Non-linear Pass-Through of the CO2 Emission-Allowance Price onto Wholesale Electricity Prices

This article considers the evidence for threshold effects in the relationship between electricity and emission-permit prices in France and Germany during the second phase of the EU ETS. Specifically, we compare linear and non-linear threshold models of electricity prices using the sample-splitting and threshold estimation approach in Hansen (Econometrica, 64 575–603 2000). We find evidence of non-linear threshold effects in both countries. The estimated carbon-price thresholds are 14.94€ and 12.57€ in France and Germany respectively. The carbon-price threshold in France perfectly matches the well-known carbon spot-price structural break of October 2008. This is not the case for the carbon-price threshold in Germany. Further analysis reveals that carbon prices before October 2008 were not reflected in electricity prices in either country. This is mainly due to uncertainty about the future of the EU ETS that led electricity producers to adopt a wait-and-see attitude. After October 2008, French electricity producers passed the price of emission permits through to electricity prices in a linear way, while their German counterparts did so non-linearly. Finally, we suggest improvements to the design of the EU ETS. Our recommendations are to strengthen the price signal to make it more clear and reliable and provide sufficient incentives for energy transition.