The impact of CO2 emissions trading on firm profits and market prices 29

RESEARCH ARTICLE www.climatepolicy.com

The impact of CO2 emissions trading on firm profits and

market prices
Robin Smale1*, Murray Hartley2, Cameron Hepburn3, John Ward2, Michael Grubb4
1
Vivid Economics, The Old Dairy, 13B Hewer Street, London W10 6DU, UK
2
Oxera Consulting Ltd, 40/41 Park End Street, Oxford OX1 1JD, UK
3
St Hughs College, Oxford University, St Margarets Road, Oxford OX2 6LE, UK
4
Faculty of Economics, Cambridge University, Sidgwick Avenue, Cambridge CB3 9DD, UK

Abstract
The introduction of mandatory controls and a trading scheme covering approximately half of all carbon dioxide

* Corresponding author. Tel.: +44-7753-984051

E-mail address: [email protected]

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 30 Robin Smale, Murray Hartley, Cameron Hepburn, John Ward and Michael Grubb

might use the allocation as a means of state aid, providing their firms with a reserve of cash with
which to compete against firms in other EU Member States;
emission reductions may be limited;
prices, particularly those paid by household consumers of electricity, will rise.

A public debate has engaged both government and business. UK government ministers have
said that the UKs draft National Allocation Plan recognises the need to preserve the competitive
position of UK industry (Defra, 2004a), while some industrialists were voicing concern about
a threat to UK jobs. Strong differences in views were held at the time, in the first quarter of
2004. More than two years have passed since those early stages of debate, but the question of
the impact of emissions trading on the competitiveness of UK f irms has not diminished in
importance.
In the academic literature, commentators have observed that there are likely to be increased
profits from the introduction of emissions trading schemes. This conclusion, which may at first
appear counterintuitive, is nevertheless founded upon conventional economic assumptions of profit
maximization and the Cournot competition model, discussed below. The underlying reason is that
although emission cap-and-trade schemes increase marginal costs, these costs are largely passed
on to the consumer, and at the same time the free allocation of emissions allowances represents a
large economic rent to firms. Based upon this logic, Vollebergh et al. (1997) recommended partial
grandfathering of allowances (or taxes with partial credits) for carbon policy in the European
Union. Bovenberg and Goulder (2000) came to similar conclusions in research on the coal, oil
and gas industries in the USA. They proposed that no more than 15% of allowances needed to
be grandfathered to preserve profits and equity values. Quirion (2003) similarly found that only
1015% of allowances need to be grandfathered to achieve profit neutrality.
This article examines the impact of the EU ETS on UK competitiveness and addresses the
potential changes in the prices, volume of sales and profits of UK firms and those of their rivals,
as a result of the trading scheme. It encompasses research carried out by Oxera under contract to
the Carbon Trust over the period 20042006, and a report published by Oxera (2004) containing
an initial set of results. Later results are presented here.

2. Background

It is estimated that the industrial activities within the EU ETS were responsible for releasing
46% of all CO2 emissions from the UK in 2002 (Defra, 2004b). However, the number of sectors
involved, as classified by the Department of the Environment, Food and Rural Affairs (Defra),
is small. In the UK, 12 sectors together represent 98.8% of all the emissions covered by the
trading regime, but only approximately 11.1% of UK value-added in 2001 (National Statistics,
2002). Furthermore, these sectors tend to have several characteristics in common. They are all
energy- and capital-intensive relative to the UK average. Energy is an important input into
production, and the production plants tend to be large because of the associated economies of
scale. Moreover, these f irms are often vertically integrated into companies that produce the
raw materials for their production process, or consume or retail their product. In combination,
these factors result in sectors comprising relatively few firms, and entry by new firms into the
sector is relatively uncommon.

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 The impact of CO2 emissions trading on firm profits and market prices 31

This research was designed to show the consequences of the EU ETS on business. The sectors
were selected expressly to make apparent the variation between:

those in which exposure to international competition is a particular concern and those that are
more insulated from overseas rivals;
those for which energy expenditure constitutes a high proportion of their production costs and
those for which it constitutes a relatively low proportion of production costs.

2.1. Defining the market

The economic model used to explore these questions delineates the behaviour of individual firms
competing against each other in a market. Hence, it is necessary to define the relevant markets
represented by the model.
Economists have devoted considerable attention to defining the relevant market, particularly in
competition law investigations. Essentially, a market can be defined along two dimensions: the
product market and the geographical market. For both dimensions, the issue concerns whether
other products/regions provide an effective competitive constraint on the production of the particular
product or on the region of production under examination. In short, a market may be defined as
something worth monopolizing.
A number of tools have been developed to test the scope of the relevant market. However, it has
not been necessary to use these tools in undertaking this study since, in all cases, an appropriate
market had already been defined in competition law investigations at both the UK and the EU
level. The products chosen within these sectors, and associated geographical markets as established
in competition cases, are set out in Table 1. Since all these decisions were arrived at recently, there
is little reason to believe that the nature of the markets will have changed substantially since then.

