Emissions trading in regulated electricity markets

Abstract

ABSTRACT In theory, by establishing a price for greenhouse gas (GHG) emissions, an Emissions Trading System (ETS) promises to encourage a shift away from carbon-intensive electricity supply. It is generally assumed that this decarbonization effect requires the liberalization of electricity markets. However, amongst the more than 40 jurisdictions throughout the world that are now implementing, planning or considering an ETS to decarbonize electricity supply, few have adopted the electricity market liberalization textbook model. Economic agents are constrained in how they can respond to an ETS through various forms of electricity market regulation but, given the political sensitivity of electricity market reform and the urgency to decarbonize the electricity sector, it is unrealistic to advocate liberalization as a prerequisite to the introduction of an ETS. Building from regulatory theory on the design of electricity and environmental markets, we develop a conceptual framework to understand the interaction between ETS and electricity market regulation under different regulatory settings. Our analysis challenges the general assumption that the introduction of an ETS depends on electricity market liberalization. We argue that the ETS can be adjusted to the electricity market reality of many jurisdictions where governments limit price discovery, restrict price pass-through or place constraints on investment decisions, and discuss regulatory alternatives to address the efficiency losses that may emerge from specific forms of power sector regulation. Key policy insights Although an ETS will be most effective when it is implemented within a liberalized and competitive electricity market, it can also be introduced in a regulated electricity market environment, albeit with some efficiency losses. Where an ETS is implemented under power sector regulation, it is important to understand where barriers to mitigation exist, how much mitigation potential will be lost, and which other policies can target these areas of the economy. A proportion of the efficiency loss might be restored through innovative emissions trading policy design that overcomes the barriers to mitigation put in place through power sector regulation. This is a topic that deserves more academic research.