Linking carbon markets with different initial conditions

Abstract

Despite the global nature of climate change, carbon pricing is driven by regional and sectoral carbon taxes or trading programs, each with unique features and disparate marginal costs. Linking these fragmented regional or sectoral programs could improve environmental and economic outcomes, but differing initial conditions pose a challenge to linking. We explore the use of an allowance exchange rate, which denominates the compliance value of an emissions allowance differently in each program. In a theoretical model, we find that linking with an exchange rate in the politically plausible range—between the benchmark regimes of autarky and traditional 1:1 trading—may reduce abatement in one program but achieves greater aggregate emissions abatement than the amount achieved at each bookend. Linking in this range also yields lower total abatement costs and greater economic surplus in each program, compared to autarky. Thus, a linked trading system with allowance exchange rates can be expected to yield benefits for the environment and each regional economy. When program caps achieve inefficiently low abatement, it is socially optimal to link at an exchange rate that increases total abatement in the linked system, which occurs within the politically plausible range of exchange rates, not at 1:1. We illustrate these results, and identify additional outcomes of interest to policymakers, using a simulation model of electricity markets.