2.2. Choice of model

As mentioned earlier, many of the sectors in the EU ETS contain a relatively small number of large
firms. 1 This suggests that it is appropriate to consider the markets as oligopolistic rather than
perfectly competitive. There are important differences between oligopolistic and perfectly
competitive markets in the way prices are determined. In a perfectly competitive market, prices
are set by the marginal cost of production (the cost of producing an extra unit of output), and
firms make profits equal to their cost of capital. In an oligopolistic market, the process is more
complicated. Marginal cost still plays an important role, but the presence of fixed costs often
means that prices are above marginal costs, allowing for the recovery of these costs and, potentially,
if there are barriers to entry, significant economic profits to be made.
A number of theoretical models seek to explain the behaviour of firms in oligopolistic markets,
including the classic Stackelberg, Bertrand and Cournot models.
In a Stackelberg equilibrium, the firms in the industry compete on quantity in a sequential
fashion. One firm moves first, and then each moves in turn until the last. Working by backwards
induction, the last firm seeks to maximize its profits, given the output decisions of all the other
firms. The Stackelberg model was rejected because it is more complicated to implement and in
most, if not all, of the markets being represented, there were no firms with a leading market share.

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The Bertrand model of competition assumes simultaneous price setting between firms. This
results in a zero economic profit equilibrium, where price equals marginal cost. The pure Bertrand
competition model obviously cannot apply to an industry with fixed costs, as a price equals marginal
cost rule would, in the long run, lead to closure of the entire industry. The pure Bertrand model
would appear to be inapplicable to all the industries under examination here, as they all have
significant fixed costs. A modified price-setting model, such as under monopolistic competition,
however, could be employed.
The Cournot model is a standard oligopoly model, and it is often used in competition policy
as a first approximation of how competition works (Martin, 1993). For our modelling purposes,
the Cournot oligopoly model offered the best combination faithful representation of market
cost structure and behaviour, and flexibility to incorporate a mixture of profit-maximizing and
sales-maximizing objectives as well as tractable conversion into a spreadsheet modelling
application.
The key assumptions of the Cournot model, as it is applied here, are as follows:

firms are profit-maximizing

firms compete on quantity rather than price
the output that firms produce is homogeneous
the cost structure consists of a fixed cost and a constant marginal cost, although the levels of
these costs within this structure may, and in this model do, differ across companies
the relationship between consumer demand and price is constant for all price/quantity
combinations (i.e. there is a linear demand curve).

Using these assumptions, a model was constructed to predict market price, total sales, individual
firm output, and individual firm profits. At first glance, the assumption over which there may be
greatest concern is that firms compete on quantity. Experience suggests that, in many markets,
firms compete on price. However, the economic literature has shown that the outcome predicted
by the Cournot model may also be realized when firms first choose their capacity levels and then
only later compete on price (Kreps and Sheinkman, 1983).
However, one important feature has been introduced in order to reflect a greater degree of
compromise between profit maximization and long-term market share, specifically to ensure that
price increases do not stimulate the entry of new firms to a degree that would reduce the incumbents
profits (see Ventosa et al., 2005).
This feature took the form of a parameter representing the degree of revenue-maximizing
behaviour. The value of this parameter (between 0 and 1 within the mathematical framework of
the model) was set so that, where there was a possibility of companies increasing their profits as
a result of the policy levers, this would never be implemented in a manner such that it would
attract new entry and therefore be self-defeating, i.e. that the firms exhibit limit pricing (see later
discussion on profit maximization). As a result, new entry was only assumed to take place when
companies did not have the opportunity of increasing their profits as a result of the policy levers
introduced.
Having solved the Cournot equilibrium for a set of incumbent firms, any company that is no
longer profitable is assumed to exit, and the Cournot equilibrium is re-calculated. Also, data from
abatement curves is used to assess whether companies would profitably undertake any abatement,
given the prevailing market conditions.

