PowerSwitch

Prior to the adoption of the EU ETS, some commentators recommended that the EU firmly set price ceilings to reduce market instability. The EU wisely resisted such restrictions, since price ceilings effectively “bust the cap” by allowing an unrestricted number of allowances to be issued when a certain price is reached. Basing the bankability of allowances on verified emissions reduced allowance volatility without resorting to price controls.

The EU also avoided price floors in the market. Politically, adopting price floors makes it hard to resist adopting price ceilings as well. Furthermore, floors may raise the costs of achieving emission reductions without improving total carbon abatement—if firms must pay a minimum price above the actual cost of achieving emission reductions, the price of meeting the cap is artificially high. Increasing the cost of carbon reduction in this manner is contrary to the proper function of cap-and-trade programs, which allow the market to ferret out the cheapest means of meeting a carbon cap.

California’s proposed carbon trading system highlights an innovative alternative mechanism for reducing price volatility. California will automatically place 1% of its allowances into a price containment reserve (this percentage grows to 7% by 2018). Allowances in this set-aside are given a fixed annual price that escalates predictably. The availability of the set-aside as a source of fixed-price permits achieves the same stabilizing effect as a price ceiling, but it doesn’t bust the cap by allowing unlimited allowances at that price.

Further, California sets a minimum price for auctioning its allowances (starting at $10 per ton), with any unsold allowances offered for sale at a later auction. However, over-the-counter trades between allowance holders are permitted at any price. This contrasts with a strict price floor for over-the-counter trades, which would increase the risk of traders holding illiquid allowances that a price floor prevents them from trading. The fear of being unable to trade the allowances would decrease their value further, increase the risk of holding allowances, and discourage participation in the market. California’s alternative design avoids the risks of a strict price floor on trades.
Along with other cap-and-trade design elements such as the EU’s allocation of allowances for longer trading periods and a declining cap, banking and associated concepts such as allowance price reserves create incentives for firms to invest in emission reductions early and efficiently while also reducing price volatility.