UK study finds airlines' profits may be affected by the extension of the EU ETS to cover aviation
Fri 8 Feb 2008 – A study prepared for the UK’s Department for Environment, Food and Rural Affairs (Defra) and Department for Transport (DfT) shows that airline profits may be affected by the inclusion of aviation into the EU Emissions Trading Scheme (ETS), depending on the level of free allocation of allowances.
The report by Vivid Economics, entitled ‘A study to estimate the impacts of emissions trading on profits in aviation’, follows on from an earlier study published in November 2007 that looked at estimated airline ticket price changes for aviation within the ETS, and which found that airlines would likely pass on around 100% of allowance costs to their passengers and customers.
This new study explores the level of allowances that should be allocated for free if the airline industry’s profits as a whole were to remain constant after its entry into the ETS, compared to their levels prior to entry. It applies the latest economic theory to construct a model that estimates the level of free allocation (as opposed to auctioning or buying allowances from the market) that would cause the EU ETS to have a neutral effect on airlines’ profits. The authors point out that the Government has no predetermined objective to ensure that the allocation mechanism leads to a profit-neutral outcome. The results, they say, are illustrative and are designed to help build an understanding of the possible impact on profits under different assumptions. “Like all models, this model is a simplification of the real-life complexity of the aviation industry,” they conclude.
The main findings are:
1.Airlines’ profits may fall when emissions trading is introduced even though ticket prices are likely to rise. Price increases would be likely to be caused by the additional costs of having to buy or hold allowances and the result of fewer journeys sold. Revenues may decline for airlines where they face price-sensitive demand (elastic demand), but may increase where they face price-insensitive demand (inelastic demand). The scale of the effect is dependent on the responsiveness of demand to any change in price. Profits are likely to be eroded relative to the pre-ETS position most quickly in markets in which there are few participating airlines, or where a few airlines supply the great majority of the market. The reduction of profits would be expected to be exacerbated where rival airlines have unequal marginal costs and where the number of fringe, small, high-cost operators is large.
2.Firms operating in the same market do not all experience the same impact on their profits. The modelling evidence suggests, without being conclusive, that larger airlines may experience more adverse impacts on their profits than smaller airlines. Within the model, larger airlines have higher profit margins. The consequence of emissions trading is that those larger airlines experience greater reductions in profits relative to their smaller peers and as a result, overall sector profits may fall by more than they would have if airlines of all sizes had been affected equally.
3.The analysis suggests that the range of free allocation required to maintain total sector firm profits at their pre-emissions trading level is estimated at between 20% and 40% of emissions (pre-ETS levels) for a wide range of market characteristics. Any additional free allocation above these levels would be likely to raise airline profits above their without-emissions trading level by the value of that additional allocation. Similarly, any shortfall in free allocation below these levels could correspondingly reduce profits. A second range, 40% to 70%, is generated when there are fewer than three airlines supplying a particular route and while assuming characteristics more typical of leisure-only services.
“While this study is just one piece of evidence to inform policy, the Government welcomes its findings,” commented Defra. “It demonstrates that it is important to recognize the possible financial impacts on the industry of introducing aviation into the EU ETS and that to achieve the environmental objectives in an economically efficient way without undue adverse impact on the industry, the right balance needs to be found between allocating allowances for free and auctioning.”