Am. Econ. Rev. 104, 2872–2899 (2014)

Credit: ROSEMARY ROBERTS / ALAMY

The European Emissions Trading Scheme (ETS) is opposed by some owing to its likely effect on electricity bills, as the cost of emissions permits can be passed through to output prices. Lack of clarity about the extent and drivers of this pass-through may hinder ETS reform.

Natalia Fabra of Universidad Carlos III, Spain, and Mar Reguant of Stanford University, USA, analysed the effect of the European ETS in the Spanish electricity market. They constructed a data set of hourly electricity supply functions from Spanish producers over January 2004 to February 2006. They quantified the cost pass-through without imposing strong assumptions on the behaviour of electricity demand or supply due to the micro-level data used. They found an average pass-through above 80%. They also found that firms are more able to pass-through carbon costs in periods of high demand. This evidence demonstrates that power companies benefitted both from the allocation of free permits and from the increase in electricity prices. The expectations of rising electricity bills following a tighter ETS could be attenuated only if these gains are avoided through good market design.