The impact of emissions trading on electricity spot market price behavior

Purpose ‐ Under the Kyoto protocol, emissions trading was imposed upon the Nordic Nord Pool Spot market in 2005. The purpose of this paper is to identify and characterize an important side-effect of emissions trading on electricity spot market price behavior by statistically comparing price behavior before and after emissions trading was introduced. Design/methodology/approach ‐ The analysis is based on an analysis of the skill of regression models in explaining price behavior before and after 2005. Findings ‐ It turns out that regression models based on background variables such as temperature, water reservoir levels, and even the price of emission rights themselves lose much of their skill from 2005 onwards. The histogram of the residual time series of an optimally calibrated regression model demonstrates a considerably more "fat-tailed" behavior after 2005, with a much higher volatility and reduced amenability for regression by background variables. Practical implications ‐ The results point to an increased medium- and long-term uncertainty in the Nordic electricity spot market, brought about by emissions trading as an unintended side-effect. It seems emissions trading has introduced a stronger "psychological" component into price behavior, increasing its volatility and making it prone to more frequent price spikes. This has made the electricity market more difficult for market managers and regulators to manage. Originality/value ‐ The paper presents the first statistical attempt to quantify the way electricity spot price dynamics have changed in Europe after starting the Emissions Trading Scheme based on the Kyoto protocol.