Emissions trading and electricity sector regulation

With the Paris Agreement’s focus on domestic action to tackle climate change, emissions trading systems (ETSs) as a cost-effective instrument for emissions control are becoming more and more prominent. While in theory ETS offers a cost-effective tool to achieve emissions reduction targets, in practice, different forms of electricity sector regulation interact with emissions trading in ways that may challenge its effectiveness.

The paper, led by ICAP in cooperation with the International Institute for Sustainable Development (IISD) and Felix Matthes, explores the interaction between emissions trading and different forms of electricity sector regulation. The objective is to better understand what role an ETS might play under differing regulatory structures, and furthermore, understand the instances where regulation may create a barrier to emissions abatement.

In their examination, the authors develop a conceptual framework to understand the interaction between allowance prices and electricity prices under different power-sector regulation settings, from liberalized markets to highly regulated systems. The framework identifies where regulation might disrupt the proper functioning of an ETS and identifies options for restoring the mitigation incentive. Options to strengthen an ETS and overcome regulatory barriers as well as the role of companion policies are also discussed.