Emission trade and the electricity markets

European countries are introducing an emission trading scheme that, overall, may result in cost savings in CO2-abatement. Emission trading may have unintended consequences, however, in integrated electricity markets. In integrated markets, the price of electricity is determined by the marginal costs of the marginal producers, while all intra-marginal producers earn profits. Emission trade raises the costs of all producers who use fossil fuels. In the integrated Nordic electricity markets, the marginal producers are also the largest emitters of greenhouse gases, usually utilising coal-fired condensation plants, which in the short run are unlikely to be entirely be replaced by less carbon-intensive plants. As it is likely that much of the cost increase can be passed to prices, emission trade is likely to raise the market price of electricity in the integrated Nordic electricity markets. As a side effect, the profits of non-marginal producers are increased. This has been seen as a problem for several reasons. In the Nordic electricity market much of the emission-free capacity is based on fixed natural resources, particularly hydropower, which cannot be substantially increased. The price rises also raise the energy bill of all electricity users and may shift the burden excessively to consumers. Finally, the European emission trade scheme bases on grandfathering, which compensates even part of the cost increase of marginal producers. A number of remedies have been suggested to the excess profit problem. The current paper evaluates some alternative proposals to lower the costs of emission trading by taxing the profits of intra-marginal producers, by developing energy taxes in general, and by introducing an investment incentive mechanism financed by the revenues from profit taxes. The results indicate that an introduction of a pure CO2-tax would lower the costs of emission reductions at the macroeconomic level, and, provided the price of emission permits is high, an investment subsidy to emission-free technologies financed with the profit tax might also lower the overall costs of reductions.