Asymmetric Price Transmission in Supply Function Equilibrium, Carbon Prices and the German Electricity Spot Market

The purpose of this paper is to explore the behavioural background for an asymmetric pass-through of input prices at a power spot market. G. Zachmann and C. von Hirschhausen report empirical evidence for such an asymmetric effect of EU CO2 emission allowance prices on German electricity spot prices at the European Energy Exchange in Leipzig (EEX). Increasing carbon prices were followed by significant increases in power spot prices. Decreasing carbon prices, however, showed smaller and less significant inverse effects on power prices. The empirical study of Zachmann et al. provides no explanation for the reason of such an asymmetric reaction. The following article attempts to shed light on this open question. Usual results of microeconomic theory suggest that a cost shock should be passed through symmetrically, no matter if the market is monopolistic, oligopolistic or in perfect competition. Theoretical explanations for asymmetric price responses to external shocks in various markets mostly considered specific circumstances, such as search costs, menu costs or specific stock adjustment policies. At power spot markets, however, there are no stocks, no search or menu costs or any other relevant frictions. Firms compete by submitting supply functions and the price is fixed by the auctioneer. Thus, asymmetric price reactions must be due to asymmetric adjustments of the submitted functions. At EEX, these individual bids are not reported and strictly confidential. My argument to explain the asymmetric pass-through of emission allowance prices is that firms use the price signal as a coordinating mechanism. Through coordinated action, firms might increase their joint profits, but since cooperation among firms is illegal, coordination should work tacitly. An asymmetric transmission of input prices permits to jointly tighten the offer and thus to increase prices slightly and stepwise over time. Specific features of carbon prices qualify them best as an instrument for collusion: carbon prices are fluctuating and exactly determined every day. Moreover, emission allowances are an input to all fossil fuel _red plants (gas or coal), who typically determine the electricity spot price as the marginal plant. Another important point is about timing: emissions trading started in 2005. This gives a natural focal point for firms at what date the coordination of bids should start, and thus reduces the need for communication. The following article explores the incentive structure of such a coordinating mechanism in a stylised model of a spot market where two symmetric firms compete in supply functions. The results show, that firms under this setting always have an incentive to collude by asymmetrically submitting input cost shocks when they start from non-cooperation

Wölfing, Nikolas (2008), Asymmetric Price Transmission in Supply Function Equilibrium, Carbon Prices and the German Electricity Spot Market, ZEW Discussion Paper No. 08-040, Mannheim.