Case Study: Electricity Pricing Under An ETS

1. Fundamental Characteristics of the Electricity Generating Industry

Demand for electricity is almost universal, an expected commodity for business and consumers. Australia's consumption per capita in 2006 was 11,332 kWh, up from 9,072 ten years prior, and from 7,309 twenty years prior [1]. Demand, and increases in demand, seem largely due from the demand for other goods which require an electrical charge for work (i.e., derived demand). Ceteris paribus, increased prices result in less quantity demanded and vice-versa. Non-price variations result in shifts of the demand curve itself. This includes disposable income, variations in tastes and preferences, relative changes in substitute products, expectations of future supply and prices, and the quantity of buyers. As a basic service that few would give up electricity is not considered to be highly elastic with significant opportunity costs; in considering the alternatives of life without electricity most consumers would see the financial outlaw minimal compared to the disutility of such a service.

In supply similar influences are expressed. Where there is demand, conscious or not, it can be expected that an entrepreneur will seek to satisfy that demand [2]. Just as quantity demanded is inversely related, the quantity supplied is directly related to price, which from a suppliers perspective refers to the cost of production and associated transaction costs of engaging in trade with those who demand the good or service. Likewise there are a number of non-price determinants to supply which influence the position of the supply curve. These are similar to those that affect demand and include; the cost of supply and the development of technology, the prices of substitutes, future expectations, the number of suppliers, and physical factors such as inclement weather. Likewise there is also the matter of elasticity in supply, the ratio that the change in supply influences change in price (not the difference with elasticity in demand) and again, there is the matter of opportunity cost.

The production of goods and services refers to the use of resources (inputs) and the resulting outputs, expressed in monetary units. Inputs include land, labour [3] and capital, meaning for electricity generation the location of the generating site or ability to store in the case of natural gas, the various skilled labour required to provide production, and the equipment required for actual production and artilleries. Production functions may be referred to as short-run or long-run, a non-temporal measure based on the ability to vary the the inputs in the production function. As an ideal measure, a short-term production function allows no variation and a long-term production function allows any level of variation. Production is also subject to diminishing returns. As units of a variable input are increased at a certain point the additional output is relatively less, and may even go into negative values. Finally, as an issue of output, electricity production is associated with negative externalities, incidental economic damage associated with the production process whose cost is borne by others.

Competition in electricity generation can cause shifts in supply and demand. Pricing and output decisions vary according to market types, which conventional economics proposes four; perfect competition, monopolistic competition, oligopoly and monopoly. Market analysis suggests that the electricity generation market tends towards oligopoly. Current production of electricity usually requires significant capital investment to take advantages of economies of scale. This is a significant barriers to market entry, as are the accepted regulative standards. The actual supply grid itself, as opposed to the generative facilities, tends towards monopoly as there is usually only one grid, with some exceptions [4].

An simplified electricity generation market, indicating the effects of negative externalities.

2. The Emissions Permits Market and the Electricity Generating Industry

The proposal for the introduction of an Emissions Trading Scheme (ETS) arises from probable costs [5] arising from the greenhouse gas emissions and their effect on the world's climate and ecosystems. In part, these effects are due to lack of internalisation of external costs, of which there are numerous examples in industrial production. Representing the public interest, legislation is a mechanism for dealing with externalities, hopefully encouraging the positive and reducing the negative varieties. An ETS is one of a number of mechanisms that could be introduced to ensure that the negative externality [6]. An ETS model is often explained as "cap and trade". A limit on emissions is set (the "cap") with emission permits auctioned or sold by the government. If a producer wishes to emit more than is allowed by the cap, then they must purchase a permit, either from the government at the time of sale or auction, or from a holder of the permit. A number of variations on the "cap and trade" model are possible.

Emissions up to the level of the cap will not be affected in supply or demand, with the normal influences applied. Emissions above the cap however will have an additional cost of production. As emissions are variable in supply this cost can - and will - be passed on to the consumer [7]. This increase is in cost will be reflected in lowered demand for electricity, and specifically, electricity produced with greenhouse gas emissions specified in the legislation. This provides a number of incentives which may operate concurrently. Suppliers will have an incentive to produce electricity in a manner that emits fewer greenhouse gases; photoelectric or hydroelectric as opposed to burning coal, for example. This will have an additional capital cost which the producer will amortise through the sale of electricity. Other suppliers may decide not to make significant changes to their electricity production methods, depending on the opportunity costs they calculate and 'wear' the increased cost of supply. Their consumers will therefore respond with lower demand for the 'dirty' electricity.

