Pricing Strategies under Emissions Trading

ELFORSK Foreword Despite having had a deregulated electricity market in Sweden for over ten years we still need to increase our understanding as to how deregulated electricity markets actually work and how possible problems are to be solved. The electricity sector is key in greenhouse gas mitigation. Electricity generation accounts for roughly one-third of carbon dioxide emissions in the industrialized countries today and is expected to account for two-thirds of the emission reductions in the first few decades of climate policy regimes. Over the last few years, Europe has experienced significant price volatility in the electricity market. A substantial share of the variations in prices can be explained by the introduction of the EU ETS. This has led to calls for some sort of regulation to manage these variations. The research carried out in this project looks at aspects that are critical for the understanding of how an economically efficient and environmentally sound regulation may be designed. Elforsk (Electricity research) is owned by the Swedish electricity industry. Its' corporate business idea is to carry out research and development in line with the interests of the owner companies and carry out these research projects in cooperation with other parties on the market. The Market Design program was initiated in 2000 for the purpose of increasing the knowledge of how deregulated electricity markets work. More information on the program, our reports and current activities is available on program's website, www.marketdesign.se. ELFORSK Summary An important feature in the design of an emissions trading program is how emission allowances are initially distributed into the market. The choice between an auction and free allocation should, according to economic theory, not have any influence on the firms' production choices nor on consumer prices. However, many observers are still incredulous that firms should be expected to raise product prices to include the value of emissions allowances they receive for free. Throughout much of Europe and the U.S., energy markets have been deregulated or are in the process of moving toward market liberalization. If market behavior does not conform to predictions of behavior in a competitive market, this may say a great deal about the nature of market liberalization in energy markets as well as about the behavior of environmental markets. If firms are able to voluntarily moderate commodity prices to be below competitive levels, it suggests an ability of these entities to exercise market power or collude-even …