Introduction

The launch of period 1 of the EU ETS in January 2005 coincided with a particularly turbulent period in Europe's electricity markets. Two directives of the European Commission, Directive 2003/54/EC (internal electricity market) and Directive 2005/89/EC (security of electricity supply), advanced the objective of complete liberalization of electricity and gas markets in the European Union. In parallel, Europe experienced an intense process of industrial concentration, with a de facto transnational oligopoly emerging around EDF, E.ON, Enel-Endesa, RWE and GDF Suez. Coupled with the intrinsic short-term inelasticity of electricity demand, the absence of storage and electricity's importance as an essential good for households and industry, the establishment of wholesale markets outside national regulatory oversight and the movement towards concentration have repeatedly given rise to suspicions of the abuse of market power. To top it off, western and central Europe experienced severe cold snaps, in the winters of both 2004/5 and 2005/6, which, in conjunction with low hydro-power levels, led to dramatic high price spikes during the first phase of the EU ETS.

There is objectively a close connection between electricity and carbon markets, and this annex explores it. The introductory remarks above should, however, draw attention to the fact that electricity prices had plenty of reason to be both unusually high and volatile during period 1, in particular during the crucial period stretching from the beginning of 2005 until spring 2006, quite independently of the newly introduced EU ETS. In addition, the European electricity market is not yet fully unified due to the saturation of certain physical interconnections at peak times and different regulatory regimes for retail prices in several EU countries.