Intertemporal emissions trading and market design: an application to the EU ETS

In this paper, the authors develop a model to assess the market stability reserve, a key feature of reforming the European Union’s emissions trading system (EU ETS).

Reforms to the EU ETS have been made in the face of a significant, prolonged downturn in the allowance price. The downturn occurred due to the economic recession and the achievements of overlapping renewable and energy efficiency policies, which reduced emissions independently of the allowance price, and thus the demand for allowances on the market. It was also a response to criticism that the market had failed to display responsiveness to changing economic circumstances.

The market stability reserve (MSR) is a rule-based supply-side control unique of its kind: effective from January 2019, it automatically adjusts the volume of annual allowance auctions based on the past market-wide allowance bank – the so-called total number of allowances in circulation.

The authors assess the role of the MSR in the functioning of the EU ETS and investigate its potential to attain its two main objectives, concluding that it is successful in raising the allowance price, but is limited in its ability to improve the system’s resilience to allowance demand shocks.

Key points for decision-makers

  • The MSR acts as a temporary patch able to curb some of the excess supply of allowances induced by the 2008 economic downturn and past achievements of overlapping policies. However, the authors find that it displays limited responsiveness to similar demand shocks in the future.
  • Specifically, the MSR reduces the cumulative volume of authorised emissions (even without cancellations of some allowances withdrawn by the MSR) and raises the allowance price (e.g. by around 30% in 2050). Cumulative cancellations are substantial, representing in the order of 5 to 10 gigatonnes of carbon dioxide.
  • Empirical studies have found that firms covered by the EU ETS behave consistently with compliance cost minimisation over time, although the degree to which they cost-minimise, their levels of foresight and their time horizons remain hard to elicit. This study shows how firms’ focus on the short term (myopia) is key in explaining observed price dynamics.
  • The authors show how the MSR’s performance will depend greatly on the type and degree of firms’ myopia and the sophistication of their understanding of the interplay between their decisions and the MSR-driven supply shifts over time.
  • The modelling framework can serve as a good basis for an ex-post assessment of the MSR for the upcoming review of the EU ETS in 2021. It can also be used to analyse the impacts of changing the MSR parameters ex-ante or introducing an allowance price corridor – a more standard supply control – in place or on top of the MSR. The authors provide a brief comparative analysis of the performances of such an alternative control.
  • The modelling framework is amenable to amendments and calibration to other systems, for instance the Regional Greenhouse Gas Initiative in the United States or the linked California-Québec ETS where other forms of price corridors, intertemporal trading provisions and compliance cycles are in place.