EPRG 0617

Jos Sijm, Karsten Neuhoff, Yihsu Chen

CO2 Cost Pass Through and Windfall Profits in the Power Sector

EPRG 0617 Non-Technical Summary | PDF

Also published in:

• Sijm, J., Neuhoff, K. and Chen, Y. (2006) “CO2 Cost Pass Through and Windfall Profits in the Power Sector”, Climate Policy 6(1)

Abstract: In order to cover their CO2 emissions, power companies receive most of the required EU ETS allowances for free. In line with economic theory, these companies pass on the costs of these allowances to the price of electricity. This paper analyses the implications of the EU ETS for the power sector, notably the impact of free allocation of CO2 emission allowances on the price of electricity and the profitability of power generation. Besides some theoretical reflections, the paper presents empirical and model estimates of CO2 cost pass through, indicating that pass through rates vary between 40 and 100 percent of CO2 costs, or – in absolute terms – between 3 and 18 €/MWh, depending on the carbon intensity of the marginal production unit and other, market or technology specific factors concerned. As a result, power companies realise substantial windfall profits, indicated by empirical and model estimates presented in the paper. In order to avoid these windfall profits, the paper concludes that free allocation to power companies should be phased out in favour of auctioning.

Keywords: Emissions trading, allocation, CO2 cost pass through, windfall profits, power sector