Profiting from Regulation: An Event Study of the EU Carbon Market

There is a long-standing perception of a fundamental conflict between the interests of business and environmental regulators. In many cases regulators apply policies that increase production costs, restrict production, or otherwise constrain the actions of firms. There is a rich literature chronicling the impacts that regulations such as the Clean Air Act have had on industrial activity. With greenhouse gas regulation a controversial subject in the United States and already under way in the European Union (EU), the question of the impacts of these regulations on industry has taken center stage. As countries and regions around the world develop policies for limiting greenhouse gas (GHG) emissions, there is an understandably great interest in how these policies will impact the competitiveness, productivity, and profitability of the industries to which they are applied.

Measuring the economic impacts of GHG regulations obviously has direct relevance to setting the levels and timings of the regulations. Even setting aside the specific goals for GHG reductions, information about the overall magnitude and distribution of economic impacts has importance for the policymaking process. This is most starkly true in the case of cap-and-trade mechanisms, which create valuable new property rights in the form of emissions allowances (or permits).

These permits constitute the “currency” of cap-and-trade markets. They also provide an important tool to policymakers for distributing the revenues collected by the carbon regulation. The process of allocating emissions allowances, while inevitably containing a strong element of political maneuvering, is usually driven by a desire to offset some of the cost impacts of the introduction of carbon regulation. Industries that claim to bear the brunt of the abatement costs usually stake the largest claim to allocations of allowances.

However, for most industrial enterprises, changes in direct abatement costs are only one piece of a complicated profitability puzzle. The introduction of a carbon dioxide (C O 2) price into an economy can have indirect impacts on firms that are not large C O 2 emitters. In most industries, increases in pollution prices will be reflected in output prices, and therefore revenues, as well as in costs. A more complete picture of these net impacts is necessary in any attempt to align allocations to the true economic impacts of C O 2 regulation on firms.

Indeed, the impact of regulations on profitability is ambiguous, even when those regulations have a substantial impact on costs. There are several mechanisms, ranging from restricting entry (e.g., Ryan 2012) to raising rivals’ costs (e.g., Puller 2006), through which revenue increases can outstrip cost increases thus enhancing profitability. With cap-and-trade regulations, the free allocation of emissions allowances adds an additional source of revenue. In the case of GHG markets, these assets can total hundreds of billions of dollars.

Despite the politically motivated tendency to award emissions allowances proportionally to emissions, several papers have concluded that this likely amounts to overcompensation of the affected industries. These papers use various simulation methodologies to forecast potential impacts of carbon taxes or caps. Bovenberg and Goulder (2001) and Goulder, Hafstead, and Dworsky (2010) utilize general equilibrium models to assess the likely impacts of a carbon tax and various cap-and-trade policies on a wide set of industries. Burtraw and Palmer (2008) simulate the US electricity sector under potential cap-and-trade scenarios. Smale et al. (2006) simulate several industries under a carbon cap in Europe using an assumption of Cournot competition. All these studies find that for many industries, compensation of less than 20 percent of emissions would offset the profitability impacts of regulation.

In this paper we study impacts on firms of the largest, in monetary terms, cap-and-trade market in the world—the EU’s Emissions Trading System (ETS) for C O 2. To date, this is the most significant effort by far at regulating C O 2 emissions in the world. As a role model for carbon cap-and-trade, the ETS has been closely scrutinized both within and outside the European Union. From the outset, the relative impact of the ETS on EU industries has been a controversial topic, one that has strongly influenced policies for the allocation of emissions allowances. During its first phase of operation from 2005 through 2007, the prices of emissions allowances in the EU market were quite volatile. While this volatility sparked criticism about the design and implementation of this phase of the market, we take advantage of it in order to examine the impact of C O 2 prices on firms.

Rather than attempting to directly untangle the many competing effects of the ETS on firms, we focus on the stock market valuations of publicly traded firms influenced by C O 2 regulation. Specifically, we examine the impact of a sharp devaluation in C O 2 prices in late April 2006 as an event study on the share prices of affected firms. Such an exercise can be interpreted in several ways. Under an assumption of fundamental market valuation, these prices should reflect the market’s expected discounted future profits of the firms. Even if one does not adhere to an assumption that the market fully reflects expectations of future profitability, the event provides a useful window into the beliefs of the market about the impacts of movements in C O 2 prices.

Our results imply that several industrial sectors benefited from the ETS rather than being hurt by the imposition of C O 2 regulation. Indeed, when C O 2 prices fell (a relaxation of regulation), the sharpest declines in equity prices occurred within industries that are the most carbon-intensive. In addition to raising costs, C O 2 regulation can “pass-through” to affect the prices of the goods sold and firm revenue. In some cases, unregulated or less-regulated firms in regulated industries may benefit from the regulation. The stock market response to the April event indicates that C O 2 prices play a significant role in determining product prices and revenues in many of these industries, and that this revenue effect may dominate costs for those industries.

We also examine the stock market price responses relative to a measure of European market exposure and find strong evidence that the benefits of higher C O 2 prices were concentrated among firms with the most exposure to markets within the EU.

Excerpt from the paper by James B. Bushnell, Howard Chong, and Erin T. Mansur published in the American Economic Journal in November 2013

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