Airlines stand to make substantial windfall profits from EU Emissions Trading Scheme allowances, says a UK Government report
Fri 30 Nov 2007 – A report commissioned jointly by the UK’s Department for Transport (DfT) and the Department for Environment, Food and Rural Affairs (Defra) concludes that airlines participating in the EU Emissions Trading Scheme are likely to pass on the costs of emissions allowances, regardless of whether they have had to pay for them, to passengers and freight customers and potentially earn substantial windfall profits.
Using an economic model calibrated with market data, the Vivid Economics report focuses on the extent to which airlines are likely to pass the costs of allowances through to ticket prices and to predict the magnitude of this increase. The key drivers of cost pass-through, it says, are:
·the nature of demand facing the airline;
·whether the airline aims to maximize profits, gain market share or maximize sales;
·the number of rival airlines competing in the same market; and
·the level of free allocations, if there is no updating to reflect changing activity or emission levels.
The study says that on average across services the level of cost pass-through will be close to 100%, with variations ranging from 80% to 150% depending on these drivers.
A case in which prices may well exceed the cost of an allowance is more likely to be seen where the types of passengers on a route are diverse and include business as well as leisure passengers, such as on a typical flight from London to New York. This is because price changes affect a wider cross-section of incomes and preferences so the response to price changes will be more gradual and is more likely to remain proportionate across a wide range of price levels; at high prices there will still be passengers willing to pay.
A case in which prices rise by less than the cost of an allowance is more likely to be seen where the type of passengers on a flight are similar, for example leisure passengers on a charter flight and therefore price sensitive. On high volume routes, ticket prices are likely to rise on average by around 100% of the allowance cost. On low volume routes, where there are particularly few airlines flying the route, the ticket price changes may be larger or smaller and on these routes they may be the largest of all for business passengers. The sector with potentially the largest price elasticity is time-sensitive freight, where the cost pass-through may lie between 80-150%, falling to 95-110% for freight that is not time sensitive.
The report says that although the aviation market is unusual in its characteristics compared to other sectors already covered by the ETS, there is enough empirical evidence to support the belief that the rate of cost pass-through will be around 100%.
The question facing the European Commission and its Council of Environment Ministers, due to meet on December 20, is just what proportion of free allowances (or permits) are made available to the aviation sector. If too high, then there is the possibility of substantial windfall profits for those airlines able to pass on all or more than the cost of their emissions to passengers and customers despite receiving free permits. Too low and the aviation sector will claim unfair treatment compared to other ETS industries already allocated their own proportion of free permits.