Interactions between market stability measures in linked carbon markets
Vivid Economics was commissioned by DG CLIMA to assess the interactions between market stability measures (MSMs) in carbon markets and how these affect the operation of emissions trading systems (ETS) if linked.
As part this project Vivid developed typologies to classify ETS around the world and established a framework to investigate the effects of linking between carbon markets with different design aspects and characteristics. A model was developed to assess the impact of linking ETS with market stability measures to other markets, including offset markets.
We find that MSMs have become an essential part of ETS design, with all major ETS operating worldwide adopting some form of measure. For each jurisdiction, we provide an overview of the key ETS characteristics before considering in detail the design of MSMs.
From this analysis, we identify five key observations from MSMs implemented to date:
- Inflexible regulatory processes can delay policy makers’ response to changed circumstances, which may necessitate the introduction or reform of MSMs.
- Implementing MSMs through auctions is a common and relatively simple approach.
- Rule based MSMs increase price predictability and refine market price expectations.
- MSMs that entail a permanent supply response alter emissions budgets and affect realised ambition levels.
- Linking ETS requires compatibility in the design of MSMs, with all linked system taking steps to coordinate MSMs to avoid potential adverse impacts.
MSMs can make carbon markets function better, but they also increase their complexity in a manner that makes ETS linking challenging. This means that jurisdictions should look to coordinate their MSMs if they are going to link to ensure markets interact smoothly and avoid adverse consequences. This suggests that linking ETSs with MSMs requires significant coordination, and a high degree of trust between linking partners. As an alternative to full linking, parties could consider restricted linking to maintain greater autonomy and independently effective MSMs. However, this will also reduce many of the advantages of linking. Similarly, as government’s preferences may change over time, this implies that clear rules for delinking are established to ensure this process is smooth.