Allocation of allowances for aviation in the EU ETS

64 Pages·2007·0.83 MB·English

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KvK 27251086
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Allocation of allowances for
KvK 27251086
aviation in the EU ETS
The impact on the profitability
of the aviation sector under
high levels of auctioning
Final report
Report

Delft, June, 2007
Authors: Bart Boon
Marc Davidson
Jasper Faber
André van Velzen
Publication Data
Bibliographical data:
Bart Boon, Marc Davidson, Jasper Faber, André van Velzen
Allowance allocation in the EU ETS
The impact on the profitability of the aviation sector under high levels of
auctioning
Delft, CE Delft, March 2007

Aviation / EC / Policy / Emissions / Allowances / Costs / Reduction / Profit

Publication number: 07.7461.19

CE-publications are available from www.ce.nl

Commissioned by: WWF UK.
Further information on this study can be obtained from the contact person Bart
Boon.

© copyright, CE, Delft

CE Delft
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This report is printed on 100% recycled paper.
Contents
Executive summary 1
1 Introduction 5
1.1 Background 5
1.2 Aim of this research 5
1.3 Reader 6
2 Allocation methods 7
2.1 Introduction 7
2.2 Allocation methods 7
2.3 Opportunity costs of emission allowances and cost pass through 9
2.3.1 Theory 9
2.3.2 Opportunity benefits in the case of benchmarking and ticket
prices 9
2.3.3 Capacity constrained markets 11
2.3.4 Allocation and emission reduction 13
2.4 Practical experience 14
2.4.1 Experiences with the EU ETS 14
2.4.2 Impact of kerosene price increases 16
2.5 Discussion 16
3 Modelling 19
3.1 General assumptions 19
3.2 Definition of variants 19
4 Impacts on emission reduction 23
4.1 Introduction 23
4.2 Modelling results 23
5 Impacts on airline profitability and ticket prices 25
5.1 Introduction 25
5.2 Impacts on operating results from the AERO model 25
5.3 Fixed costs 27
5.4 Impact on ticket prices 28
5.5 General development of ticket prices and disposable income 30
6 Discussion 31
Literature 35
A Assumptions on business as usual emission developments 41
B Assumptions and methodology for analysis of ticket price impacts 43
C AERO modelling results 45
D Response to Ernst & Young and York Aviation (2007) 57

Executive summary
At the end of 2006, the European Commission put forward a proposal for
inclusion of aviation emissions in the EU ETS. WWF UK asked CE Delft to study
one particular aspect of this proposal, namely the initial allocation of allowances
to aircraft operators. We have looked specifically at:
− The interaction between allocation method and the likelihood that costs of
allowances are passed through.
− How the allocation method may affect emission reductions within the aviation
sector.
− The impact of high levels of auctioning on the profitability of the aviation
sector.
In this report we list the findings of our study.

Before describing the results of our analysis in detail, note that the use of
allowances implies opportunity costs, whether the allowances have been bought
or obtained free of charge. In the first case, the opportunity costs are reflected in
actual expenditures on allowances either from the purchase of allowances at an
auction or at the EU ETS market. Not passing through real expenditures will
negatively affect the operating margins. In case of freely obtained allowances, the
opportunity costs are not reflected in actual expenditures. If the opportunity costs
are passed through nonetheless, this may actually increase the operating margin.

In general, in competitive markets where price setting is based on marginal cost
levels, opportunity costs will be passed through fully in air fares, whether they are
related to actual expenditures or not. Empirical results for the power sector
indicate that pass through of opportunity costs is real. There are however two
situations in which these opportunity costs might not accompanied by a (full)
corresponding increase in air fares. First, from a theoretical perspective, it may
be argued that expenditures on allowances will not be passed through fully in
case of congested airports. The empirical data available however point in the
direction that also at congested airports additional expenditures are passed
through fully.

Second, in addition to opportunity costs there may also be what we call
‘opportunity benefits’. In its proposal for aviation the European Commission put
forward so-called repeated or updated benchmarking. The allowances allocated
for the next trading period depend on the performance during the current trading
period. There may thus be opportunity benefits of producing RTK’s in addition to
the opportunity costs. These cancel out largely and it is therefore not expected
that these allowances will be reflected in the ticket prices1. Actually, if as under
the current proposal, one specific year will be used as benchmark year to allocate
emissions for the upcoming five year period, there will be a perverse incentive for
operators to lower their prices during this benchmark year, so to ensure the

1 Note that this is not in line with the results reported in previous CE Delft studies. These did not consider in
detail the impacts of updated benchmarking.
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allocation of more free allowances for the next period. Under one off
benchmarking and auctioning, in contrast, there are no opportunity benefits and it
may be expected that opportunity costs are fully passed through.

In general, under emissions trading aircraft operators will take all measures that
cost less than handing in allowances. These measures may be technical (e.g.
purchasing a more efficient aircraft), operational (e.g. increasing the load factor),
or may incorporate volume measures. Volume measures are said to occur when
the cost pass through in tickets results in lower demand. Since under updated
benchmarking, the freely allocated allowances are not fully reflected in ticket
prices, the incentive for volume measures is reduced substantially. Therefore the
emission reduction within the sector is lower under updated benchmarking then
under auctioning or one off benchmarking. In any case, the expected reductions
within the sector are in the order of 2 to 10% of the amount of allowances that will
be purchased on the EU ETS market.

