The interaction between emissions trading and energy and competition policies

Abstract

Emissions trading is a “cap and trade” regulation aimed at reducing the cost of meeting environmental targets. This paper studies how this regulation interacts with energy and competition policies. Two vertically related and imperfectly competitive markets are investigated: 1) the electricity market (output market); 2) the market for natural gas (input market). The effect of energy policy is simulated by assuming that the supporting scheme is able to improve the competitiveness of the low carbon technologies which are able, at the same time, to increase security of supply. The effect of the competition policy is accounted for by assuming that firms try to meet a profit target rather than to maximize profits, because of the regulatory pressure exerted by the competition and sector-specific authorities. By using the dominant firm model (in both markets) and the auction approach (in the output market), the paper highlights a trade-off between these policies. Without regulatory pressure, the result is ambiguous. Together, environmental and energy policies can lead to an increase in market power and its effects, but this in turn not necessarily amplifies their performances. However the worst case, the absolute increase in pollution in the short-run, is excluded. With regulatory pressure, the environmental and energy policies may imply a decrease in market power and this in turn can lessen their performance. In addition, this time the absolute increase in pollution in the short-run is not only possible but even likely. However this unfavourable effect would happen only if the pollution price is sufficiently low, that is if the environmental policy is rather modest. From the policy implications point of view, the analysis suggests what follows. If the models used to estimate performances and costs of environmental and energy policies ignore the full role of imperfect competition (the impact on prices combined with the strategic use of power capacity), this may induce incorrect estimations of the cost of the public action or may lead to incorrect policy calibrations, depending on how the policy targets are set. Finally, although the results are based on a series of simple assumptions about the operation and the structure of energy markets, they seem to be enough robust. Nevertheless the paper suggests caution in extending to other market structures the outcome of the dominant firm model.