Emissions trading systems with cap adjustments

Emissions Trading Systems (ETSs) with fixed caps lack provisions to address systematic imbalances in the supply and demand of permits due to changes in the state of the regulated economy. We propose a mechanism which adjusts the allocation of permits based on the current bank of permits. The mechanism spans the spectrum between a pure quantity instrument and a pure price instrument. We solve the firms' emissions control problem and obtain an explicit dependency between the key policy stringency parameter – the adjustment rate – and the firms' abatement and trading strategies. We present an analytical tool for selecting the optimal adjustment rate under both risk-neutrality and risk-aversion, which provides an analytical basis for the regulator's choice of a responsive ETS policy

System responsiveness and the European Union Emissions Trading System

This paper argues in favour of a reform of the European Union Emissions Trading System (EU ETS) that makes the system more responsive to unexpected price shocks. The paper proposed rules based mechanism for withdrawing and injecting allowances from the market based on price trends. Key points: Following the 2008 economic recession, the price of European Union Allowances (EUAs) unsurprisingly dropped, following a fall in demand. However the low price has persisted despite mild economic growth within Europe since the beginning of the crisis. Policy regulators are currently unable to respond to unforeseen changes in economic circumstances, technology advancement and complementary policies that generate downward price pressure. The decision by the European Commission to temporarily withdraw 900 million EUAs from the market will have little impact on the long term market price expectation. Other one-off measures would also leave the system vulnerable, addressing the symptoms but not the cause of structural weakness in the system. What is needed is a responsiveness mechanism that enables the European Commission to respond to unanticipated shocks. This ‘rules-based reserve management mechanism’ would have a double trigger system in place. A price trend ‘trigger’ to determine when intervention would be needed, and a volume ‘trigger’, that would determine the amount of EUAs to inject or withdraw. This would encourage self-adjusting behaviour from market participants, anticipating an intervention by looking at the price trend over the specified period, thus acting in their own interest to buy, sell or banking their EUAs in advance of an intervention. This behaviour would help regulate the supply-demand balance of the market which would effectively limit the need for an intervention to exceptional circumstances

Dynamic supply adjustment and banking under uncertainty in an emission trading scheme:The market stability reserve

We study the impact of a supply management mechanism (SMM) similar to the Market Stability Reserve proposed in 2015 which preserve the overall emissions cap and we comment on the recent cap-changing amendments. We provide an analytical description of the conditions under which an SMM alters the emissions abatement paths, affecting the expected length of the banking period and its variability. While abatement strategies of risk neutral firms solely depend on the former, for riskaverse firms changes in the latter would lead to higher risk premia, accelerated depletion of the bank and, consequently, further reduction of abatement and allowance prices. Cancellation of part of the reserve could partially outweigh the effect on risk premia sustaining allowance prices

Responsive market regulation in environmental economics: an agent-based stochastic equilibrium approach

