Study
Innovation & MarketsHigh ImpactStrong effect

Cap-and-Trade Market Prices Heavily Influenced by Administrative Price Floors/Ceilings Due to High Emission Uncertainty

Significant uncertainty in baseline emissions and the impact of non-market policies means that cap-and-trade market prices are often dictated by pre-set administrative price controls rather than actual market supply and demand.

American Economic Review · 2019

01

Key Findings

  • 01There is substantial ex ante uncertainty in business-as-usual emissions.
  • 02Abatement resulting from non-market policies also exhibits significant uncertainty.
  • 03This uncertainty is often larger than the potential abatement driven by allowance prices within politically acceptable ranges.
  • 04Consequently, market prices are likely to be determined by administrative price floors or ceilings.
02

Application

Design takeaway

When designing cap-and-trade systems, prioritize robust administrative price controls to manage inherent uncertainties in emissions and abatement, as these are likely to dominate market price discovery.

How to apply

When developing or evaluating emissions trading schemes, conduct thorough sensitivity analyses on baseline emissions and non-market policy impacts to inform the setting of price collars.

Project actions

  • 01When researching market designs, consider the impact of external uncertainties.
  • 02Investigate how administrative controls can stabilize market outcomes.
03

Method & Evidence

AimTo understand the potential equilibria and price determination mechanisms in greenhouse gas cap-and-trade markets, considering ex-ante uncertainty in emissions and abatement.
MethodEconomic modeling and simulation
ProcedureThe study modeled potential market equilibria for California's cap-and-trade program using information available prior to its inception. It analyzed the impact of uncertainty in business-as-usual emissions and non-market abatement policies on the resulting allowance price.
ContextEnvironmental market design, specifically cap-and-trade systems for greenhouse gas emissions.

Variables

IVUncertainty in business-as-usual emissions, uncertainty in non-market abatement policies.
DVMarket price of allowances, market equilibrium.
CVCap-and-trade market design parameters (e.g., total cap, allowance allocation), administrative price floor/ceiling levels.
04

Strengths & Limitations

Strengths

  • +Provides a theoretical framework for understanding price determination in uncertain environmental markets.
  • +Uses a relevant real-world case study (California's cap-and-trade).

Limitations

The models used are simplifications of complex real-world systems and may not capture all behavioral or systemic factors.

Reliability & validity

The study's validity relies on the accuracy of its economic models and assumptions about market behavior. Reliability would be demonstrated by consistent results across different modeling approaches or data sets.

Think critically

To what extent can market-based mechanisms truly achieve efficient price discovery when faced with such profound inherent uncertainties?

05

Design Principles

"Environmental market designs should incorporate mechanisms to mitigate the impact of high ex ante uncertainty on price discovery, such as well-defined price floors and ceilings."

This insight is crucial for designers of environmental markets, highlighting that the effectiveness and price discovery mechanisms of cap-and-trade systems can be significantly constrained by factors outside the direct market design. It suggests that robust administrative price controls are essential for market stability and predictability.

06

What This Means for Your Design

In environmental trading schemes, the price is often controlled by rules set beforehand because it's hard to predict exactly how much pollution will happen or how other rules will affect it.

How to use in your project

  • 1.Reference this study when discussing the challenges of price discovery in environmental markets or the importance of regulatory price controls.
07

Add to My Project

08

Quick Cite

(2019). Expecting the Unexpected: Emissions Uncertainty and Environmental Market Design. American Economic Review. https://doi.org/10.1257/aer.20161218 Retrieved from https://designdex.org/study/e71e2139-5459-41db-97fa-17f7ed162915/cap-and-trade-market-prices-heavily-influenced-by-administrative-price-floors-ceilings-due-to-high-emission-uncertainty

Paragraph starter

Research indicates that significant ex ante uncertainty in baseline emissions and the effectiveness of non-market abatement policies can lead to cap-and-trade market prices being determined by administrative price floors or ceilings, rather than by the interplay of supply and demand (Borenstein et al., 2019).

09

Source

American Economic Review

Expecting the Unexpected: Emissions Uncertainty and Environmental Market Design

journal · 2019

View source

Questions about this research

What does the research say about cap-and-trade market prices heavily influenced by administrative price floors/ceilings due to high emission uncertainty?
When designing cap-and-trade systems, prioritize robust administrative price controls to manage inherent uncertainties in emissions and abatement, as these are likely to dominate market price discovery. Evidence: American Economic Review (2019).
Why does "Cap-and-Trade Market Prices Heavily Influenced by Administrative Price Floors/Ceilings Due to High Emission Uncertainty" matter for design?
This insight is crucial for designers of environmental markets, highlighting that the effectiveness and price discovery mechanisms of cap-and-trade systems can be significantly constrained by factors outside the direct market design. It suggests that robust administrative price controls are essential for market stability and predictability.
How can designers apply this research?
When designing cap-and-trade systems, prioritize robust administrative price controls to manage inherent uncertainties in emissions and abatement, as these are likely to dominate market price discovery.
What were the main findings?
There is substantial ex ante uncertainty in business-as-usual emissions.. Abatement resulting from non-market policies also exhibits significant uncertainty.. This uncertainty is often larger than the potential abatement driven by allowance prices within politically acceptable ranges.. Consequently, market prices are likely to be determined by administrative price floors or ceilings.
What research method was used?
Economic modeling and simulation.
How strong is the evidence?
Evidence strength is rated Strong effect, based on a 2019 journal from American Economic Review.
What should I do differently in my next project?
When developing or evaluating emissions trading schemes, conduct thorough sensitivity analyses on baseline emissions and non-market policy impacts to inform the setting of price collars.
What are the limitations?
The study focuses on a specific market (California) and may not fully capture all nuances of other regulatory environments or future market evolution.
Is there evidence that price affects design outcomes?
The study found that unpredictable baseline emissions and the impact of other environmental regulations create so much uncertainty that the price of emission allowances in cap-and-trade markets is usually set by government-imposed price limits, not by the trading activity itself. This insight is crucial for designers o Source: American Economic Review (2019).
Where does this administrative price research apply?
Environmental market design, specifically cap-and-trade systems for greenhouse gas emissions. It sits within innovation & markets research on designdex.org.

Related research topics

price design research · evidence on price · does price improve design outcomes · administrative price studies for designers · price and administrative price findings · innovation & markets research evidence