The introduction of ETS also creates a new market, that for the buying, selling, and trading of permits. This comes with transaction costs, which will also be passed on to the consumer. The relative economic efficiency of the supplier conducting their ETS transactions varies the amount the cost of production, and as a result, the change in demand. In seeking the most economic transactions, managers will have to decide whether to engage in outsourcing these transaction costs or adding to internal operating costs, or a combination of both. Given the simplicity of the transaction, it is quite probable that the ETS permit market will have many of the features of both government auctions or sales for licenses with the purchase and sale of permits similar to the share market. There may be modest capital barriers to entry (e.g., bulk discounts etc), however competitive advantage - or disadvantage - is acquired primarily due to asymmetric knowledge. The ETS market will therefore be imperfectly competitive with excess profits possible in the short-run, where price based on the average revenue (AR) curve, but not in the long-run as the demand curve and average revenue will shift as other firms entered the market and increase competition.

The ETS market in the short run. Excess profits can be derived from product differentation based on asymmetric knowledge.

ETS market in the long-run. All inputs are now variable and the market is competitive.

3. Free Permits Model and 4. No Free Permits Model

One hypothetical model is that electricity generators are allocated free permits for five years based on their emission levels at the time of introduction of the ETS. Only the electricity generation industry is provided these permits, with other emitters being required to purchase permits at government auctions or in the permit market. Such a model would have significant effects on the electricity generation industry, including some consequences opposite in intention to the introduction of an ETS (a perverse incentive), relating to knowledge of such a bill being introduced to parliament. Dealing with such public knowledge first, the electricity generation industry would see this as an opportunity to gain a competitive advantage in the acquisition of permits, whether for their own use or for sale on the market. As proposed, an incentive would be provided for electricity generators to maximise their emissions immediately prior to the introduction of the scheme; note that this is regardless of whether or not electricity is actually produced. Clearly this is the opposite of the intention of ETS legislation, even if the proposal is to provide temporary subsidies to electricity generators to aid in the transit from prior emission-intensive investments. Instead, a smoothed multi-year average prior to the introduction of the bill avoids such unintended consequences.

This is precisely the policy implemented in The White Paper for the Australian Government's Carbon Pollution Reduction Scheme (CPRS) [8]. An Electricity Sector Adjustments Scheme (ESAS) provides a fixed allocation of up to 228.7 million permits to generators over ten years. Transitional assistance will be provided to coal-fired generators that have an emissions intensity above 0.86 tonnes of carbon dioxide equivalent per megawatt hour generated, and that were in operation, or committed to be constructed, on 3 June 2007. The argument presented by the government is that ESAS provides businesses and industry the ability to engage in a "smooth transition" (i.e., suffer no losses) as they move from a high greenhouse-emitting generation method to a lower one, "promoting stable energy contracting markets and supporting investor confidence".

The free permits give an enormous monopolistic advantage to those organisations and industries which receive them in terms of their ability to participate in the ETS market or engage in emissions to the point where they use up their permits. In the first case the capacity for other organisations to purchase auctions is reduced precisely by the value of the free permits held by the emitting industries. It is, in effect, a capital barrier to entry. This is in addition to the asymmetric knowledge bonus that such industries would already have in place, being quite aware of which businesses are likely to desire additional permits. In the second case the free permits effectively act as an extension to the 'cap' for the selected businesses who receive them. A further issue is that the industry may collectively decide to 'fail' to implement low-emissions technology and appeal for further subsidies with the backing of political precedent [9]. In either case the businesses in question receive as subsidy of around $7.3 billion of assistance, according to the government's estimations.

An alternative model is that no free permits are offered. In a sense, the permit model and no free permit model are two points along a continuum of possibilities. If no free permits are allowed the ETS would operate largely as previously discussed (point 2). The market for ETS permits would still provide electricity companies an advantage as they would have sophisticated market knowledge on which businesses are likely to need emission permits. However the effective capital barrier that a free permit model would provide would not exist. As previously mentioned, emissions up to the level of the cap would not affect supply or demand, whilst those over the cap would result in additional cost that would be passed on to consumers, leading to a reduction in demand. Electricity generators that did not wish to face this loss of trades would have to find other ways to improve demand, with an clear systematic preference towards making investments in low emission electricity generation methods (solar, geothermal, hydroelectric, wind, tidal and perhaps nuclear). The choice in a no free permits model is stark; either reinvest or lose profits.

Either way, the electricity generating essay would find themselves bearing a loss, albeit possibly a temporary one if their directors have the will to invest in the future. There is simply no economic alternative to the reality of an industry that has been receiving abnormal profits that do not reflect the true economic cost. This does have a significant influence on the industry, especially for those costs where there was an expected amortisation. Investors, as perhaps correctly identified by the government, are herd creatures of irrational nervous disposition [10] rather than the stoic and sober calculative ideal which the market system presumes. A sudden implementation of the full economic cost to electricity generation is likely to cause panic. Whether or 'shock therapy' to a market that is causing damage to the economy as a whole however is a matter of empirical investigation.

