Emission Costs in Electricity Markets: Who Pays the Bill?

In Europe, several sectors are subject to the carbon emissions regulation, requiring firms to cover their carbon emissions with emission permits. Who bears the costs of such permits? Is it firms, as they have to buy the permits? Or is it consumers, as firms pass on the costs of such permits to the prices of the final goods? Natalia Fabra (uc3m) and Mar Reguant (Northwestern) analyzed highly detailed, high-frequency data to shed light on this question in the context of the Spanish electricity market.

Natalia and Mar concluded that the pass-through rate of emissions costs to electricity prices is as high as 80% on average. This means that a one euro increase in emissions costs translates into an average increase in wholesale electricity prices of more than 80 cents, with firms bearing only a 20 per cent of the cost increase. They also found that firms are more able to pass-through costs during periods of high demand, when firms are not subject to dynamic cost considerations. In fact, the pass-through estimate goes up to 100 percent during peak times when the generating firms face no start-up costs.

Natalia and Mar analyzed whether the specificities of electricity markets contributed to such a high pass-through rate. Notably, electricity auctions are repeated on a daily basis, giving firms flexibility to modify their bids as frequently as cost conditions change. Furthermore, firms are subject to similar cost shocks as their technology portfolios are similar. Together with the high degree of demand inelasticity, these features allow firms to add their emissions costs to their bids without losing production.

During the period that Natalia and Mar analyzed, firms received the emissions permits for free. Theory predicts that firms should internalize the opportunity costs of the permits, even if given for free, as permits can be resold in the emissions market. Interestingly, the empirical analysis confirms that this was indeed the case. Therefore, the emissions regulations implied no costs for firms, but rather a windfall profit of 80 per cent of the emissions costs due to the price pass-through. Natalia and Mar concluded that it is paramount to face firms with emissions costs but it is equally important to rely on good market design to avoid that emissions regulations result in large transfers from consumers to firms.

This article was published at the American Economic Review in 2014, and it was highlighted at the NBER Digest, as well as at Nature Climate Change.

Fabra, Natalia, and Mar Reguant. 2014. “Pass-Through of Emissions Costs in Electricity Markets.” American Economic Review, 104(9): 2872-99.