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3. Operation of the model

Initially, the model assumes that the market is populated by a number of identical, typical firms.
All of the firms choose the same volume of output to maximize their individual profits. If, at this
optimal level of output, the firms cannot pay their fixed and variable operating costs, including
providing a reasonable return to providers of f inance, at least one f irm would close. As a
consequence of the closure (exit) of a firm, the individual outputs of the remaining firms would
increase and their profitability would improve. The model automatically reduces the number of
firms in the industry until the remaining firms cover their costs and achieve a reasonable profit.
The EU ETS affects costs (both fixed and variable), prices, and quantities in the market. It is
helpful to divide these impacts into marginal and fixed effects: marginal effects determine the
impact on the price or quantity sold; fixed effects do not alter these allocative decisions, but have
a direct impact on the profit made and hence on the number of surviving firms.
Under the EU ETS, CO2 emissions become a factor of production that has to be paid for, in the
same way as labour or raw materials. It is assumed in the modelling that marginal costs are constant
across the range of output considered, i.e. that each additional unit of output has the same marginal
impact on costs. The introduction of the EU ETS leads to two potential changes in the marginal
cost of production:

the direct CO2 cost the amount of CO2 emissions from producing an additional unit of output
multiplied by the market price of allowances. This affects EU ETS participants only;
an increase in the price of electricity the amount of electricity consumed in producing an
additional unit of output multiplied by the change in wholesale market price of electricity caused
by the EU ETS. This will affect all companies within the EU.

An increase in marginal cost has an impact on a firms profits in three ways:

the level of production is reduced as the costs of production increase, quantity supplied is
reduced, regardless of whether prices are changed;
some costs are absorbed by the firm this does not lead to an increase in price, but the margin
achieved on each unit is eroded;
some costs are passed on to customers this does not erode margins, but the increase in price
leads to a decrease in volumes and hence revenues.

The first of these impacts, which always takes place, reflects the fact that, as each unit of production
is now more costly, the level of output at which marginal cost equals marginal revenue will also
necessarily be lower. The extent to which this factor results in lower output depends critically on
the number of other firms in the market that also face the marginal cost increase.
The second and third impacts depend on the extent to which the marginal cost increase is
passed on to customers, and occur in inverse proportions. In the Cournot model, the extent of this
pass-through is determined by each firm pursuing a profit-maximizing strategy (Varian, 1992,
p. 290). Under certain assumptions, including the assumptions that demand is linearly related to
price (each quantum of price rise reduces demand by a fixed amount), the extent to which a
change in cost leads to an increase in price is given by the formula X/(N + 1), where X is the
number of companies affected by the cost change, and N is the total number of companies operating
in the market.2

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For example, for the extreme case of a monopolist, N = 1, and therefore X also = 1. As such, a
monopolist facing linear demand passes through half of any increase in costs. However, as the
sector becomes more competitive, and the number of firms increases, the amount of cost pass-
through to customers rises until it is close to 100%. In other words, the more competitive the
industry, the greater the cost pass-through. This is explained by the fact that, as an industry becomes
more competitive, prices become more aligned with costs. This rule also shows that the smaller the
proportion of firms in the market that are affected by the marginal cost increase, the lower the
level of cost pass-through. Thus, a lower proportion of costs will be passed through if a larger
proportion of demand is satisfied by small or overseas firms not affected by the EU ETS.
The same basic idea can be applied if demand is assumed to be isoelastic, i.e. demand is related
to price with constant elasticity () in which case the cost pass-through rule is:

dp/dc = N/(N + 1)

where N is the number of firms (Varian, 1992, p. 290).

For a monopolist (N = 1) facing a constant elasticity demand curve, the cost pass-through rule is
thus / ( + 1), which corresponds to that found by Bulow and Pfleiderer (1983). Note that
because < 1 for a monopolist, isoelastic demand therefore implies cost pass-through of more
than 100% of any price change, and the pass-through would decline towards 100% for more
competitive markets.
For the purposes of the analysis in this article, we assume a linear demand, partly because the
higher rates of pass-through under isoelastic demand are inconsistent with the claims and concerns
of many industries regarding the difficulty of passing through cost changes. 3 As shown below,
even assuming linear demand, it can be shown that significant pass-through occurs along with
resulting profit-making from the EU ETS; adopting the isoelastic assumption would simply tend to
make these effects even greater.
Once the proportion of cost increase that is passed on to customers is known, the impact on
profits from a decrease in margins can be established relatively easily. The magnitude of this
effect is given by the sensitivity of demand to price, the own-price elasticity of demand. Estimates
of this elasticity are available in the economic literature.
The final impact is on the fixed costs of firms. A firms fixed costs may rise as a result of
abatement investment undertaken to reduce exposure to the marginal cost impact of the EU ETS.
Knowing the cost of CO 2 emissions, a company can decide whether to invest in abatement
technology to reduce emissions. Using published abatement cost curves, the model estimates the
level of abatement investment for both CO2 emissions and electricity consumption. For simplicitys
sake, it is assumed that the cost associated with the introduction of new technology is entirely a
capital cost, and that the new technology does not change the fixed or variable operating costs of
production, except to the extent that marginal costs are reduced due to the lower intensity of
electricity or CO2 consumption.
More important than abatement investment (in financial terms) is the free allocation of allowances
to firms. This is equivalent to a fixed, lump-sum revenue transfer to the firm, because the revenue
that the company could generate from selling these allowances is independent of its own production
volumes.
While, in the short run, the number of companies in the sector is fixed, in the long run firms
can enter or exit. The model shows the financial impact of the EU ETS as though it were distributed

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equally across all the firms in the market. If the reduction (increase) in profitability is sufficiently
great, it is expected to cause f irms to exit (enter) the market. This alters the degree of cost
pass-through (through the x/(n +1) rule), and requires further iterations of the model, giving a
new financial impact estimate. The iterations continue until a long-run equilibrium number of
firms in the industry is established. The treatment of firm entry and exit is discussed further
below.