Table 1 Qualitative comparison of impacts of different allocation methodologies
Pass through in Windfall profits Demand effect Industry
ticket prices measures
Auctioning ++ - - ++ ++
Grandfathering + + + ++
Repeated - - - ++
benchmarking
One off + + + ++
benchmarking
Note: ++: very likely; +: likely; -: unlikely; - -: very unlikely.

Table 1 summarizes the likely impacts under different allocation methods. If it is
decided that (part of) the allowances should be allocated free of charge, there will
either be windfall profits and a demand effect, or no windfall profits and no
demand effect. Only in case of auctioning windfall profits can be avoided while
still inducing a demand effect.

The impacts of different allocation methods on the profitability of airlines has
been studied by applying the AERO model. We find that the operating margin of
airlines is hardly affected, provided that opportunity costs associated with
expenditures are passed through and opportunity costs from updated
benchmarking are cancelled out by the opportunity benefits this allocation
method induces.
If, contrary to the outcome of our analysis, airlines do not pass through the
expenditures on allowances, they will incur a loss and the operating margin will
decrease. They would have expenditures that would not be met by revenues.
Similarly, if airlines would receive allowances free of charge without future
updating, as would be the case under one off benchmarking, airlines could
increase air fares while not having expenditures. Consequently, their operating
margin would increase and there would be windfall profits.

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It should be noted that the AERO model applied is a static model, calculating
equilibrium situations. It thus assumes that the aviation industry has fully adapted
to the new policy and investments levels have been adjusted accordingly. In the
short run there may be fixed costs associated to the investments, and
environmental policy that reduces demands may cause excess capacity. This
would mean a loss to airlines.
Given the strong growth of the aviation sector and the lead time between the
announcement of emissions trading and actual implementation, we expect the
potential of overinvestment to be small. However, there may be some years
between ordering an aircraft and its delivery, possibly exceeding the lead time of
emission trading. In that case, raising the percentage of auctioned allowances
over time may further enable airlines to take full account of the influence of
emissions trading on their investment decisions.

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4 7.461.1/Allowance allocation in the EU ETS
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1 Introduction
1.1 Background
The European Commission brought forward a legislative proposal to include the
climate impact of the aviation sector in the EU Emissions Trading Scheme (ETS)
in 2006 (EC, 2006). As proposed, the scheme will cover flights between EU
airports from 1 January 2011. After one year, the scheme is set to be expanded
to cover all flights arriving at or departing from an airport in the Community. The
total number of allowances to be allocated to the aviation sector will be set equal
to the average emissions from aviation in the years 2004-2006.

The European Commission also proposes to allocate a fixed percentage of the
total quantity of allowances free of charge on the basis of a benchmark to aircraft
operators which submit an application (the earliest application relating to 2008
data). For the period 2011-2012 this percentage will correspond to the average
percentage proposed by the Member States including auctioning in their national
allocation plans. Thereafter this will be reviewed in the light of the results of the
general review of the emissions trading scheme. The European Parliament
(2007) estimates about 3% being allocated by auctioning in the first period (2011-
2012).

Experiences in the power sector, however, indicate that allocating allowances
free of charge to companies may increase the costs of emission reduction,
ultimately resulting in less stringent environmental targets. If this would also hold
for the aviation sector, there would be reason to increase the percentage of the
total quantity of allowances to be auctioned among airlines. However, increasing
the percentage of the total quantity of allowances to be auctioned may also affect
the airline profitability and thus the sector’s support.
1.2 Aim of this research
In this context the objectives of this study are:
− To assess the degree to which aircraft operators are able to pass through the
costs of allowances, and the extent to which this is dependent on the
allocation method used (including an assessment of the impact on ticket
prices).
− To investigate how the allocation and distribution of allowances (in
combination with other design factors) may affect emission reductions within
the aviation sector and in other sectors.
− To investigate the impact of high levels of auctioning on the profitability of
airlines.
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1.3 Reader
Different allocation methods are discussed in chapter 2. We discuss the influence
of the allocation method on the probability that expenditures on and opportunity
costs of allowances are passed through. Section 2.3 discusses this mainly from a
theoretical perspective. First the general theory is presented and next reasons
why the general theoretical framework may not apply are discussed. In section
2.4 empirical data on pass through are presented, both related to emissions
trading in general, and the pass through of fuel price increases in the aviation
industry. Section 2.5 discusses the theoretical and empirical findings.

In this study we have modelled the impacts under different allocation variants.
The variants and modelling assumptions are presented in chapter 3.

In chapter 4, we discuss the results from the modelling regarding the impact of
the allocation method on the emission reductions within the aviation sector.

Next, in chapter 5 the impacts on airline profitability and ticket prices are
presented and discussed.

Finally, chapter 6 discusses the results of this study in light of its objectives.

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