The impact of carbon trading on the electricity sector

This paper asks whether the European Union Emission Trading Scheme (EU ETS) provides economic incentives to reduce carbon emissions. If so, electricity producers should include the price of carbon in their cost functions. After identifying different sub-periods of the EU ETS during its pilot phase (2005-2007), we model day-ahead electricity prices in France and Germany and look at their volatility around the fundamentals white evaluating the correlation between electricity prices in the two countries. We find that electricity producers in both countries were constrained to include the carbon price in their cost functions during the first two years of the EU ETS. We also find evidence of fuel switching in electricity-generation in Germany after the collapse of the carbon market. Furthermore, the EU ETS has greatly contributed to the partial alignment of the wholesale price of electricity in France to that in Germany.