4. The assumption that firms pursue profit-maximization

The assertion that firms maximize profits is so common in economic analysis that it might seem
surprising to question it. Yet it is widely discussed, and its importance in the context of modelling
the EU ETS is that it determines the fundamental trade-off that firms face between maximizing
profits in the short term, and maximizing market share (and hence gross revenues) and thus
potentially maximizing profits in the longer term. Raising product prices increases profits but
leads over time to loss of market share.
Generally, shareholders have a shorter time horizon than the investment cycle of firms, and thus
the assertion that firms maximize profits (in a given period of analysis, such as 5 or 10 years)
is based upon the implicit set of assumptions that (1) shareholders seek profit maximization;
(2) management aims to best achieve shareholder objectives; and (3) management is able to achieve
its aims. All three assumptions have been questioned, as discussed below.

4.1. Do shareholders desire profits?

It can hardly be denied that shareholders seek profits. It is an open question as to whether they
have motivations other than profits. In recent times, there has been an emergence of an ethical
investment sector, where managed funds pursue profits in conjunction with additional ethical
objectives, such as environmental protection. These additional objectives are often satisfied simply
by placing constraints on the types of firms these funds will invest in. On other occasions, the fund
is a more active participant in guiding firm policies. Even so, however, the question of most interest
in the popular press is whether the ethical sector is more or less profitable than other sectors. In
short, the focus is still squarely on profits, and it is safe to proceed on the assumption that shareholders
seek profit maximization (see Baumol, 1958; Jensen and Murphy, 1988; Murphy, 1985).

4.2. Do managers seek to achieve shareholder objectives?

The crux of the debate concerns the divergence between the incentives of shareholders and
managers. This debate is not new. Over 40 years ago, Koplin (1963) stated that the prof it
maximization assumption has long been under attack, chiefly on the grounds that it lacks realism.
The attack was largely begun by Baumol (1958, 1959), who conjectured that managers salaries
appeared to be more closely correlated with total sales revenue rather than bottom-line profits. As
such, he asserted that managers induce over-expansion of firms, not for reasons of profitability,
but because managers see expansion as a means to obtaining higher salaries.
All firms consist of several distinct groups of stakeholders (employees, managers, shareholders
and customers) and each group has different objectives. The dominant groups are generally the
owners and the managers. As Stiglitz (1991) encapsulates it: the fundamental problem of owners

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of firms is how to motivate their managers to act in the interest of the owners. This, of course, is
just an example of the classic principalagent problem.
Baker et al. (1988) noted the relatively stable empirical finding that managers salaries increase
by 3% for every 10% increase in sales and, perhaps more importantly, Murphy (1985) showed
that this relationship is causal, and not merely a matching of more productive workers to larger
firms, implying that pay can increase with firm size even if this reduces firm value. Stiglitz (1991)
agrees that managers often behave to the detriment of shareholders, pointing out that managers
sometimes prevent takeovers that would be in the best interests of their shareholders by taking
poisoned pills (entering the firm into contracts costs that would impose costs on the new owners)
and golden parachutes (entering the f irm into commitments to pay high levels of f inancial
compensation to managers who are ousted during a takeover). Given that managers have an incentive
to increase sales as well as (or even instead of) profits, sales maximization appears to be empirically
plausible.
The implications from this are that firms should be expected to maximize the dual objectives of
profits and sales if (1) managers are powerful relative to shareholders, or (2) the market structure
is oligopolistic and quantity leadership provides a profit advantage. It follows that managers might
find it optimal to use the lump sum represented by their grandfathered allowances as a war chest
with which to reduce prices and increase sales in the output market, in an attempt to take Stackelberg
leadership, as outlined earlier.

