OverviewIn the fight against climate change, the EU and many countries/regions around the world have established policies in order to reduce CO_2 emissions levels. For the EU, the guiding principle was laid out in 2007 under the EU 20-20-20 1 stipulating that, by 2020, EU as whole will lead a 20% reduction in CO_2 emissions compared to 1990 levels, 20% of the energy consumption from renewables, and 20% increase in energy efficiency. Well into reaching its goals for 2020, policymakers are expecting a continuation of CO_2 emissions reduction from electricity generating facilities through the Emissions Trading Scheme (ETS). Since its second phase, the ETS assigns emissions allowances. The allowances can then be traded on regulated exchanges for compliance purposes.The EU is projected to achieve its goal for 2020, partially because of an economic downturn that has reduced electricity demand and the price of CO_2 emissions allowances. However, one concern that might undermine the effectiveness of ETS is that there are some EU member states that are located on the periphery of the ETS who might be exposed to the risk of carbon leakage. In current context, carbon leakage is defined as the situation in which the reduction in emissions in the ETS region is partially offset by an increase in carbon emissions in the non-ETS regions. So far, carbon leakage has been showed in the context of a two-node stylised example2 as a result of the introduction of carbon tax. On a more realistic scale, levels of carbon leakage have been compared under different allowance allocation schemes in the California market3. To the best of our knowledge, carbon leakage on the periphery of the ETS in power markets has not yet been addressed. Thus, further analysis to address this concern is essential to safeguard the effectiveness of ETS. We apply a bottom-up partial equilibrium framework to study the extent of emissions leakage in South-East Europe using South Eastern European Regional Electricity Market (SEE-REM). In addition to emissions leakage, we also address the impact in terms of generation, transmission flows, electricity prices, CO_2 allowances, and social welfare.MethodsSEE-REM is a bottom-up model based on game theory where following market players are considered: producers, consumers, and a transmission system operator (TSO). Such models can be implemented computationally both as a single optimisation problem and by formulating it as a complementarity4 problem where each entity’s optimisation is addressed separately.Producers are modelled as perfectly competitive. Each producer owns a number of generating units, located in different locations that are characterised by their marginal costs of production and CO_2 emissions rates based on different technologies. Moreover, each producer’s objective is to maximise its profit and subject to a number of constraints related to maximum generation capacity and energy balance. Consumers are represented by the inverse demand function at each node, which could be viewed as the results from solving their utility-maximisation problem. The TSO’s profit is given by charging the wheeling fee (transmission) for the power transmitted through the grid. In a sense, it maximises the scarce transmission resources. The TSO’s optimisation problem is constrained by the maximum transmission capacity on the lines and Kirchhoff’s laws. The flows on the lines are modelled using the DC load flow approximation. Finally, the electricity market is cleared by mass-balance at each location, i.e., equating the difference between sales and generation at a node with imports to that node. The price of CO_2 emissions is exogenous, and it affects the producers through their marginal cost of production.We consider nine scenarios by varying a combination of CO_2 prices and hydropower availability. Of these nine scenarios, one is the baseline scenario (price of allowances is equal to zero) that we use for the purpose of calibration to 2013 actual market data. Two scenarios correspond to two different prices of allowances (€30/ton and €40/ton), two scenarios consider two different levels of hydropower production (based on data from wet and dry years and price of allowances equal to zero), and the final four scenarios are the interaction between different prices of CO_2 allowances and hydropower production levels.ResultsIn the table above, we present main results related to emissions and carbon leakage in different scenarios. Wehave three types of water years, viz., wet, dry, and normal, with six levels of CO_2 permit prices (€0-50/ton). Our analysisdecomposes the CO_2 reduction into three categories: demand response, fuel switching, and increase in imports from thenon-regulated area. The emissions associated with the increased imports are what determines the level of carbon leakage,which is defined as follows:CL=e_(New)~(Non-ETS)-e_(Base)~(Non-ETS)/e_(Bace)~(ETS)+e_(Base)~(Non-ETS) (1)where e is emissions, the superscript indicates the area of SEE-REM, and the subscript the scenario.Introduction of allowance prices translates into a higher cost of generation for the producers in the ETS area,thereby leading to higher electricity prices. Higher electricity prices in the ETS area suppress power demand and induceincreased imports from the non-ETS area. The latter is due to the fact that higher ETS-region electricity prices offereconomic incentives for non-ETS producers to increase their exports while, at the same time, driving up domestic prices.For example, a price of €10/ton causes a reduction of emissions by 15% in the ETS area and an increase in emissions of29% in the non-ETS area, effectively offsetting ETS emissions reduction by 5.64%. Furthermore, a detailed analysisindicates that associated with, for example, an allowance price of €30/ton scenario, prices in Macedonia increase from€21.19/MWh to €23.71/MWh on average throughout the year.As for the decomposition of CO_2 reduction, the inclusion of allowances prices might also change the merit-ordercurve, thereby leading to fuel switching. In fact, we notice an increase in low-carbon technology generation in the ETSarea (e.g. natural gas) and a reduction of high-carbon technology generation (e.g. coal). Regarding the variation ofhydropower production levels, as expected, emissions are higher in the dry year and lower in the wet year. This isparticularly noticeable in the non-ETS area where most of the countries have a large proportion of hydropower in theirgeneration mix.In relation to the interaction between CO_2 allowances prices and levels of hydropower production, we have twomain observations. First, total ETS and non-ETS emissions are lower in the wet year and higher in the dry year comparedto the baseline, yet carbon leakage in both the wet and the dry year is higher than the baseline. Higher carbon leakage inthe dry year is expected due to lower availability of domestic low-polluting sources in the ETS. Higher carbon leakage inthe wet year could be due to a lower demand for conventional thermal power in the hydro-rich non-ETS countries. This,in turn, renders more capacity available for export. Second, increasing the price of CO_2 allowances leads to a slightdecrease in leakage, which can be explained by demand response to higher domestic electricity prices in the non-ETSarea.ConclusionsThrough the analysis of the SEE-REM, we conclude that implementation of ETS might face two mainchallenges: carbon leakage and an increase in electricity prices in some non-ETS countries. The former suggests that thepolicy currently in place in the EU might overlook the emissions that might be produced as a result of increased importsby the ETS countries on the periphery of the ETS from countries with less strict CO_2 emissions reduction policies. Thiscan have an effect on the competitiveness of the producers in ETS member countries on the periphery of the ETS andundermine EU targets for CO_2 emissions reduction. The latter suggests that the current policy can have undesirableoutcomes for the consumers in the non-ETS countries due to higher domestic electricity prices while non-ETS producerswould experience an increase in their profits due to higher power prices as well as exports.
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