Intertemporal Emissions Trading and Market Design: An Application to the EU-ETS

Published on 08 January 2019

By Simon Quemin and Raphaël Trotignon

We develop a model of competitive intertemporal emissions trading under uncertainty with supply-side controls. We introduce two sources of bounded rationality on the part of regulated firms: myopia and limited sophistication in understanding the interplay between their decisions in equilibrium and the control-driven supply shifts over time. We tailor the model to the EU-ETS, calibrate the market’s interest rate, myopia and marginal abatement cost to match observed price and banking paths over 2008-2017, and highlight the key role of myopia in the price dynamics.

We use our calibrated model to assess the recent market reform, essentially the market stability reserve (MSR). We find that the MSR always reduces the cumulated cap (even without cancellations) and raises the permit price. The MSR acts a temporary patch curbing past excess supply but displays limited responsiveness to future permit demand shocks (e.g. recession, renewable deployment). We also show how MSR performances depend greatly on the firms’ types and degrees of myopia and sophistication, and compare them with those of a soft price collar.

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You may find also the summary for policy makers on the London School of Economics and Political Science website