Infrastruktur + Verkehrspolitik 10 INTERNATIONALES VERKEHRSWESEN (62) 10/ 2010 Fig. 1: Methods for the allocation of allowances. Source: Own production Peter Forsyth / Andreas Schröder How airlines sidestep EU ETS auctions This article examines a specific strategy of airlines aiming at minimizing their exposure to allowance auctions under the EU Emission Trading System (EU ETS). Airlines have interest in receiving allowances aplenty and free of charge. An attractive loophole is offered by a poor design element of the benchmark metric used for free allowance allocation by member states. For the entire trading period of eight years, an individual airline‘s allowance allocation depends on revenue-tonne-kilometre (RTK) data of solely one single reporting year. Obviously, this creates massive incentives for airlines to abruptly boost RTK volumes in reporting years. How does this strategy pay off in detail? Die Autoren Prof. Peter Forsyth, Monash University, Clayton Campus, Room E860, Building 11, Vic 3800, Australia, Peter.Forsyth@BusEco.monash.edu.au; Andreas Schröder, Deutsches Institut für Wirtschaftsforschung (DIW), Mohrenstr. 58, 10115 Berlin, Germany, aschroeder@diw.de N umerous studies have demonstrated potential competition distortions to the air transport market arising due to the allowance allocation mechanism under the EU ETS. (Scheelhaase et al., 2009; CE Delft, 2007; Morrell, 2007; Forsyth, 2008; EC, 2006) Effects cited in these studies cover the impact on long-haul international versus short-haul domestic services, low-cost versus legacy carriers, big versus small players and (transit) traffic diversion, amongst others. Cost passthrough rates as well as specific emission factors have been identified as main determinants of the trading scheme‘s impact on the airline business. Most of the relevant literature concludes that a 100 % auctioning of emission permits could dampen competition distortions. However, as the vast majority of emission permits will be issued to airlines free of charge according to a benchmark, major distortions to the competitive game are likely to arise. Different methods of allowance allocation are illustrated in Figure 1. The method used by the European Commission corresponds to 15 % auctioning and 85 % free allocation based on an one-off sector average benchmark. This means performance in one year is decisive for allocations in a trading period of several years. In principle, there are three ways to allocate emission permits among aircraft operators: 1. Grandfathering: free allocation on the basis of historic emissions; 2. Auctioning: no free allocation; 3. Benchmarking: free allocation on the basis of an indicator of output, efficiency or fleet characteristics. On the one hand, theory suggests that the allocation method should not affect the level of cost pass-through that airlines choose because opportunity costs are the same regardless of the type of allowance allocation. However, there is one exception: in case of repeated benchmarking, where allowances are issued according to a continuously updated benchmark, opportunity costs are not likely to be passed through to consumers. (CE Delft, 2007) If it is assumed that opportunity costs cannot be passed through in their entity, the allocation method is an important factor in determining the financial burden that airlines could encounter. Further explanations on the theory of cost pass-through and updated versus one-off benchmarking are given in CE Delft (2007). The benchmark metric itself has received little attention in the literature 1 , although being of tremendous relevance for impact assessments. This paper investigates the current benchmark in use for the free allocation of allowances under the EU ETS. It points to undesired effects on the competitive game in years relevant for emission reports of airlines. Analysis The EU ETS caps overall emissions per sector when allocating allowances in the beginning of each trading period. The overall emissions cap for the aviation sector amounts to 97 % in 2013 and subsequently 95 % of average sector emissions in the period 2004-2006. Note that the cap does not prevent airlines from buying allowances from other sectors, Emission Reduction Units and Certified Emission Reductions. 