Weitzman meets Taylor: EU allowance price drivers and carbon cap rules

Cap-and-trade systems are the primary market-based approach for regulating greenhouse gas emissions, but significant shortcomings have been exposed in recent years, particularly in terms of high permit price volatility. Adjusting the cap to respond to shocks based on available information could help, but the selection of factors that should guide these adjustments remains unclear.

This paper addresses this issue by developing a model to identify the most influential drivers of carbon permit prices within the EU Emissions Trading System (ETS) and proposes a novel approach to estimating less-observable shocks. The authors quantify the contribution of each factor to carbon price variability. They propose a rule-based cap adjustment mechanism that dynamically responds to deviations in emissions and abatement costs, reduces volatility by 55% compared with the current EU ETS cap, and cuts welfare losses in consumption equivalence terms by 40%.

Key points for decision-makers

• The authors identify emissions abatement, energy prices, transition demand for permits, and regulatory supply shocks as the key drivers of permit prices in the third phase of the EU ETS (2013–2019).
• They develop a two-sector structural model to identify the most influential factors and propose a novel approach to estimating less-observable shocks, in particular abatement costs shocks.  
• They quantify the contribution of each factor to carbon price variability, which they find to be approximately 80 times greater than it would be under an optimal carbon pricing scenario aligned with the social cost of carbon. This excess volatility leads to welfare losses.
• To address this, they propose a ‘Carbon Cap Rule’ (CCR) – a rule-based cap adjustment mechanism that dynamically responds to deviations in emissions and abatement costs.
• The CCR reduces volatility by 55% compared with the current EU ETS cap, and cuts welfare losses in consumption equivalence terms by 40%.
• By aligning the cap more closely with key market fundamentals, the CCR enhances the efficiency of the carbon market, supporting long-term investments in emissions reduction and contributing to a more effective transition to a low-carbon economy.
• Like the Taylor (1993) rule in monetary policy, the CCR responds to current economic conditions; the CCR also echoes the principles advocated by Weitzman (1974), who highlighted the importance of contingent climate policy.