Adjustable emissions caps and the price of pollution

Abstract

Cap and trade schemes often use a policy of adjustable allowance supply with the intention to stabilize the market for allowances. We investigate whether these policies deliver with a focus on allowance prices. Motivated by existing policies, we study schemes that rely on either the allowance price (price measures) or the surplus of unused allowances (quantity measures) to adjust supply in a dynamic cap and trade market. Compared to emissions trading under a fixed cap, we find that price measures stabilize allowance prices. Quantity measures can be destabilizing. Though phrased in the context of changing interest rates, our results warn more generally against the belief that quantity measures are a suitable instrument to promote a stable cap and trade market.