15 % of all allowances will be auctioned off and additional 3 % are assigned to a special reserve for emerging airlines. The rest is allocated free of charge according to the following systemacy: A i,2013 − 2020 = ( A i = 1 I ∑ i,2013 − 2020 ) ⋅ RTK i,2011 i = 1 I ∑ RTK i,2011 (1) RTK i,year corresponds to the revenuetonne-kilometres flown by airline i in the reporting year and subject to the EU ETS; ∑ RTK i,year designates revenue-tonne-kilometres flown by all airlines in the reporting year and subject to EU ETS legislation; A i,period is the number of allowances airline i receives free of charge in the trading period; ∑ A i,year is the amount of free Infrastruktur + Verkehrspolitik 11 INTERNATIONALES VERKEHRSWESEN (62) 10/ 2010 allowances available to the aviation sector. This last figure is an absolute number which was supposed to be released by the European Commission by August 2009. Disclosure has been delayed hitherto. We therefore retrieve estimations outlined in Scheelhaase et al. (2009). The benchmark obviously incentivizes airlines to boost RTK volumes and thereby increase their market share in reporting years. Although this incentive has eventually no impact on overall emissions of the aviation sector, which are capped, it is likely to affect the competitive game. Table 1 approximates the effect. It specifies additional allowances that airline i receives in the trading period 2013-2020 when adding an additional RTK in the reporting year 2011. Ceteris paribus, one additional passenger or 100 kg cargo on a 1,000-km trip in the reporting year yield free additional allowances with present value of up to a maximum EUR 8.64 for Lufthansa or EUR 9.18 for Continental during the ensuing 8-year-long trading period. The additional allowances can be sold at the market price of allowances. If the allowance price turns out to exceed the assumed 20 EUR (2011 present value), possible revenues could be further amplified. Additional revenues do not outweight costs of volume expansion, when average costs of up to EUR 78 (Lufthansa) and EUR 54 (Continental) are assumed per passenger trip but consitute an additional incentive for airlines to offer cheaper than usual fares. Approximations for emission performance of two exemplary airlines, namely Lufthansa and Continental, are based on Scheelhaase et al. (2010). Figures for the entire market rely on Scheelhaase et al. (2009). Adding one passenger is assumed to cost 16.1 UScents/ mile for Lufthansa and 11.1 UScents/ mile for Continental (Gillen, 2010; Contintental, 2010). The analysis assumes that the respective airline is alone in the market to embrace strategic action. Otherwise, if all airlines adopt strategic action, ∑ RTK i,year increase and marginal benefits would vanish. Interestingly, the incentive to boost RTK volumes decreases with the market share of airline i, meaning that airlines with low EU market share have strong incentives to raise their share during reporting years. This effect is dampened by the number of competitors embracing such strategy. If all airlines behaved the same way, market shares of individual airlines would not be modified. This means no additional free allowances could be obtained. Moreover, adding RTK in years other than the reporting year does not yield additional allowances. In the presence of perfect competition, where individual market shares of atomistic agents approach zero, the described effect is strong. In a monopolistic setting, where one single firm dominates the entire market, the distortious effect is close to absent. The analysis points to strong skewed incentives for airlines to decrease prices and to increase load factors in the reporting years, notably for airlines with low EU market share. Doing so represents an effective path for airlines to sidestep costly EU ETS auctions. Potential distortions to competition may result. Some airlines may find it easier to behave strategically in reporting years than others. Additional passengers or cargo can be more easily absorbed by airlines with relatively low load factors, i. e. pure cargo carriers and legacy carriers in passenger traffic. Passenger airlines, notably low-cost carriers with their high capacity utilization rates have less potential of acting strategically. Moreover, non-EU carriers with naturally low EU market share have slightly more scope to reap the benefits of strategic action compared to EU carriers, resulting in potential competition distortions to the advantage of non-EU