EU-ETS and Nordic Electricity: A CVAR Analysis

A cointegrated vector autoregressive (CVAR) model is estimated to determine the dynamic relationship between Nordic wholesale electricity prices and EU emissions trading scheme (EU-ETS)CO2 allowance prices. An impulse response analysis reveals that electricity prices have large short-term responses to CO2 price shocks, but that this response dampens over time. Using hourly Nordic electricity spot market prices, I find that the value of short-term response of electricity prices to a shock in CO2prices in off-peak hours is consistent with expected values for near complete pass-through of CO2 emission costs when coal-generated power is at the margin. Likewise, the estimates reveal that peak hourelectricity price responses to CO2 price shocks are as expected for a market that has near complete passthrough of CO2 emission costs when natural gas-generated power is at the margin. These results further suggest the Nordic electricity market is pricing as a competitive market.

In a paper examining recent electricity price trends in the Nordic region of Denmark, Finland, Norway, and Sweden, RFF Fellow Harrison Fell focuses on the influence of carbon pricing on electricity markets. The relationship between carbon dioxide (CO2) emissions permit prices and electricity prices has been of considerable interest in many political circles, particularly given the concern that permits given away freely could result in windfall profits for electricity generators.

Fell finds that the response of electricity prices to a price shock in CO2 emissions permits—known as EUAs—is consistent with near complete pass-through of CO2 emissions costs. “From a policy perspective, the estimated short-term responses of electricity prices to EUA price shocks suggest that the CO2 market has created a wealth transfer from electricity consumers to electricity producers,” Fell writes.

His conclusions are derived from a vector autoregressive model commonly used in the macroeconomic literature that estimates a relationship between Nordic region electricity prices, relevant fuel prices, and EUA prices. This region is particularly interesting to study due to its varied electricity generation technologies. Owing to this variety, Fell finds that the response of electricity prices to increases in EUA prices are higher at low electricity demand hours compared to high electricity demand periods. Such findings are consistent with the observation that the price-setting electricity generators in low demand periods tend to have higher CO2 emissions intensities than the price-setting generators in high demand periods.