4.3. Can management achieve its aims?

The final argument used to question models based on profit maximization centres on the claim
that managers are incapable of determining the profit-maximizing strategy. Instead, managers
operate by rules of thumb. The intellectual background for this view is to be found in the concepts
of satisficing and bounded rationality, and this is increasingly being expounded in the economic
literature concerned with behaviour. Several rules of thumb are now considered.
Average-cost pricing, also known as markup pricing or cost-plus pricing, is where a markup is
added to the average unit cost of production. This appears to be particularly common in the retail
sector, where the proliferation of products implies that a careful study of demand for each product
is uneconomic.
Survey evidence suggests that this practice is particularly widespread. Govindarajan and Anthony
(1983) concluded that most firms in the Fortune 500 price their products based on average cost,
and Shim and Sudit (1995) found that 69.5% of the 600 US manufacturing companies surveyed
claimed to base their pricing decisions on full costs, with only 12.1% using a variable cost method.
Lucas (2003) presents a useful survey of the various econometric and case study evidence for and
against average cost pricing, and suggests that both average cost and marginal cost pricing are
plausible, and that further empirical research is required before any conclusions can be drawn.
Limit pricing consists of pricing to ensure that no additional firms will find it profitable to enter
the industry. It is a long-run profit maximization strategy for monopolistic or oligopolistic firms.
In a survey of 54 industries in the USA, Koutsoyiannis (1984) found evidence against short-run
profit maximization (and sales maximization) and evidence for limit pricing. He substantiated this
view by citing 37 industries where the evidence is consistent with limit pricing, while in the
remaining 17 industries the evidence is inconsistent. The model parameters were set to achieve
limit pricing in those circumstances where limit pricing was a profitable strategy.

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Profit maximization and other assumptions: lessons for modelling

As discussed in the text, although it is clear that shareholders desire profits, it is unclear
whether managers seek to maximize profits. In particular, there is good evidence to show
that they seek to maximize sales instead, although sales maximization is actually a profit-
maximizing strategy in some oligopolistic industries. Sales maximization results in the
conclusion that managers would not keep all the rents from grandfathered allowances, and
would instead use them to reduce prices and increase output.
This has implications for model design. A model in which firms maximize a weighted
average of profits and sales may provide a more realistic representation of markets than one
which purely maximizes profits. The weights on sales and profits would determine how much
of the economic surplus is spent on increasing revenues, and how much is retained as profit.
There is a final popular argument which should also be taken into account. Irrespective
of whether the three assumptions are fulf illed, Friedman (1953) has argued that in a
competitive environment, firms must maximize profits or they will eventually be driven
out of the market. Thus, he states that under a wide range of circumstances individual
firms behave as if they were seeking rationally to maximize their expected returns.
However, Dutta and Radner (1999) have rigorously examined a model similar to that
which Friedman puts forward and have arrived at the opposite conclusion. They say that if
innovating firms in a stochastic environment are subject to competitive pressure, the result
will be that the profit-maximizing firms will eventually go bankrupt and, after a period of
time, practically all the surviving firms will not be maximizing profits. The Dutta and
Radner (1999) setting does not apply here, but it does question the legitimacy of the as-if
profit-maximization of Friedman (1953), which is commonly encountered in the literature.
Furthermore, Nabil et al. (2004) consider an oligopolistic market with product
differentiation where firms adopt real-world accounting practices, including practices where
fixed (and sunk) costs are bundled in together with variable costs. With the assumption
that firms follow adaptive learning in adjusting prices, they find that pricing above marginal
cost predominates, and all firms end up showing a sunk cost bias. This provides further
evidence against the Friedman (1953) hypothesis.

5. Initial market conditions

With the number of companies in the market established, the actual profits made by each company
can be calculated. A check is performed to ensure that all companies that enter remain profitable.
Therefore, a company that enters the market first and makes high profits could end up making
losses due to the subsequent entry of other companies. Thus, the model finds an equilibrium
where all the companies in the market are profitable and any company that is not in the market
would not make profits by entering. Note that the geographical scope of the market is either the
UK, Europe or global, as set out in Table 1. Since the EU ETS changes the production costs of EU
firms relative to global firms, where it has an effect on the market share of UK or EU firms the
effect is that market share is gained by non-EU firms.

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Table 1. Sectors, products and geographical markets

Relevant Selection of European
Sector Product market market Commission Cases
Cement Grey cement UK Lafarge/Blue Circle (Comp/M.1874, 07.04.2000)
Newsprint Newsprint Europe
Petroleum Refined products Europe
Steel Cold-rolled carbon European Usinor/Arbed/Aceralia (Comp/ECSC.1351
steel flat products 21.11.2001)
Aluminium Global Alcan/Alusuisse (Comp/M.1663, 14.03.2000)
Norsk Hydro/VAW (Comp/M. 2702, 04.03.2002)
Elkem/Sapa (Comp/M.2404, 26.06.2001)

With the number of companies in the market established, these companies are then labelled as
being either UK, (other) EU or global companies. This is decided on the basis of the share of
supply that was gathered from published research.
The cost shocks of environmental policy are then introduced. Depending on the scenario being
modelled, either fixed or marginal costs can change. UK companies are assumed to be affected by
both UK and EU policies, while other EU companies are assumed to be affected only by the EU
ETS. There is no attempt to address the financial impact of national environmental policies other
than those introduced by the UK government. There is assumed to be no change in the costs of
global companies, operating outside the EU.
With these amended costs, the revised prices, quantities and profits of the companies in the
market can be calculated. In examining these short-term effects, it is assumed that there are no
changes in the number of companies in the market and that companies cannot respond to the
policy shocks by changing their costs, i.e. that no abatement takes place.

