Theory and Empirical Evidence for Carbon Cost Pass-Through to Energy Prices

Simulation models of emissions trading performance are generally based on the assumption that carbon prices are fully (or almost fully) passed through to energy prices (with pass-through rates equal or very close to one). Unfortunately, empirical analyses of wholesale electricity spot markets do not confirm this simple rule. Pass-through rates can be much lower or much higher than one and can sharply vary over time or across countries and markets. In several cases, such rates are not significantly different from zero and can even be negative. Until now, only a few authors have tried to offer a theoretical justification for the divergence between the assumptions used in simulation models and the results of empirical evidence. The main finding of these theoretical studies is that, when the characteristics of specific energy markets (e.g., organization, vertical and horizontal structure, technology mix, firms’ strategies) are adequately taken into account, the existence and degree of imperfect competition can explain why pass-through rates can vary widely and can even assume negative values. Therefore, if the models carried out to estimate the performance and costs of environmental policies are used to support policy decisions, ignoring the role of imperfect competition and the characteristics of energy markets may induce significant distortions in estimations of the impact of public action and may lead to incorrect policy calibration.