A Market Design Proposal for Decoupling Carbon and Electricity Prices

TL;DR

This paper proposes a market design modification in European electricity markets to reduce consumer costs by reallocating inframarginal rents from non-emitting generators through a threshold-based pricing mechanism.

Contribution

It introduces a novel settlement mechanism that adjusts payments for non-emitting generators when prices exceed a certain threshold, aiming to lower consumer expenditure.

Findings

Estimated 8.5% reduction in Austria's electricity expenditure in 2025.

Estimated 4.7% reduction in Germany's electricity expenditure in 2025.

Discusses incentives, interactions, and implementation aspects of the proposed mechanism.

Abstract

In European day-ahead electricity markets, carbon allowance costs passed through by marginal fossil plants raise consumer expenditure and generate inframarginal rents for non-emitting generators. We propose a settlement modification: when the zonal day-ahead price exceeds a threshold, non-emitting generation is remunerated at the clearing price minus a fixed CO2 proxy deduction, while all other units continue to receive the uniform price. The mechanism thus reallocates a part of the inframarginal rents to consumers. Using hourly data we estimate static average expenditure reductions of about 8.5% in Austria and 4.7% in Germany in 2025. We discuss bidding incentives around the threshold, interactions with Contracts for Difference, implementation in coupled bidding zones, and a gas-cost variant for the 2022 energy crisis.