Drivers and pass-through of the EU ETS price: Evidence from the power sector

Despite low and volatile allowance prices observed between 2008 and 2018 within the European Union (EU) Emission Trading System (ETS), power generators' responses were by and large consistent with predictions of economic theory. We infer this in a number of steps. First by establishing that the qualitative response of the EU ETS allowance price to variations in the pre-eminent drivers of short-term fuel-switching, both the gas and coal price, is as economic theory prescribes. Second, we decompose allowance price returns and impute that allowance banking had value in helping generators smooth compliance costs. Third, we show that pass-through of allowance costs was (more than) complete in seven major European markets for both coal-and gas-fired power generation. Our inference on pass-through is novel in that we impute allowance cost pass-through by dispatch technology even when the merit-order curve is unobserved. Put together, our findings imply that even prior to the recent reform-induced price appreciation, the EU ETS was more functional than many observers recognized.

Automated summary

Despite low and volatile allowance prices, power generators' responses within the EU Emission Trading System (ETS) were consistent with economic theory. This is evidenced by the qualitative response of allowance prices to fuel prices, the value of allowance banking for compliance costs, and the complete pass-through of allowance costs in major European markets. These findings suggest that the EU ETS was more functional than previously recognized.