Opportunity Costs and Pass-through of Emission Costs

Abstract

We analyze the response of firms to the introduction of emissions permits in the Spanish electricity market. While previous papers have focused on assessing the pass-through of emission costs to electricity prices, there is still little evidence on how firms incorporate these costs in their output or pricing decisions. If there are significant frictions in the market, the emissions price might not be reflective of the opportunity cost of the permits, which could bias pass-through estimates. We proceed in two steps. First, we hypothesize and test that the emissions market price is the opportunity costs perceived by the firms. Second, we decompose the other channels that might affect the pass-through, such as demand response, market power and heterogeneity of cost shocks. Results are consistent with the price of the emissions as being reflective of the opportunity cost of the free permits. We also find incomplete pass-through of emission costs and pass-through distributions consistent with cleaner generators substituting dirtier ones at the margin.

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