Pass-Through of Emissions Charges in Electricity Markets

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...the average pass-through in this market is over 80 percent...

In Pass-through of Emissions Costs in Electricity Markets (NBER Working Paper No. 19613), Natalia Fabra and Mar Reguant analyze the Spanish wholesale electricity market before and after the European cap-and-trade program for carbon emissions was introduced. They find that the average pass-through in this market is over 80 percent, implying that a one euro increase in emissions costs translates into an average increase in wholesale electricity prices of more than 80 cents. They also find that firms are more able to pass through costs during periods of high demand. In fact, the pass-through estimate goes up from an average 80 percent to 100 percent during peak times when the generating firms supplying electricity face no start-up costs.

The availability of high-frequency and highly disaggregated data makes electricity markets an attractive setting for studying pass-through. Because electricity markets are organized as auctions, it is possible to observe not only market clearing prices and quantities but also hourly demand and supply schedules. It is also possible to construct reliable engineering-based marginal cost estimates for production, given that the electricity production function is well known and that fossil fuels are traded in international markets with readily observable prices. In addition, marginal emissions costs can be measured very accurately since they depend on the carbon price and on the emissions rate of the price-setting unit, whose identity is revealed by bids. This institutional setting makes it possible to analyze how cost shocks induced by changes in carbon prices are passed through to prices.

The high pass-through rate that the authors find can be explained by three facts. First, electricity is traded through high-frequency auctions in which many buyers have very inelastic demand. Second, cost shocks are highly correlated across firms. Third, the costs of price adjustment are very small, which means that it costs electricity producers very little to alter their prices to pass on cost increases from emissions charges.

The institutional features of electricity markets also allow the authors to separately estimate how firms incorporate cost shocks into their strategic behavior. They find that firms fully internalize the carbon price as the relevant opportunity cost of using permits despite the fact that these were allocated for free. This suggests that auctioning of permits should not result in inflationary effects on prices, at least in the short run.

Electricity generators earned substantial profits from enactment of the carbon trading program because they were able to raise wholesale prices to cover the cost of permits and they received a free endowment of permits. This generated substantial political controversy, which provides a reminder of the importance of considering distributional effects when designing environmental policies.

--Matt Nesvisky