To meet its obligations to reduce greenhouse gas (GHG) concentration under the Kyoto Protocol, the European Union (EU) introduced the first cap-and-trade mechanism for carbon dioxide emissions in the world starting in 2005. Launched in 2005, the EU ETS works on cap-and-trade principle by putting a cap or an upper limit on the total amount of CO2 emissions per annum, which can be emitted by industries, power plants and other installations in the system. Within this cap, the emitters receive emission allowances, which indicate the maximum allowable CO2 emissions. However, these emission allowances are tradable within the EU, and if the emitters need more CO2 allowances, they are free to purchase from the entities, which have excess quantities of emission allowances thus rewarding the entities for reducing their emissions. In addition, the companies may get extra CO2 allowances by implementing green or less carbon intensive technologies to under CDM and JI mechanisms. It is reasonable to say that the implementation of EU ETS is a serious effort towards global CO2 emissions reduction with the ultimate goal being bring about drastic reduction in CO2 emissions (80% reduction from the base year emissions by 2050) and promote low carbon energy production technologies in the long term.

The emission trading scheme started with first three-year trading period (2005-2007) recognized as a trial period and this was followed by the present five year (2008-2012) second phase of EU ETS.In each phase, the EU member states allow a maximum amount of carbon dioxide equivalents to be emitted by the installations included in the EU ETS. This emission limit is expected to be reduced in future periods, thereby increasing the incentive for technology investments that reduce emissions. In the third phase of EU-ETS, which would come into force from 2013 for a period of eight years (until 2020), the grandfathering or the free allocation of carbon credits will no more be an option for energy producers and they would need to buy the emission allowances via market based auctioning of emission rights. This is expected to further increase the marginal cost of electricity production using conventional sources such as coal and gas fired power plants, which in principle would make investments in renewables and green technologies attractive.

However, it should be kept in mind that the European Union is expected to need some 650GW of new power capacity and to replace some 330GW of existing power stations over the next 30 years (IEA, 2003a). Investment in new power is also essential for a well-functioning electricity market. But, the decisions pertaining to investment in new capacity are surrounded by considerable uncertainties about the future economics of the projects. On one hand, the introduction of EU ETS is expected to promote green technology investments in the long run, on the other hand, the auctioning of emission allowances, unclear policies in long term and volatility of CO2 prices are seen as the main hurdles for investments in electricity production industries.

The present study is an attempt to critically analyze the impact of EU ETS on the investment outlook in the electricity market over the long term. The study builds up the arguments based on the work carried out by previous researchers and identifies the key issues which affect the investment decisions in the power sector. The study extrapolates the arguments to assess the future investment scenario in the EU electricity generation within EU ETS regime.

Literature review

The main purpose of the EU ETS is to achieve emission reduction targets at minimum costs and to promote global innovation (EU, 2005).Ideally, the “cap and trade” approach ensures that emissions are reduced such that it is cheapest to do so and that the market price for allowances creates a effective price signal and reflects their scarcity in the system (Baumol & Oates, 1988). In other words, the EU Emission Trading Scheme (ETS) creates a continental market for CO2 emissions by attaching an economic value to environmental externalities. In this market, the price of carbon should be equal to the lowest marginal abatement cost which encourages power utilities to shift towards a lower carbon intense fuel mix at the cheapest cost. Hence in recent times, the marginal cost of electricity production for different technologies has become the most important criteria for investment decisions.

Considerable amount of research has been put in assessing current and future performance of the EU ETS in achieving its main aim of cost-efficient greenhouse gas abatement. The researchers have analyzed expected effects of different design alternatives of the regulation on aggregated (i.e., not firm-specific) technology investment decisions. The main subject of all these studies have been the different rules governing the allocation of emissions allowances. Whereas earlier work by researchers was more of a general manner (Vesterdal and Svendsen, 2004), recent studies have been focusing on incentives and distortions introduced by different detailed allocation rules for e.g. closure rules, updating, and allowance allocations to new entrants (Ahmanet al., 2007,Ahman and Holmgren, 2007,Betzet al., 2006 & Neuhoffet al., 2006). Another set of studies tries to elucidate the effect of emission trading on operating decisions and investment options by analyzing the varying cost increases for different technologies. Whereas Reinaud (2003)analyzed the effects of different carbon prices on profitability of different power plant capital investments,Laurikka and Koljonen (2006)used real option pricing approach to incorporate the large uncertainties in investment decisions.

Also about the power generation technology, Laurikka developed a stochastic simulation model based on the real option theory, and explored the influence of carbon emissions trading, the EU ETS in particular, on integrated gasification combined cycle (IGCC) investment. The results showed that a straightforward application of discounted cash flow (DCF) analysis may not be a appropriate and might lead to biased results within the carbon emissions trading scheme, where a number of uncertainties potentially combined with several real options could make quantitative investment appraisals very complex. Moreover, the IGCC technology did not yet seem competitive in power plant retrofits within the EU ETS, for its investment cost was too high for viable retrofit in investment (Laurikka, 2006).

Case studies of German & Finni