airlines. Transferability The problemacy investigated in this paper does not generalize to trading schemes for aviation around the world. Table 2 gives an overview on selected national cap-and-trade schemes relevant for the Scenario: Airline i adds 1,000 RTK in reporting year, all other airlines ceteris paribus Million RTK 2011* Market share 2011* A i,2013-2020 * Additional A i,2013-2020 Additional revenue in EUR** Add. cost in EUR ‘’ Add. rev/ Av. cost Lufthansa 18,866 7.85 % 88,537,976 0.432 8.64 78 11 % Continental’ 5,129 2.14 % 24,070,353 0.459 9.18 54 17 % Market 240,205 100 % 1,127,280,000 Source: *Based on Scheelhaase et al. (2010) **EUA market price of 20.- (Present Value, discount factor zero) assumed. ‘A merger of Continental and United is disregarded in this analysis. ‘’Cost of Available Seat Mile (CASM) data from Gillen (2010), Continental (2010). Tab. 1: Benefit of strategic action. Infrastruktur + Verkehrspolitik 12 INTERNATIONALES VERKEHRSWESEN (62) 10/ 2010 air transport sector. The United States are on their way to realizing a comprehensive cap-and-trade scheme which indirectly impacts the aviation sector. The analysis in this paper does not transfer to the US cap-and-trade system mainly because the US system does not directly involve airlines but petrolium dealers. Moreover, international flights are likely to be excluded from the scheme, similarly to the cap-and-trade scheme in place in New Zealand. This implies that competitive distortions between domestic and international services are dampened. The New Zealand Emission Trading System entails a full auctioning of allowances. Under such allocation regime, the distortious effects described in this paper are irrelevant. Recommendations It could be profitable for airlines to price below marginal cost so as to obtain additional allowances. This strategy is profitable up to the point where short-term revenue cuts are compensated by subsequent gains in emission permits. What should one recommend to airlines for them to fully exploit the described potential without affecting profitability? Suitable options are manifold and include price discrimination through blind booking, last minute booking and lotteries, where passengers and cargo are allocated to flights with free capacity on very short notice. The airline can replenish cargo capacity with unbound, random payload and declare this as regular freight service at the very last minute prior to gate closing so as to increase RTK at low cost. In our view, the performance of airlines in the reporting year is weighted too heavy as opposed to subsequent years, creating skewed incentives and inducing manipulative strategies. Airlines with poor performance in reporting years forego ample benefits and they are locked into their default for several years. In contrast to the designated ‚one-off benchmark‘, a so-called ‚repeated benchmark‘ (cf. Figure 1) could constitute a remedy. Such mechanism for allowance allocation takes account of continuous airline performance averaged over a range of reporting years. Moreover, it entails the advantage of potentially lowering the cost passed through to end consumers, and thereby possibly trimming down windfall profits. (CE Delft, 2007, p. 9 ff.) A drawback of an updated benchmark, though, is the fact that it shortens the planning horizon of airlines. Another alternative is to choose a fixed historic emission level per airline and apply individual growth rates. (Fischer, 2009) We also recommend modifying the benchmark for free allowance allocation so as to distinguish between types of services, e.g. passenger vs. cargo or international vs. domestic flights. Such benchmark could succeed in minimizing competitive distortions arising between different airline segments. The European Commission, confronted with reviewing the benchmark allocation in 2012 right after the first trading period, is invited to reflect on these propositions. Following our recommendations does not imply significant administrative efforts since airlines need to record and report their emissions every year anyway. Data necessary for the differentiation of allowance allocation is already available to member states. Conclusion We have spotlighted warped incentives for airlines during reporting years under the designated EU ETS allowance allocation mechanism, resulting in potential disturbances to the competitive game. As a remedy, we recommend introducing a continuously updated and further differentiated benchmark averaged over a series of reporting years. Such dynamic benchmark could contribute to minimizing both, possible windfall profits and strategic behaviour. 