Introducing CO2 Allowances, Higher Prices For All Consumers; Higher Revenues For Whom?

Abstract Introducing a ceiling on total carbon dioxide (CO2) emissions and allowing polluting industries to buy and sell permits to meet it (known as a cap-and-trade system) affects investment strategies, generation quantities, and prices in electricity markets. In this paper we analyze these effects under the assumption of perfect competition and make a comparison with another potential way of reducing CO2 emissions, namely a fixed carbon tax charged per unit emission. We deal with an energy only market and model it as a two-stage game where capacities are installed in the first stage and production takes place in the future spot market. For a stylized version of this model (with no network effects and deterministic demand), we show that at the equilibrium either one or a mixture of two technologies is used. Such a mixture consists of a relatively clean and a relatively dirty technology. In the absence of a ceiling on total emissions, marginal operating costs of different technologies form a fixed merit order; that is, the marginal costs are ordered in an ascending fashion. Based on the observed demand, this fixed merit order is used to determine the total number of technologies used so that all demand is satisfied. We show that, as long as there is enough capacity in the system, when a fixed maximum allowance level is introduced, different demand levels impose different prices for a unit of emission allowance, and consequently there is no fixed merit order on the technologies. Therefore, for different levels of observed demand one can find a different optimal mixture. We develop an algorithm for finding the induced optimal mixture in a systematic way. We show that the price of electricity and the price of allowances increase as the maximum allowance level decreases. When, in comparison, a fixed tax is charged for the emissions, the merit order is fixed for all demand levels and the first technology in the merit order is the only generating unit. By means of a numerical study, we consider a more general version of the model with stochastic demand and observe that a broader mixture of technologies is used to satisfy the uncertain demand. We show that if there is a shortage of transmission capacity in the system, only introducing financial incentives and instruments (such as taxation or a cap-and-trade system) neither is sufficient to curb CO2 levels nor 1 necessarily induces investment in cleaner technologies.