Climate Policy

Climate Policy 6 (2006) 49–72

Research Article

CO2 cost pass-through and windfall profits in the power sector

Jos Sijm, Karsten Neuhoff and Yihsu Chen

In order to cover their CO₂ emissions, power companies receive most of the required EU ETS allowances for free. In line with economic theory, these companies pass on the costs of these allowances in the price of electricity. This article analyses the implications of the EU ETS for the power sector, notably the impact of free allocation of CO₂ emission allowances on the price of electricity and the profitability of power generation. As well as some theoretical reflections, the article presents empirical and model estimates of CO₂ cost pass-through for Germany and The Netherlands, indicating that pass-through rates vary between 60 and 100% of CO₂ costs, depending on the carbon intensity of the marginal production unit and various other market- or technology-specific factors. As a result, power companies realize substantial windfall profits, as indicated by the empirical and model estimates presented in the article.

Keywords: Emissions trading; Allocation; CO₂; cost pass-through; Windfall profits; Power sector

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