Windfall profits in the power sector during phase III of the EU ETS: Interplay and effects of renewables and carbon prices

Abstract

Abstract Since power utilities were originally grandfathered into the EU ETS by way of a free allocation of carbon emission allowances (EUA), the issue of windfall profits accruing to producers with carbon-intensive generation portfolios has been the subject of critical analysis. One of the chief aims of the switch to a predominantly auction-based allocation system at the onset of Phase III of the EU ETS was to negate the incidence of windfall profits. The following analysis examines the merits of this policy aim. Drawing on economic theory of power markets, a linear optimisation model covering the electricity market of the EU member states is deployed to investigate this question. Scenarios reflecting developments over a medium-term horizon (10 years) are developed, with which carbon prices are endogenously determined. Their effects on the contribution margins of producers in the member states are subsequently evaluated. The overall findings indicate that the incidence of windfall profits in the power sector remains prevalent in the overwhelming majority of EU countries. The analysis suggests that the carbon intensiveness of the respective generation fleet is not the deciding factor as to whether producers earn windfall profits but rather the fundamental generation structure of the power plant fleet. The results raise questions about the capacity of the current EU ETS regime to provide the desired decarbonising effect on power producers’ generation portfolios in European power markets.