1 A short discussion can be found in Fischer (2009). References CE Delft (2007): Allocation of allowances for aviation in the EU ETS: The impact on the profitability of the aviation sector under high levels of auctioning, B. Boon, M. Davidson, J. Faber, A. van Velzen, Delft: CE, 2007. Continental (2010): Reconciliation Information for 2010 Cost per Available Seat Mile, Continental Airlines Website. http: / / www.continental.com/ web/ en-US/ content/ company/ investor/ docs/ continental_reconciliation_casm_guidance_2010_q3.pdf [Retrieved 21 July 2010]. EC, European Commission (2006): Impact Assessment of the inclusion of aviation activities in the scheme for greenhouse gas emission allowance trading within the Community, COM (2006) 818 final, SEC (2006) 1685, Brussels: European Commission. Fischer, F. (2009): Emissionszertifikate im Luftverkehr - Falsche Anreize? , Wirtschaftsdienst, 89. Year, Edition 9, 2009, p. 570. Forsyth, P. (2008): The Impact of Climate Change Policy on Competition in the Air Transport Industry, Discussion Paper 2008-18, 2008. Paris, France: OECD/ ITF. Gillen, D.; Morrisson, W. (2010): Airports and Airlines: Threats and Opportunities in an Evolving Industry, presented at the 5 th Hamburg Aviation Conference. Morrell, P. (2007): An evaluation of possible EU air transport emissions trading scheme allocation methods”, Energy Policy, 35 (2007), pp. 5562 - 5570. NZME, New Zealand Ministry for the Environment (2007): Emissions Trading and Transport, Factsheet 18, Wellington. Scheelhaase, J.; Schäfer, M.; Grimme, W., Maertens, S. (2009): EU-legislation tackling aviation’s CO2 emissions: Model-based empirical estimation of the economic and ecologic impact of the EU-Emissions trading scheme on the international aviation sector, Presented at Air Transport Research Society Conference, Abu Dhabi, July 2009. Scheelhaase, J.; Schäfer, M.; Grimme, W. (2010): The inclusion of aviation into the EU emission trading scheme - Impacts on competition between European and non-European network airlines, Transportation Research Part D 15 (2010) 14-25, 2010. Windram, C. (2009): Comparison of Waxman-Markey, EU ETS and CPRS Emissions Trading Schemes, Think Carbon, 11 June 2010. http: / / thinkcarbon.wordpress.com/ 2009/ 07/ 11/ comparison-of-waxman-markey-eu-ets-and-cprsemissions-trading-schemes/ [Retrieved 10 June 2010]. Zusammenfassung Wie Fluglinien EU-ETS-Versteigerungen umgehen Der Beitrag macht auf verzerrte Anreize für die Fluglinien aufmerksam, die während der Berichtsjahre gemäß dem konzipierten Mechanismus für die Zuteilung von Emissionszertifikaten unter dem Emissionshandelssystem der EU entstanden sind, mit den daraus resultierenden möglichen Störungen für das Wettbewerbspiel. Als Abhilfe wird die Einführung eines kontinuierlich aktualisierten und weiter differenzierten Benchmarks vorgeschlagen, dessen Durchschnitt über eine Reihe von Berichtsjahren berechnet wurde. Solch ein dynamischer Benchmark könnte dazu beitragen, sowohl mögliche Zufallsgewinne zu minimieren als auch strategisch ausgerichtetes Verhalten einzuschränken. Table 2: Selected cap-and-trade schemes relevant for the air transport sector. Source: Compiled from NZME (2007), Windram (2009). Region USA EU New Zealand Name Waxman-Markey bill Kerry-Lieberman bill EU ETS NZ ETS Starting date Not clear 1 January 2012 Transition phase July 2010 to December 2012 Trading period Not clear 8 years (2013-2020) in Phase III Commitment period of Kyoto Protocol Coverage No direct coverage of aviation sector but through coverage of jet fuel dealers. International flights exempted through provision of “compensatory allowances”. Domestic and international coverage. All departs from EU airports subject to EU ETS. Arrivals at European airports covered in the absence of climate action by state of origin. Covers purchasers of more than 10 million litres of jet fuel (for now only Air New Zealand), international traffic excluded. Allocation ca. 20 % of allowances auctioned, increasing to about 70 % by 2030. 82 % of reference year freely allocated. 100 % auctioning Benchmark Not clear One-off sector-average benchmark No benchmark