policy debates and may yield to the implementation of inefficient “corrective” policies.
Three common fallacies on CO2 windfall profits often appear in the debate:
Fallacy 1: generators should not pass-through CO2 cost when allowances are given for free;
Fallacy 2: the pass-through of CO2 cost only implies windfall profits for energy companies at the expense of electricity consumers;
Fallacy 3: full pass-through of CO2 cost is an evidence of anti-competitive behavior.
These fallacies call for a clarification of the definition of windfall profits and their fundamental reasons. This article presents the main results of a comprehensive study of the interactions between electricity and CO2 markets – a research financed by Endesa.