Free permits or not?

One important aspect of the design of an ETS concerns whether permits should be free or not.

In the EU scheme, most of the permits were given away free to airlines, at least in the early years of the scheme.Thus, the airlines had a chance to adjust to potentially large changes in their costs and ways they face in doing business. At

Air transport and climate change 61 the time of the extension to aviation, the market price of permits was low, and thus the cost of gaining permits was only a small proportion of the overall cost of operating. The presence of free permits poses a number of questions related to the design of the scheme and how it will work, however.

One of these, which was important in the years prior to the introduction of the extension, was that of who would gain the free allowances. Different rules of allocation will create winners and losers. The EU developed a set of rules for allocation, based on previous outputs of the airlines, with an attempt to ensure that there were some incentives for airlines to reduce their pre-scheme CO, emissions. Not all the free allowances were allocated to existing airlines — there has been some provision for new entrant airlines. Different business models of airlines were treated differently, and the worst off were regional airlines with short flights. As with all systems of allocation of valuable resources, there have been disputes about the allocations, though these have been moderate (see the chapter by Morrell in this volume).

The other important question concerns how the airlines will behave when granted free, but quite valuable permits - will they pass on opportunity costs to their passengers and profit from the free permits, or will they base their fares on actual payments only?

Take the case of non-free permits first. How would an airline offering a fare on 100 Euro respond to a 5 Euro tax or permit price? In a competitive market, it may not pass on the whole 5 Euro in the short run, though it is likely to pass on the whole amount soon. If the airline market is monopolist or oligopolistic, it may not pass on the whole 5 Euro (see Section 8). Full pass through need not occur when the airline market is constrained by airport slots or regulatory limits on capacity.

It is far from clear how airlines will behave if they are given free permits. Suppose that, on this flight, the airline requires five permits (valued at 5 Euro) but receives four of them free. How will it respond? If it sets its price according to its costs, it will raise the fare by 1 Euro - even though it requires five permits, it will pass on the benefits of the free permits to its passengers.

Alternatively, it may behave in a profit-maximising manner. The opportunity' cost of the permits is 5 Euro, even though it gains four of them free.The average cost of the flight is 101 Euro, but the marginal cost is 105 Euro. Under competition, the profit-maximising fare for the flight will be 105 Euro. If all airlines behave as profit maximisers, fares for this route will rise to 105 Euro, and airlines will gain profits to the value of the free permits they receive. However, demand will drop due to the increased fare, which will probably lead to further changes in the markets.

Most of the discussions of airline behaviour in the context of the EU ETS assume that airlines will behave as average cost fare setters (e.g., see Scheelhaase and Grimme,2007). In this case, fares will rise only' to the extent that airlines need to pay for the permits they use. Indeed, the airlines themselves are saying that they will raise their fares only' as needed to buy permits. In a competitive market, it is difficult for one firm to raise fares if all around, its competitors are keeping fares low. However, one should not necessarily assume that this is the whole story.

Suppose that airline products are not perfect substitutes, and airlines have some discretion over the fares they charge. An airline will be aware of themarginal cost of its services. It will have an incentive to reduce services and sell off the permits if the fare it is receiving is less than the marginal cost of the flight.The airlines behaviour under the ETS under (partly) free permits will be an interesting test case of the profit-maximising assumption. At least for the next few years, there will be a big difference between profit maximising prices and prices set at cost (especially in the EU case if allowance prices remain at around 25 Euro per tonne). Cost-based pricing will cost the airlines a lot -especially in that airlines are not a ver}' profitable industry. Will airlines be able to convert free permits into profits, or will they be too competitive to do so? If they do, there may be a problem of rent seeking developing over time (see Flues and van Dender, 2017).

An ETS has an effect on emissions from both the direct and supply side. There is a constraint on emissions which, regardless of the elasticity of demand, has an effect of reducing emissions. An ETS also gives the airlines an incentive to reduce emissions through the supply side. Creating emissions is costly for airlines, and they gain by developing ways, such as through improved engines, to lower emissions.

A further aspect of the airlines’ behaviour (whether airlines set their price at average cost or opportunity/marginal cost) needs to be recognized. Some commentators have expressed concern that free permits or subsidised permits sold at lower than the market price lead airlines to respond too little to the ETS, and that if the airlines were required to pay the full price for their permits, they would reduce emissions more (see Hemmings et al. in this volume).

However, an ETS works by setting a fixed limit on emissions — this will stay the same no matter how the industries and airlines act. Different airlines may respond differently to the imposition of the limit, but overall, airlines will generate the same total of emissions. If trading of permits is not permitted, each industry will be required to keep to the emissions cap, including air transport. When trading is permitted, whether firms set prices at average cost or oppor-tunity/marginal cost will be irrelevant for the total emissions generated of CO,. The firms’behaviour can make a difference as to the allocation of emissions and a difference to the amounts of permits traded, and possibly the direction of the trade, but not the total amount of emissions of CO,. If airlines behave as profit maximisers, the price of air travel will be higher, and the emissions from air transport will be lower, than if the airlines only cover cost, and emissions from air transport will be higher (and emissions from other industries correspondingly lower).Total emissions of CO, will be the same, though total emissions of non-CO, gases are likely to be higher if air transport emits more of these than other industries.