Windfall profits out of “thin” air

28Apr07

Governments and politicians are expert professionals at generating windfall profits out of thin air for themselves and their cronies. But at the margin, they would of course create more windfall profits for themselves rather than their corporate cronies.

Here is how CO2 cap-and-trade works under the Kyoto protocol. Each national government makes an annual National Allocation Plan. The total amount of CO2 emission for that year is capped to a certain value (lower than the previous year obviously) and then these emissions are distributed to CO2 emitters as allocations of “right to emit”. The biggest emitters and receivers to these rights are power generation corporations, and recently there has been talk of adding the airlines to them as well. If a company emits less than it was permitted to, it can sell its rights to emit on the open market for a higher emitter to buy. This sounds really good – the total amount of emissions reduces each year and there is an incentive to emit less than your permitted amount in order to profit from selling the rights and to avoid paying for extra rights. Trade, after all, is good. This is a “free market” solution, right? Wrong.

First of all, this works well only if the allocations were made well. In the last couple of years of implementation, Germany has always managed to give away “too many” rights, thus deflating the price of the permits on the market, and not even managing to reduce emissions significantly. What it did do is to create an arbitrage opportunity for German companies in the following way: other EU countries that allocated rights “honestly” forced companies in those countries to buy rights from German companies which had received generous rights. The prices for the rights were very high, till Germany announced that there had been too many rights thus causing the prices to crash – a neat profit for German power companies, created virtually out of thin air.

The problem here is that the government makes an artificially scarce resource virtually out of nothing – the right to emit. Emission rights are given the characteristic of property rights. It is arbitrarily assumed that the government “owned” that property before and will distribute the property titles honestly and objectively. The property title gives a concrete nature to emissions and attaches an economic value to them. The nature of the allocation obviously can dramatically manipulate the prices of that property title, and anyone who was not present at the negotiations when the titles were distributed ends up paying a high cost. It is easy to see how vulnerable this whole business is to the might of large corporations and how strongly it favours incumbents by virtually blocking out any possible competition from smaller or newer entrants (potentially with more innovative ideas to reduce emissions) to the energy market. Then, of course, the same politicians who generated rents for themselves and their big coporate cronies are free to blame the “free-market” for its failure to reduce costs for the consumer and blame energy firms for their windfall profits from “gouging”. The remedy would be – why, state intervention surely.

All this is not new. These are oft-repeated facts. But this year, politicians have become smarter in Europe. They want a greater cut in the windfall profits of the energy companies. Germany is now discussing whether to excercise the EU provision to auction 10% of the emission rights for next year instead of merely giving them away. This way, the government generates revenue for itself and cannot be accused of favouring anybody. Sounds like a fair idea, right? Sounds like a “market-based” idea, right? Wrong.

The principle has not changed. The government gifted itself property titles to a resource that it made artificially scarce to start with. Auctioning those titles instead of giving them away changes nothing, except transfering the profits of rights-trading from energy companies to politicians. And who pays for this profit generated for the government? Why the consumers naturally. Besides, the auction favours large incumbents even more now, since they would find it easier to bid up the allocation prices than smaller or newer entrants. Obviously, you won’t find big companies complaining too much besides the token protest. This will be utilized by the politicians to justify their decision since it is also “acceptable” to industry. On the other hand, there is near unanimity amongst politicians to go for the auctions. Some have even suggested that 100% of the rights should be auctioned, and the environment minister Sigmar Gabriel has called it the “only reasonable option”.

You could even go so far as to justify all of this, if the result was at least a reduction of emissions (assuming all the doomsday predictions and the assumptions/proofs of human causation are true). But there is no way that Germany is going to favour its coal constituency, reduce CO2 emissions substantially and phase out nuclear power simultaneously. What this does make obvious though, is the reason for widespread consensus among social democrats and greens to phase out nuclear power. Continuing with nuclear power substantially reduces opportunities for rent-seeking and windfall profits at the cap-and-trade table. Instead of expressing leftist jealousy for Gerhard Schroeder’s salary after leaving office, Germans might be want to question his deeper malice – his zealous opposition to nuclear power and systematic contribution (both as Chancellor as otherwise) to German dependence on Russian gas. He sits on the Gazprom board.

Filed under: Cap-and-Trade, Energy, Environment, European Union, Political Auction, Special Interests   |  1 Comment