6. Data
The data required to run the model were substantial. They included financial data of individual
companies, fuel use and CO2 emissions per product, in addition to the price of an average product.
Other data inputs included the own-price elasticity of demand, the total volume of product
consumed, the number of firms manufacturing the product, and the proportion of total consumption
supplied by imports.
These data were gathered for each of the following sectors: cement, newsprint, steel and
petroleum. Numerous sources were used, including academic articles, competition inquiries,
company accounts, company environmental reports and material gathered from trade associations,
the UK Department of Trade and Industry, the UK Office of National Statistics, and The Carbon
Trust. The market data is sourced from sector market reports; while the elasticity estimates are
taken from the economic literature, although, in the case of aluminium smelting, no elasticity
estimates could be found. The production cost data are concerned with the marginal cost of
production (although the average variable cost of production is often used as a proxy); the fixed
cost of production (including fixed operating costs, depreciation of capital assets and financing
costs); and an abatement curve of the unit cost and potential for reducing electricity use and
abating CO 2 emissions. The production cost data are taken from published sector studies and

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Table 2. Data sources

Variable Data sources
Industry elasticity Academic articles and competition inquiries
Import penetration Competition inquiries, analyst reports and national trade statistics
Energy intensity The Carbon Trust and company environmental reports
Fixed and marginal costs FAME database and competition inquiries
Price Companies and competition inquiries
Quantity Trade associations and competition inquiries

Table 3. Assumptions
Variable Cement Newsprint Petroleum Steel Aluminium
Price elasticity of demand 0.27 0.5 0.8 0.62 1.1
Marginal/average variable
cost of production 14/t 195/t 0.08/litre 190/t 786/t
Tonnes CO 2 emitted/marginal
unit of output 1.09/t 0.63/t 0.0002/t 1.75/t 2.2/t
Electricity consumer/marginal
unit of output (kWh/t) 136 648 0.1 330 15,351
Market share of non-EU
suppliers (%) 5 15 11 20 70

were corroborated with company accounts from a sample of firms. Abatement cost data are taken
from a database developed for the UK Department of the Environment, Food and Rural Affairs
supplemented with material derived from industry discussions. Tables 2 and 3 detail some of the
sources and assumptions.
UK costs were used for companies in the UK, Europe and the rest of the world, and no account
was taken of existing differences in the terms of trade. Market shares for each location of company
were achieved by attributing an appropriate number of companies to that location. Thus, for example,
in a sector where the model was predicted to have 10 companies, if the UK market share was 40%,
European 30% and rest of the world 30%, then four companies were labelled as UK, three European
and three rest of the world.

7. Scenarios
The scenarios involved combinations of allowance prices of d7.5/tCO 2, d15/tCO 2 and d30/
tCO 2, all with allowances fully grandfathered. Shortly before the EU ETS was introduced in
2005, allowance prices had been around d7/tCO2. The scenario with a price of d7/tCO2 reflects
this initial situation. However, once participating countries had fixed their allocations and as gas
prices rose, increasing demand for coal and increasing the demand for allowances, the price
rose to around d25/tCO2. The two higher-price scenarios are intended to reflect the recent range
of actual allowance prices and to encompass some departure from this range to either higher or
lower prices in the future while acknowledging that future prices could lie outside the range of
these scenarios.

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 40 Robin Smale, Murray Hartley, Cameron Hepburn, John Ward and Michael Grubb

Table 4. Effect on marginal costs

Sector Impact of carbon price on
short-run marginal production
cost (% increase)
Allowance price d15/tCO 2 d30/tCO 2
Cement 70 144
Newsprint 2.6 6.0
Petroleum 0.3 0.6
Steel 8.0 17
Aluminium 4.0 13

The scenarios also incorporate the UKs Climate Change Levy (a tax on the business use of
energy) and Climate Change Agreements. The Agreements are sectoral targets for energy use
or energy intensity which, if achieved, entitle the holder to an 80% reduction in the tax rate
applicable under the Climate Change Levy. Within the model, their only effects are to modify
the cost of electricity and to cause a minimum level of energy efficiency improvement to take
place.
The impact of the opportunity cost of carbon allowances on the marginal cost of production has
been estimated and is shown in Table 4. It ranges from 0.3% for petroleum refining with an allowance
price of d15/tCO2, to 17% for steel with an allowance price of d30/tCO2. The cement sector is an
exception, with the impact on its marginal production costs lying well outside this range, at up to
140%.

