In order to comply with their commitments under the Kyoto Protocol, France and Germany participate to the European Union Emission Trading Scheme (EU ETS) which concerns predominantly electricity generation sectors. In this paper we seek to know if the EU ETS gives appropriate economic incentives for an efficient and strong system in line with Kyoto commitments. Because if so electricity producers in these countries should include the price of carbon in their costs functions. After identifying the different sub periods of the EU ETS during its pilot phase (2005-2007), we model the prices of various electricity contracts and look at their volatilities around their fundamentals while evaluating the correlation between the 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 operation of the EU ETS. During this period, German electricity producers were more constrained than their French conterparts and the inclusion of the carbon price in the cost function of electricity generation has been so much more stable in Germany than in France. Furthermore, the European market for emission allowances has increased the market power of the historical French electricity producer and has greatly contributed to the partial alignment of the wholesale price of electricity in France with those of Germany.
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