Postponing Auctioning Versus Cancellation of Allowances in the EU Ets

Abstract

Policy makers reformed the European Union (EU) Emission Trading System (ETS) by tightening the cap and strengthening the Market Stability Reserve (MSR) the market’s dynamic supply control mechanism. The capacity of the reformed EU ETS to deliver on the reform objectives is to be evaluated on its capacity to not only raise and stabilize prices, but also foster emission reductions. To elaborate this issue, we simulate a dynamic model of irreversible investments and dynamic capacity adjustment costs for both fossil and renewable technologies. We show that postponing allowance allocations through the MSR can be equally, if not more significant than cancellation. To assess the MSR’s capacity to stabilize prices and foster emission reductions, we extend our deterministic model for stochastic demand shocks. Our findings indicate that the MSR increases price volatility, and its current design fails at moderating price escalations and volatility.

Keywords: Capacity investments, Emission trading, Low-carbon investments, Market stability reserve, European union, Sunk costs