8. Results
The results, shown in Table 5, exhibit the following features.
The EU ETS delivers emissions reductions and has a positive (or at least non-negative) impact
on earnings before interest, tax, depreciation and amortization (EBITDA). This is because companies
respond to the increase in marginal cost brought about by the EU ETS by cutting back output and
so increasing prices to cover the additional costs, and simultaneously benefiting from the free
allocation of grandfathered allowances. The petroleum refining sector shows little reduction in

Table 5. Results, Effect of EU ETS and UK policy measures, percentage change

Physical
Sector Emissions production output EBITDA
Allowance price Euro Euro Euro Euro Euro Euro
scenario 15/tCO 2 30/tCO 2 15/tCO 2 30/tCO 2 15/tCO 2 30/tCO 2
Cement 12 14 1.2 4.4 13 25
Newsprint 4 4 0.2 +0.68 9 15
Petroleum 0.4 0.7 0.2 0.7 0.4 0.6
Steel 14 21 2.1 10.6 12 18
Aluminium 100 100 100 100 100 100
Source: Oxera.

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 The impact of CO2 emissions trading on firm profits and market prices 41

emissions because it has a low intensity of emissions and has relatively little opportunity for
abatement.
UK aluminium smelters are assumed to be outside of the trading part of the scheme, but still
exposed to the UK-specific electricity price increase that this would engender. In practice, some
aluminium smelters may own and some may have contractual arrangements with fossil-fuel power
stations, meaning that they do participate in the EU ETS, and the results described below will not
apply to them.
There is a stark contrast between the results for the aluminium smelting sector and those for the
other sectors. In short, because aluminium smelting is assumed to be a global market, even relatively
small changes in cost are predicted to have significant impacts on the competitiveness of UK/EU
companies relative to global companies (which are assumed not to have environmental policies
applied to them).
Prior to the introduction of the policies, there is one representative UK aluminium smelting
company, one representative EU company and four representative global companies in the model
equilibrium. From this starting position, the model simulation produces an outcome that in any of
the scenarios tested the UK (and EU) aluminium smelters exit the market and their place is taken
by companies operating exclusively outside the UK or EU. There is a subtle difference between
the scenarios concerning how this position is reached. On some occasions, the initial impact of the
policy is sufficiently severe to cause both the UK and EU companies to exit the market immediately.
In other situations, one of the two companies remains in the market initially (with the other one
closing), but the impact of a new global company entering in order to take the place of the first
closure is, in turn, sufficient to precipitate the exit of the second non-global company. While this
discussion has been framed in terms of global companies entering the market and non-global
companies leaving the market, it can also equally well be thought of as existing companies located
in the UK/EU relocating to outside of these areas.
UK and EU aluminium smelters are much more exposed to adverse competitiveness implications
from the introduction of environmental policies, due to the global nature of competition in this
market, than participants in any of the other markets analysed. However, as previously noted,
some aluminium smelters are protected via contracts or association with electricity generators
who either participate in the EU ETS or generate power from renewable sources. Hence the impact
of the trading scheme may be that instead of the aluminium smelting activity ceasing, the profitability
of the power generation activity is made lower than that of comparable power generators, where
power prices are under the contracts or between associated companies are not raised to the new
levels in the electricity market at large.
For other sectors, the ostensibly toughest policy scenario, where the CO2 price is d30/t, leads to
the largest increase in profits. This is because, although the CO2 price, and hence marginal cost rise,
is significant, the grandfathered allowances are more valuable. As the proportion of allowances to be
grandfathered remains high in these scenarios, the effect of receiving such a valuable allocation
dominates the higher marginal costs. If the high CO2 price were associated with a much lower
proportion of allowances being grandfathered, the profit impact would be expected to be markedly
different.
The pattern of impact between the sectors is that the steel and cement sectors are notably more
affected, in terms of both profit and predicted emissions savings, than the newsprint sector. In
contrast, the petroleum sector is only very marginally affected, due to its relatively low energy,
and hence carbon, intensity.

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 42 Robin Smale, Murray Hartley, Cameron Hepburn, John Ward and Michael Grubb

Although emissions are cut while profits are boosted, the increase in costs, and in prices, invariably
has a negative impact on output produced and sold, and prices to consumers rise. The impacts on
output across the different sectors are reported in Table 5. The output changes drive a large
proportion of the total UK emissions reduction in each sector, also reported in Table 5.
Again, a number of observations can be drawn.
In all the markets modelled other than aluminium, the impact of the introduction of the policies
is to reduce the total amount of output produced and sold within the UK.
When the geographic market is wider than the UK, the impact of the output reduction within the
market can be asymmetric across locations of companies. Most clearly, for the market in which
there is non-EU production (steel), despite the overall fall in market output, the non-EU companies
are predicted to see their output increase. In the case of newsprint in one scenario, the change in
output is actually predicted to be positive, because there is an implied reduction in the marginal
cost of production as a result of improved energy efficiency.
The composition of these effects on prices, output and profits is shown in Figures 15.
The figures show the cumulative change in EBITDA:

from the increase in the marginal cost of production

compensated by the allocation of allowances
after adjusting for changed product prices
accounting for change in demand
noting the effect of abatement action.

