An important feature in the design of an emissions trading program is how emission allowances are initially distributed into the market. The choice between an auction and free allocation should, according to economic theory, not have any influence on the firms’ production choices nor on consumer prices. However, many observers are still incredulous that firms should be expected to raise product prices to include the value of emissions allowances they receive for free.
Throughout much of Europe and the U.S., energy markets have been deregulated or are in the process of moving toward market liberalization. If market behavior does not conform to predictions of behavior in a competitive market, this may say a great deal about the nature of market liberalization in energy markets as well as about the behavior of environmental markets. If firms are able to voluntarily moderate commodity prices to be below competitive levels, it suggests an ability of these entities to exercise market power or collude - even if this is motivated by a desire to hold back and not pass through the value of emissions allowances in product prices.
This paper reports on the use of experimental methods to investigate behavior with respect to how prices will be determined under a cap-and-trade program. We find participants in the experiments employ various approaches. Some participants initially recognize the opportunity cost of emission allowances and included them in their economic choices regardless of how the allowances have been obtained, and other subjects initially do not. However, given a simple economic setting in which pay-offs depend on this behavior, we find that subjects learn to consider the value of allowances and overall behavior moves toward that predicted by economic theory.
The observations from the experiments may help to understand the ongoing public debate over the interaction of the EU ETS and energy markets. Emission allowance markets are a new phenomenon to many politicians, firms and policy officials, and one which they are not used to dealing with. In addition, the deregulation of energy markets is a relatively new process and progress is not uniform across countries, resulting in markets in different stages of liberalization. When one considers this, it is not surprising that the public and political intuition of how markets ‘should’ work may diverge from economic theory, much in the same way as it initially did for the subjects in our experiments.
If the observation of ongoing learning is correct, there are grounds to be optimistic about the future development of the European energy system. On the other hand, there are proposals from important member states that energy customers be protected from price increases through re regulation of energy markets, for instance by limiting the level of pass-through of emission allowance costs. If such measures become widespread, the process toward a more integrated and competitive European energy market is under threat. It remains to be seen which route politicians choose to take.