Effects of Allocation Method on Electricity Firm Behaviour in the EU ETS: Empirical Study Investigating the Effects of Auctioning versus Grandfathering on Germany’s Electricity Sector

Abstract

Being a key instrument in fulfilling compliance with the Kyoto-Protocol, the EU Emission Trading System has since its inception in 2005 undergone three phases1. Between phases, policymakers adjust initial allowance allocation methods from grandfather in the earlier two phases to auctioning in phase III. As the EU ETS represents a new effort with regards to market-based policy regulation, we investigate: Does allocation method within a cap and trade system matter for market dynamics? & Does such change market structure influence firm behaviour?
We find that market structure in terms of allocation method does influence firm behaviour. In line with previous research we find a positive carbon cost pass-through in phase II, yet no further pass through in phase III. This suggests, that market structure can correct some of the distributional rent2distortions introduced by grandfathering. On the other hand, we cannot find significant effects of allocation method on energy production in form of input fuel share in Phase III. However, Phase II suggests a rather unexpected response of a proportional increase in carbon intensive electricity production3to an increase in carbon prices, as opposed to no effects in phase III.
These are important findings from a policy perspective. Our analysis suggests that system design, and hence policy interventions targeting system design are able to steer firm behaviour. Within the EU ETS the EU directive was successfully able to transfer the rents collected by energy generating firms in forms of auction revenue without making consumers worse off. It is up to member states to re-use these revenues to correct the distortions introduced by grandfathering.