Emissions Trading in Forward and Spot Markets of Electricity
Makoto Tanaka, National Graduate Institute for Policy Studies (GRIPS), +81-3-6439-6178,
Overview
There has been a growing concern about emissions trading scheme, i.e., cap and trade system such as European Emission Trading Scheme (EU-ET). Specifically, an emerging issue has been the interaction between oligopolistic electricity markets and emissions allowances markets. For example, Chen and Hobbs (2005) examine the complementarity approach to simulate the interaction of emissions allowances markets with electricity markets, using a conjectural variation model for the permits market. Chen et al. (2006) consider a Stackelberg game in which the largest producer can manipulate both electricity and emissions allowances markets. Fowlie (2009) investigates two-period forward and spot markets of electricity with emissions leakage, where allowances price is determined exogenously. However, as far as the author knows, two-period model in which allowances price is determined endogenously has not been fully developed. The current paper develops an endogenous model to analyze the interaction of emissions allowances markets with forward and spot markets of electricity under the framework of oligopolistic competition. How will Cournot firms use forward contract? Will initial allocation of allowances have effects on efficiency? We will address such questions in this paper.
The paper is organised as follows: In Section 2, we present a two-period model with endogenous pollution allowances trading. In Section 3, we consider a stylized numerical example to illustrate the interaction of emissions allowances markets with forward and spot markets of electricity. Section 4 summarizes our results.
Methods
Allaz and Vila (1993) show that a Cournot duopolist has a strategic incentive to trade forward, seeking for the first mover advantage. However, when both do so, a prisoner’s dilemma makes them worse off. Bushnell (2007) examines a two-period Cournot model with multiple symmetric firms and simulates the PJM market under the symmetric assumption. Su (2007) proves the existence of two-period market equilibrium in the more general case.
We extend the two-period models by Allaz and Vila (1993) and Bushnell (2007) to incorporate emissions allowances trading. Allowances price is determined endogenously
Ø First period: forward contract.
Ø Second period: spot transaction and allowances trading
The maximization problem of each firm in the first period is expressed as Mathematical Program with Equilibrium Constraints (MPEC). Then, we can define Equilibrium Problem with Equilibrium Constraints (EPEC) as the collection of all Karush-Kuhn-Tucker (KKT) conditions and solve it numerically using PATH (Dirkse and Ferris, 1995).
Results
We consider a stylized numerical example with two asymmetric firms:
Ø Firm 1: marginal cost of generation is high, but CO2 emission rate is low (e.g. natural gas-fired power plants).
Ø Firm 2: marginal cost of generation is low, but CO2 emission rate is high (e.g. coal-fired power plants).
Three cases are comparered:
Ø Base Case: forward and spot markets without allowances trading.
Ø Case 1: initial allowances are allocated in proportion to historical emissions (grandfathering).
Ø Case 2: initial allocation of allowances is not exactly proportional to historical emissions; initial allowances of Firm 1 are increased compared to Case 1, while initial allowances of Firm 2 are decreased compared to Case 1; total initial allowances and hence total emissions in Case 2 remain the same as in Case 1.
In Case 2, Firm 1 who has a low emission rate increases power supply, while Firm 2 who has a high emission rate decreases power supply. Thus, total power supply is greater in Case 2 than in Case 1 even though total emissions are the same in both cases. As a result, power price is lower in Case 2 than in Case 1.
In Case 2, Firm 1 whose marginal cost of generation is high increases power supply, while Firm 2 whose marginal cost of generation is low decreases power supply. Thus, social cost of generation is greater in Case 2 than in Case 1. However, social benefit from power consumption is greater in Case 2 than in Case 1. In total, social surplus is greater in Case 2 than in Case 1.
We find that initial allocation of allowances would have effects on efficiency under the framework of oligopolistic competition. Changing initial allocation of allowances would improve efficiency, increasing power supply and decreasing power prices.
Conclusions
We have developed EPEC model to analyze the interaction of emissions allowances markets with forward and spot markets of electricity under the framework of Cournot competition. Some numerical experiences show that changing initial allocation of allowances may improve efficiency, increasing power supply and decreasing power prices.
References
Allaz, B., and J. L. Vila (1993) “Cournot Competition, Forward Markets and Efficiency,” Journal of Economic Theory 53(1), 1-16.
Bushnell J. B. (2007) “Oligopoly Equilibria in Electricity Contract Markets,” Journal of Regulatory Economics 32(3), 225-245.
Chen, Y., and B. F. Hobbs (2005) “An oligopolistic power market model with tradable NOx permits,” IEEE Transactions on Power Systems 20(1), 119-129.
Chen, Y., B. F. Hobbs, T. Munson, and S. Leyffer (2006) “Leader-Follower Equilibria for Electric Power and NOx Allowances Markets,” Computational Management Science 3(4), 307-330.
Dirkse, S. P., and M. C. Ferris (1995) “The PATH Solver: A Non-Monotone Stabilization Scheme for Mixed Complementarity Problems,” Optimization Methods and Software 5, 123-156.
Fowlie, M. (2009) “Incomplete Environmental Regulation, Imperfect Competition, and Emissions Leakage,” forthcoming in American Economic Journal: Economic Policy.
Su, C. L. (2007) “Analysis on the Forward Market Equilibrium Model,” Operations Research Letters 35, 74-82.