Rules vs. Discretion in Cap-and-Trade Programs: Evidence from the EU Emission Trading System

73 Pages Posted: 28 Oct 2020

See all articles by Marina Friedrich

Marina Friedrich

VU University Amsterdam

Sébastien Fries

VU University Amsterdam

Michael Pahle

Potsdam Institute for Climate Impact Research (PIK)

Ottmar Edenhofer

Potsdam Institute for Climate Impact Research (PIK); Mercator Research Institute on Global Commons and Climate Change (MCC); Technische Universität Berlin (TU Berlin)

Date Written: 2020

Abstract

Long-term commitment is crucial for the dynamic efficiency of intertemporal cap-and-trade programs. Discretionary interventions in such programs could destabilize the market, and necessitate subsequent corrective interventions that instigate regulatory instability (Kydland and Prescott, 1977). In this work, we provide evidence for this claim from the EU’s cap-and-trade program (EU-ETS). We ground our analysis in the theoretical finance literature, and apply a mixed method approach (time-varying regression, bubble detection, crash-odds modelling). We find that the recent EU-ETS reform triggered market participants into speculation, which likely led to an overreaction that destabilized the market. We discuss how the smokescreen politics behind the reform, which manifested itself in complex rules, was crucial for this outcome. We conclude that rules only ensure long-term commitment when their impact on prices is predictable.

Keywords: rules vs. discretion, cap-and-trade, overreaction, allowance pricing

JEL Classification: Q480, Q500, Q560

Suggested Citation

Friedrich, Marina and Fries, Sébastien and Pahle, Michael and Edenhofer, Ottmar, Rules vs. Discretion in Cap-and-Trade Programs: Evidence from the EU Emission Trading System (2020). CESifo Working Paper No. 8637, Available at SSRN: https://ssrn.com/abstract=3718517 or http://dx.doi.org/10.2139/ssrn.3718517

Marina Friedrich (Contact Author)

VU University Amsterdam ( email )

Netherlands

Sébastien Fries

VU University Amsterdam ( email )

Netherlands

Michael Pahle

Potsdam Institute for Climate Impact Research (PIK) ( email )

Telegrafenberg 31
Potsdam, Brandenburg 14473
Germany

Ottmar Edenhofer

Potsdam Institute for Climate Impact Research (PIK) ( email )

P.O. Box 601203
14412 Potsdam, Brandenburg
Germany

Mercator Research Institute on Global Commons and Climate Change (MCC)

Torgauer Straße 12-15
Berlin, 10829
Germany

Technische Universität Berlin (TU Berlin)

Straße des 17
Juni 135
Berlin, 10623
Germany

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