Improving Liquidity in Emission Trading Schemes
Forthcoming, Journal of Futures Markets
Posted: 1 Jul 2021 Last revised: 28 Jul 2021
Date Written: June 22, 2021
This paper constructs a model of an Emission Trading Scheme (ETS) market using bid-ask spreads. We show that when such a market is dominated by a small number of traders with substantial market power, they tend to maximize their profits by widening bid-ask spreads, thereby reducing market liquidity. We argue that adding more market participants, including derivatives traders, can alleviate this illiquidity problem. Policy changes at the European Union’s ETS illustrate our theory, as the market significantly increased liquidity by enacting liquidity-provision policies to attract more participants as it transitioned from Phase 1 to Phase 2.
Keywords: EU ETS, market power, market activation, policy effectiveness
JEL Classification: G13, G14, H32, Q54, Q58
Suggested Citation: Suggested Citation