Climate Change Policy and Its Effect on Market Power in the Gas Market

Abstract

The European Emissions Trading Scheme (ETS) limits CO2 emissions from covered sectors, especially electricity (accounting for about 56%). At 44 billion per annum. the ETS is the largestemissionstradingsystemever,40timeslargerthanUSprogrammes.Thearticledemonstrates that fixing the quantity rather than the price of carbon reduces the price elasticity of demand for gas appreciably, amplifying the market power of gas suppliers, and amplifying the impact of gas price increases on the electricity price. A rough estimate using British data suggests that this could increase the Lerner Index by 50%. (JEL: Q54, Q58, L94) The European Union has agreed upon the European Emissions Trading Scheme (ETS) as its principle means of reducing emissions of the main greenhouse gas (GHG), carbon dioxide, CO2. The ETS fixes the quantity of CO2 that can be emitted from the covered sector, and can be contrasted with the alternative (and as argued herein, preferable) policy of taxing or setting a charge for the release of CO2. More than half (56%) of emissions from the covered sector come from the electricity supply industry (ESI; i.e., electricity generation), and in the EU in 2004, 31% of electricity was generated from coal, and 19% from gas. Nuclear, hydro, and renewables—all zero-carbon sources—accounted for 46% of total generation (IEA 2006, p. 507). For the EU-15 the share of gas is higher (at 21%) and of coal lower (at 27%). The zero carbon generation is inelastically supplied over the course of the year, as it has very low variable costs, but coal, which is very carbon-intensive, competes with gas-fired generation, which has half or less of coal’s carbon intensity.