Designing a US Market for CO2
Posted: 30 Jan 2009
Date Written: January, 30 2009
The United States may soon have a market for carbon. If so, it will grow out of government regulation of carbon emissions in the form of a cap-and-trade system like the EU's Emissions Trading System for CO2 or the US Acid Rain Program for SO2. The efficient functioning of the market is key to the success of cap-and-trade as a system. We review the performance of the EU CO2 market and the US SO2 market and examine how the flexibility afforded by banking and borrowing and the limitations on banking and borrowing have impacted the evolution of price in both markets. While both markets have generally functioned well, certain episodes illustrate the importance of designing the rules to encourage liquidity in the market.
We focus on four episodes. First, when the EU CO2 market opened in 2005, the market was thin and illiquid with only shorts participating. The result was that prices quickly rose to a surprisingly high level. Fortunately, an accident of how the system was implemented gave companies the ability to borrow allowances one-year forward, which moderated the price rise. Second, the restriction against banking allowances from the first phase that ended in 2007 into the second phase that started in 2008 created a regulatory seam evident in the sharp divergence between the spot price at the end of 2007 and the futures price for 2008. Third, the US SO2 market avoided such a seam by allowing unlimited banking of allowances forward through the transition from its phase 1 into phase 2 in 2000. Fourth, in 2005-2006, the US SO2 market experienced a startling spike in the price despite allowing the banking of allowances that should have prevented the spike. But other institutional features of the system limited the actual role of the bank for moderating price spikes.
Keywords: CO2, carbon, emissions trading, EU-ETS, SO2 market
JEL Classification: Q25, G18, G13
Suggested Citation: Suggested Citation