The present work is concerned with stochastic modelling of markets for regulated resources. Here, we use the term regulated resource (or regulated commodity) in the sense of some tradable good, the total aggregate deployment of which is subject to control by some public or private, central entity. More precisely, we are interested in regulatory systems that can control the inflow of commodity units. Such control systems allow the regulator to force potential externalities, arising from using the resource, to be priced in on the market, without explicitly deciding on the respective premium or explicitly quantifying the economic damage avoided for each unit of the commodity. Such (quantity-based) trading systems are traditionally viewed as alternatives to conventional price-based systems such as taxes. The question whether a quantity-based or price-based system is more advantageous has first been studied by [Weitzman, 1974], whose deliberations came down to comparing the relative slopes of the marginal abatement cost curve and marginal benefit curve (of avoiding emissions). However, Weitzman appreciated that an ideal instrument would implement a contingency message, indicating what policy would be implemented, based on the current state of the system. In the present work, we pick up on this idea and examine how the costs efficiency of controlling the use of a resource can be improved by such dynamic control systems. What’s more, we construct a quantitative framework by which we can represent an entire spectrum of policies between ‘pure’ price-based and ‘pure’ quantity-based instruments. Thusly we fill a significant gap in the pertinent literature. Limitation or regulation of the inflow of commodity units to some economy can be in the collective interest of a group of economic entities, or in the interest of the society which is subjected to those entities’ externalities. While examples for the former are mainly found in the context of cartels, the latter is relevant whenever societal damages are the result of the con- sumption of a commodity – e.g. through overfishing or non-sustainable forestry. Another, particularly topical example are climate relevant commodities such as fossil fuels or emissions allowances. The main inspiration for our modelling work are Emissions Trading Systems (ETSs), the currently largest of which is the European Union ETS (EU ETS). Therein, emissions allowances (EUAs – European Emission Allowances) are made available by the regulator through regular auctions and free allocations. Those allowances can then be traded freely among market participants at the price dictated only by supply and demand on this secondary market. After a given calendar year, agents whose facilities are subject to the regulation of the EU ETS have to present a number of EUAs equal to their total emissions of greenhouse gases, measured in (metric) tonnes of CO2-equivalent (CO2e), during the respective year. For each tonne not covered in this way, each agent who is short in allowances has to pay a penalty of (currently) 100 Euros. (It shall be mentioned that paying the penalty does not absolve the agent from having to present the respective allowances in the next year.) In the wake of the economic crisis of 2007/08, we saw a strong and persistent erosion of EUA prices, which is mainly at- tributed to an oversupply resulting from an unanticipated drop in production. It was this price erosion, along with the ETS’s lack of provisions to adapt to such circumstances, that brought about doubt in the efficacy of the instrument altogether. More precisely, a number of experts in academia, politics and some stakeholders believed that the system was unable to ‘function in an orderly fashion’ [The European Commission, 2012] in the presence of such an enormous oversupply. In particular, the system lacked provisions to adapt the allocation scheme to changes in economic circumstances. Based on public consultations, the European Commission released a report in November 2012 (see [The European Commission, 2012]), presenting a number of reform options for the EU ETS, which aimed at relieving the current oversupply and, poten- tially, making the system more responsive to changes in economic circumstances. One such measure is the introduction of the so-called Market Stability Reserve (MSR), which aims at making the supply of allowances dynamic and dependent on the state of the system, rather than static and rigid, as it was. Furthermore, this supply adjustment system is designed based on a transparent set of rules, rather than discretionary interventions. The MSR has been ratified in 2016 and is set to start operating in 2020. In the present work, we construct a continuous-time stochastic equilibrium model of a market for an abstract regulated com- modity, with special interest in applications to climate-relevant resources such as emissions allowances. In doing so, we put special emphasis on a mathematically rigorous representation of stochasticity and risk-aversion on behalf of market partici- pants, as well as on a detailed (agent-based) derivation of the equilibrium dynamics in closed-form. In the process, we solve each agent’s optimisation problem, along with the associated Hamilton-Jacobi-Bellman Equation, for which we are able to find an explicit solution. Furthermore, we construct a generic regulatory mechanism of dynamic resource allocation, similar in spirit to the Market Stability Reserve. Our dynamic regulatory mechanism adjusts the resource allocation based on the current system state. The system state, however, is dependent on the allocation scheme, which implies the existence of a feed-back loop between the market and the regulation. We are, notably, able to solve this inter-dependency and derive the equilibrium under this regulation. This in turn allows us to quantify the costs associated to any given parameterisation of the mechanism, adjusting its responsiveness in order to maximise the cost-efficiency of the system. What’s more, by employing an adjustable responsiveness, we are able to represent an entire spectrum of policies between pure price instruments and pure quantity in- struments. Thereby, we fill a significant gap in the stream of literature pioneered by [Weitzman, 1974]. The present text is divided into four chapters. In Chapter 1 we describe our motivation along with the literature context of our work. In Chapter 2 we present some general concepts and observations on stochastic equilibria which will prove useful for our modelling approach. In Chapter 3 we derive our equilibrium in closed-form, before we construct our dynamic regulatory mechanism in Chapter 4. Therein, we furthermore compute total aggregate abatement costs as a function of the responsiveness of the system. This allows us to present means for the construction of a mechanism that maximises the policy’s cost-efficiency. We also provide an in-depth analysis of how the above-mentioned spectrum of policies can be represented by our mechanism’s parameterisation

Is a market stability reserve likely to improve the functioning of the EU ETS? : evidence from a model comparison exercise

In January 2014 the European Commission proposed the introduction of a Market Stability Reserve (MSR) to improve the functioning of the European Union Emissions Trading System (EU ETS). According to the European Commission, the MSR is designed to adjust the EU ETS to supply-demand imbalances and protect the system from unexpected and sudden demand shocks and by doing so, ensure an efficient abatement pathway for the long-term decarbonisation of the European economy (European Commission, 2014). We explore what market and regulatory failures could inhibit the functioning of the EU ETS and result in deviations from the efficient abatement pathway. Different research teams explore the implications of potential market and regulatory failures and/or inefficient responses to incomplete or complex information. Simulation models show that each of these factors can result in deviations from the efficient abatement pathway, and that an MSR can restore some of the lost efficiency. In considering MSR designs, an Early Start MSR (2017) with the back-loaded allowances placed directly into the reserve is shown to improve the performance compared to an MSR implemented in 2021. Laboratory experiments with human subjects show the importance of the quantity trigger levels and point to the importance of review provisions for adjustments in the early 2020ss to ensure private banking requirementscan be met