5. Recommendations

The issues reviewed in this paper provide an overview of the electricity generation industry, the economics of an emissions trading scheme, and two hypothetical cases for implementing such a scheme and their effects on the aforementioned industry. Two issues are discussed here in conclusion; how permit allocations would be implemented, and whether or not emitters would be compensated. There are, of course, various arguments for the implementation of said schemes and, along with the issue of compensation, they may be described as "politically sensitive", typically code for meaning "may upset sections of the landlord and capitalist classes". Whilst this is an argument of politics, and specifically the art and science of policy implementation, it is not an economic argument as such, and will be screened from discussion of the issues. The counter-factual perspective posited here is that from a manager of policy, capable of introducing legislation solely on the basis of economic criteria, an independently of the perils of the tyranny of the majority or selective private interest.

With regards to the first issue, from an economic - and scientific - point of view, an ETS is a compromise, with a moderate possible of success based on the current distribution of political power. In natural reality, any industrial activity that engages in any emissions is creating negative externalities. Based on a purely economic and scientific argument, there should be no 'cap'; all damaging emissions should be subject to their total economic cost, internalising the externality. With no cap there would be no permits either; the permission to emit is not really an economic argument but rather a political one using economic mechanisms. Instead, what is recommended is an tax to be directly applied to each unit (say, tonne) of emissions. Evaluating externalities has long been recognised as problematic. Two proposal are suggested here; first is through expert assessment, the second through a Coarse auction. The selection should be subject to further investigation, but dealing with the question raised; the recommendation regarding the allocation of permits is that there are no permits allocated.

With regard to the second issue of compensation of emitters, the typical argument put forth is that emitting industries have made substantial investments in various capital equipment which cannot be easily altered to suit the new legal conditions. These are sunk costs, which cannot vary regardless of future decisions made by industry managers. This is a strong legal and political argument, again, making use of economic tools for illustrative purposes. A counter legal argument can be made of course, using examples of the tobacco industry et. al, that knowledge of producing harmful products creates responsibility. On a similar trajectory, it can be argued politically that the emitters have been effectively subsidised by avoiding external costs for a substantial period of time. Expressed economically, emitters have been engaged in a type of "rent-seeking", in economic terms the practise of receiving income without contributing equally to production. In this case, greater than economic profits were generated by passing the costs on to the rest of the community. As such, in pure economic terms, the question is resolved as no compensation should be paid to emitters and indeed there is an economic argument that they owe to the community who has borne their costs for some time.


[1] World Bank Economic Indicators, 2006.

[2] There is also a counter position, known as Say's Law, that supply creates demand. See Jean-Baptiste Say, A Treatise on Political Economy, FP 1803 (English translation)

[3] "Entrpreneurship", other managerial abilities and "human capital", are considered here to be a sub-type of labour. See Karl Marx, Capital: Volume III, Chapter 48: "The Trinity Forumula" and Chapter 49 "On the Analysis of Production Processes", Penguin, 1981 [FP 1894].

[4] The Victorian town of Walhalla was the first non-Melbourne town to have its own electricity supply and the last town to join the grid. But even in this case, there was only one grid within Walhalla - in other words, the owner of that grid was a monopoly; a monopoly can be local in scope.

[5] Stern Review on the Economics of Climate Change, HM Treasury, United Kingdom, 2006. The main conclusion was that an early investment of 1% per annum of global GDP would be required for investment to prevent a 20% decline in global GDP in the future. See also the Garnaut Climate Change Review: Final Report, Commonwealth of Australia and Cambridge University Press, 2008

[6] Others measures could include criminalisation, civil tort law and litigation, Pigovian taxes and subsidies or, if the conditions are available, the application of Coase theorem.

[7] An exception to this is land-rents, see Adam Smith, The Wealth of Nations: Book V, Chapter 2, Part 2, Article I: Taxes upon the Rent of Houses, FP 1776

[8] Carbon Pollution Reduction Scheme, Commonwealth of Australia 2008. In particular see Chapter 13 "Assistance to strongly affected industries"

[9] Mancur Olson, The Logic of Collective Action : Public Goods and the Theory of Groups,
(Revised edition ed.), Harvard University Press, 1971[FP 1965].

[10] Peter Lunn, What me, irrational?, New Scientist, Issue 2671, August 27, 2008

Diagrams of negative externalities and short and long run monopolistic competition from Wikipedia and released under the GPL

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