Markets for Carbon and Power Pricing in Europe

Markets for Carbon and Power Pricing in Europe

Theoretical Issues and Empirical Analyses

New Horizons in Environmental Economics series

Edited by Francesco Gullì

Why do power prices seem to be correlated with the carbon price in some markets and not in others? This crucial question is at the centre of Francesco Gullì’s enlightening book, through which the contributing authors investigate a number of related issues. In particular, they explore why power firms are not consistent in passing-through into power prices the opportunity cost of carbon. They also examine the relationship between the pass-through mechanism and the structure of the power market.

Chapter 6: A Vector Error Correction Model of the Interactions Among Gas, Electricity and Carbon Prices: An Application to the Cases of Germany and the United Kingdom

Derek W. Bunn and Carlo Fezzi

Subjects: economics and finance, energy economics, environmental economics, environment, environmental economics


Derek W. Bunn and Carlo Fezzi INTRODUCTION 6.1 The European Emissions Trading Scheme (EU ETS), started on 1 January 2005, has been a substantial initiative of the European Union (EU) to fulfil its carbon abatement targets following the Kyoto Protocol. According to the ETS directive (European Commission, 2003), tradable allowances are allocated to industrial emitters of carbon dioxide, specifying the amount of CO2 they can emit each year. Since companies are allowed to trade permits freely with one another within the EU, the scheme should ensure not only that overall emissions are reduced, but also that the cuts are made by those firms that provide lower abatement costs. Therefore, the economic impact of reducing CO2 emissions should be minimized. Prior to the emergence of actual evidence from carbon trading in practice, extensive theoretical and simulation analyses have speculated upon its effects, in particular on the energy sector (for example, Böhringer, 2002; Barreto and Kypreos, 2004; Böhringer and Lange, 2005). Although capable of providing normative and policy insights, these theoretical models are not appropriate for explaining carbon price dynamics on a daily basis. Indeed, as soon as the first market data became available, empirical, econometric models were developed to explain CO2 price behaviour. For example, Mansanet-Bataller et al. (2007), using several regression models, identify weather and energy price variables (in particular oil price) as the main determinants of CO2 price changes during 2005. However, their analysis does not provide a complete picture of the interactions between energy...

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