**1. Introduction**

The European Union introduced the first and largest trading system for greenhouse gases in the world, the Emissions Trading System (EU ETS). Its launch in 2005 came as a direct consequence of the Kyoto Protocol as a means of achieving the climate objective of reducing emissions by 43 % between 1990 and 2030 [1]. The design is based on a *cap and trade* system, which allows only a fixed amount of emissions for various greenhouse gases such as carbon dioxide (CO2), nitrous oxide (N2O), and perfluorocarbons (PFCs). In the past, the annual limit of greenhouse gases has been decreased in order to reduce greenhouse gases and to thus achieve climate goals.

The actual design of the cap and trade system represents a challenging task for policy-makers. On the one hand, the price for emission allowances needs to be fairly high in order to provide an incentive to reduce emissions [2]. On the other hand, the price should not threaten economic development. Therefore, policy-makers need to combine social, economic, and environmental considerations. For example, the European Commission has broadened the number of industries that are subject to the trade mechanism as part of the modifications when transitioning from phase II to III of the Emissions Trading System. Nowadays, about 11,000 heavy energy-using installations are part of the EU ETS, accounting for approximately 45 % of all emissions in Europe. In particular, the entire power production sector in Germany is obligated to participate in the EU ETS. Accordingly, every power company must hold a sufficient number of European Emission Allowances (EUA) by the

end of the year, whereby each EUA entitles the energy producer to emit one ton of carbon dioxide or its equivalents.

Since 2013, phase III of the EU ETS represents the status quo. It differs from phase II (years 2008–2012) in the following key dimensions [1]:


Based on the changes between phase II and III of the ETS, one would expect a stronger influence of the carbon price on electricity prices. In theory, the necessary expenditures on emission allowances should increase costs for operators of power plants and it is thus likely to be linked to the price of electricity. For example, lignite-fired power plants emit about 0.984 tons of carbon dioxide per 1 MWh energy, while power plants fired by natural gas produce about 0.548 tons of carbon dioxide per 1 MWh energy. (Retrieved from http://www.eia.gov/tools/faqs/faq.cfm?id=74&t=11 on 11 June 2019.) In other words, one can assume an influence of emission allowances on electricity prices if the underlying pass-through rate is nonzero [3,4]. Consequently, the price of EUA is incorporated in the price setting algorithms of electricity producers, thus resulting in electricity price fluctuations in the short run [5]. Policy-makers demand such evaluations, which allow them to assess whether emissions trading encourages high amounts of sustainable sources of electricity generation on a national or international scale.

Our literature survey later reveals that the link between carbon and European Power Exchange (EPEX) electricity prices has been studied for phase II of the EU ETS but not for phase III. Here, we follow earlier research which has focused on the short-run relationship between EUA prices and electricity prices as a means to study the price setting mechanisms of electricity firms (e.g., References [5,6]). It is thus the key contribution of this paper to quantify the impact of carbon prices on EPEX electricity prices during phase III of the EU ETS. For this purpose, we specifically compare the effect across day-ahead and intraday markets. We additionally calculate the distributional properties of the pass-through rate by means of quantile regression to test whether a price premium for EUA is only added for a certain threshold price.

Our results sugges<sup>t</sup> a negative relationship between emission allowances and electricity prices. The corresponding implications are discussed by considering the intentions of policy-makers when designing phase III of the EU ETS. Especially, the findings are later set in relation to the context of various proposed changes to the EU ETS that are currently under consideration by policy-makers. Altogether, these insights can help to improve the future market design for emissions trading in order to achieve the desired climate objectives. Our findings should be seen as a starting point for future

research as they call for further attention to better understand the consequences for price setting that result from the introduction of the EU ETS.
