Dynamic Supply Adjustment and Banking Under Uncertainty: The Market Stability Reserve

Abstract

The supply of allowances in the European Union Emissions Trading System is currently determined by a rigid allocation programme. The Market Stability Reserve (MSR) makes the allocation of allowances flexible and contingent on the aggregate bank, while preserving the overall emissions cap. We investigate under which conditions the MSR can alter the abatement and allowance price paths. We show that, for risk-neutral firms a cap-preserving MSR is largely irrelevant. The MSR will not influence the expected equilibrium allowance price or average price volatility. We then relax the risk neutrality assumption and investigate how the MSR can impact the risk of an unexpected breakdown of inter-temporal optimisation, ultimately affecting the equilibrium at different points in time. In this context, we show that changes to the timing of allowance allocation by the MSR can have a substantial impact on abatement and allowance price paths when firms are risk-averse.