Pass-Through of Emissions Costs in Electricity Markets

Abstract

We measure the pass-through of emissions costs to electricity prices. We perform both reduced-form and structural estimations based on optimal bidding in this market. Using rich micro-level data, we estimate the channels affecting pass-through in a flexible manner, with minimal functional form assumptions. Contrary to many studies in the general pass-through literature, we find that emissions costs are almost fully passed through to electricity prices. Since electricity is traded through high-frequency auctions for highly inelastic demand, firms have weak incentives to adjust markups after the cost shock. Furthermore, the costs of price adjustment are small. (JEL D44, L11, L94, L98, Q52, Q54)

Opportunity Cost Pass‐Through from Fossil Fuel Market Prices to Procurement Costs of the U.S. Power Producers

“…Our finding suggests that for coal fired power plants, coal spot prices are not a good measure of fuel procurement costs when measured at the month level. The results are consistent with Fabra and Reguant [] which finds that pass‐through for fuel prices is significantly noisier than those for emissions permits. This finding has implications on constructing counterfactual competitive supply curves commonly used in the static approach of measuring market power in the electricity market .…”

“…The result also provides evidence in support of the existing literature. Fabra and Reguant [] find that fossil fuel price pass‐through estimates to wholesale electricity prices are noisily estimated relative to pollution permit prices. The authors argue that fuel market spot prices may be an imperfect proxy for power plants’ true costs.…”

“…Measuring bidding behavior response by the marginal generating unit to changes in its marginal costs (e.g., fluctuations of fossil fuel procurement costs) is challenging because a firm's optimal bidding behavior depends not only on fossil fuel price shocks, but also on the strategic adjustment of markups (Wolfram []; Borenstein et al . []; Hortacsu and Puller []; Fabra and Reguant []). These strategic incentives are likely to change with market conditions.…”

“…[]) and the electric power industry (Zachmann and Von Hirschhausen []; Fell []; Fell et al . []; Fabra and Reguant []). The energy sector is particularly important because both households and firms budget for energy expenditures, which account for roughly 5% of GDP…”

“…Our results are robust to both controlling for coal characteristics explicitly and estimating separate regressions for coal originating in different U.S. regions. Second, a mismatch between observed cost shocks and a firm's actual opportunity costs could be an issue (Nakamura and Zerom []; Fabra and Reguant []). Our use of EIA's propriety fuel cost data makes this less of a concern since we use actual purchase data.…”