Project 2c – Evolution of carbon markets

Project lead: Luca Taschini

European Union Emission Trading System

The European Commission has proposed a structural reform of the EU ETS, including the implementation of a mechanism to adjust allowance allocation, the so-called Market Stability Reserve (MSR). In ‘Dynamic Supply Adjustment and Banking under Uncertainty: the Market Stability Reserve’ we explore what are the effects of the MSR (a cap-preserving mechanism) on emission abatement and allowance prices considering different risk preferences. By relaxing the assumption of risk-neutrality, we contribute to the literature on inter-temporal trading under uncertainty and to the emerging literature on the assessment of allowance supply adjustment mechanisms. In ‘The European Union Emissions Trading System and the Market Stability Reserve: Optimal Dynamic Supply Adjustment’ we study the effect of a permanent adjustment of the cap and identify an optimal adjustment rate

  1. “Dynamic Supply Adjustment and Banking under Uncertainty: the Market Stability Reserve” (with S. Kollenberg) – JEEM R&R.
  2. “The European Union Emissions Trading System and the Market Stability Reserve: Optimal Dynamic Supply Adjustment” (with S. Kollenberg) – preprint.

International carbon markets

The Paris Agreement, especially Article 6, contains provisions which support the use of “internationally transferred mitigation outcomes”. The ultimate aim of these provisions is to improve the cost effectiveness of global emissions reduction efforts. Our paper ‘Carbon dating: When is it beneficial to link ETSs?’ speaks directly to this policy debate. The paper evaluates the economic advantage of regulating carbon emissions by linking the emissions trading systems of two jurisdictions versus operating them independently. We show that linking partner matches, what we call carbon dates, can vary significantly in the value they generate based on pair characteristics. We spell out the conditions under which one partner can in fact prefer autarky. In an empirical exercise, we calibrate the pair characteristics and demonstrate that the linking partner match is far from trivial. It is no doubt an important element of the policymakers’ calculus of economic cost savings.

  1. “Carbon dating: When is it beneficial to link ETS?” (with B. Doda) – submitted JAERE.

Renewables, ETS and capacity expansion in energy markets

In ‘Renewables, Allowances Markets, and Capacity Expansion in Energy-Only Markets’ we investigate the combined effect of an Emission Trading System (ETS) and renewables on electricity generation investment in energy-only markets. We propose a simple representation of the capacity expansion decision between conventional and renewable generation where demand is uncertain. Increasing renewable capacity creates a tradeoff for producers: a higher share of renewable production can be priced at the higher marginal cost of conventional production, yet the likelihood of achieving higher profits is reduced because more demand is met by cheaper renewable generation. A numerical application of the model shows producers prefer withholding renewables investments, calling into question the long-term efficacy of an ETS in achieving decarbonisation goals.

  1. “Renewables, Allowances Markets, and Capacity Expansion in Energy-Only Markets” (with C. Pelizzari and P. Falbo) – to be submitted.

Conservation payments

In ‘Conservation payments under uncertainty’ we illustrate the useful insights that can be obtained from the application and adaptation of pre-existing economic theory to the design of economic instruments for conservation policies. In this, real options theory is applied to the design of incentive payments, or payments for environmental services, to conserve tropical forest. The novelty of this paper is to show how uncertainty in alternative land-use returns over time can influence the decision of whether or not to deforest. The model was simulated using time-varying, secondary data on alternative land uses in Brazil as well as data on carbon prices, which were used to simulate a potential carbon market for forest protection and provided insights for REDD+ policy design.

  1. Conservation Payments under Uncertainty” (with S. Engel, C. Palmer and S. Urech) – Land Economics – Vol. 91(1):36-56 (2015).