This presentation shows the extent to which the impact of profit is a consequence of marginal cost
increases, the extent to which this is compensated for by additional income from grandfathered

Source: Oxera.

Figure 1. Decomposition of effect on EBITDA for steel.

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 The impact of CO2 emissions trading on firm profits and market prices 43

Source: Oxera.

Figure 2. Decomposition of effect on EBITDA for cement.

Source: Oxera.
Figure 3. Decomposition of effect on EBITDA for newsprint.

allowances or higher prices, and the relative offsetting of this position by demand changes and
abatement cost savings.

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 44 Robin Smale, Murray Hartley, Cameron Hepburn, John Ward and Michael Grubb

Source: Oxera.
Figure 4. Decomposition of effect on EBITDA for petroleum.

Source: Oxera
Figure 5. Decomposition of effect on EBITDA for aluminium.

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 The impact of CO2 emissions trading on firm profits and market prices 45

9. Conclusions
9.1. The impacts on profits
The impacts of policies were most significant in the most energy-intensive sectors and those facing
the greatest international competition. Even here, changes in EBITDA were commonly positive and
large, being greater than 10%, and reaching as high as 25%. Prices rise in the cement sector, which
is a UK market, because the EU ETS applies to 9095% of the product supplied in the UK; and thus
cement manufacturers are able to pass costs on to consumers. Prices rise in the steel sector, which is
an EU market, because the EU ETS applies to 80% of the product supplied in Europe; as such, steel
manufacturers are able to pass on a proportion, 65%, of their marginal cost increases to consumers.
At the same time, across all the sectors and policies, there was a reduction in volume of production,
in most cases by much less than 1%. In two extreme cases steel and cement under the toughest
policy scenario, the output reductions were of 10% and 5%. This supports the suggestion, made for
example by the CBI, that the EU ETS might cause a reduction in employment in some sectors.
The one exception to this picture is aluminium smelting, which, if not tied to electricity production,
is exposed to large increases in marginal cost, with consequential migration of production outside
the EU trading area. In all the scenarios, EU production of aluminium ceases.

9.2. The impact on emissions

The emissions reduction effects are caused in part by a reduction in UK output a combination of
a change in the share of the UK market held by UK producers and of weaker demand from
consumers as a consequence of higher prices. They are also caused by investment in carbon-
efficient technologies. Most of the emissions reduction is attributable to greater carbon efficiency,
driven by the carbon abatement curves prepared for The Carbon Trust by Ecofys. Only in the steel
and cement sectors does output reduction contribute to a significant carbon reduction.
It is notable that the abatement curves predict similar levels of emissions reduction across all policy
scenarios. There is an initial level of abatement that is achieved under low allowance prices, according
to the abatement curve method. This is presumably because the curve contains a volume of abatement
that has been deemed beneficial or costless to the company. Thereafter, little additional abatement is
stimulated by increasing incentives from tougher policies, which indicates that the abatement curve is
quite steep, i.e. abatement costs rise steeply after the initial, virtually costless, actions are exhausted.

9.3. The impact on output

In the steel and cement sectors, there were reductions in output of 10% and 5% in the scenarios
involving the highest penalties on carbon emissions, although, in both cases, these reductions
were accompanied by greater increases in profits as prices rose. The increased profits combined
with slightly reduced output result in a stronger financial position for the companies. In reaching
the new equilibrium level of output, in none of the scenarios is capacity hit so hard that profits fall
and companies exit the market, although there might be some shedding of labour and manufacturing
capacity within companies.
In newsprint, a sector with medium energy intensity, impacts on output were small, at around 1%
or less, but the effects on profits were still significant in some cases, being as large as +15%. These
levels of output and profit change are unlikely to have a material effect on labour or investment.

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 46 Robin Smale, Murray Hartley, Cameron Hepburn, John Ward and Michael Grubb

Acknowledgements
We thank, at Oxera, Gareth Davies, and at The Carbon Trust, James Wilde, for comments on this
article, and Amra Topcagic for her contribution to the Oxera research. We also thank the referees
for their insightful questions and helpful suggestions.

Notes
1 The significance of this market structure is that firms pass less of a marginal cost increase through to their customers than
firms in a perfectly competitive market would do.
2 See, for example, Ten Kate and Niels (2005).
3 Incomplete cost pass-through can be consistent with isoelastic demand if the cost increase is not industry-wide, which is
relevant to industries subject to intense international competition.

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