Short answer
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.
- Field
- Innovation & Markets
- Source
- American Economic Review (2019)
- Method
- Economic modeling and simulation
- Evidence
- Strong effect
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. This innovation & markets research insight is drawn from a 2019 study published in American Economic Review. Using Economic modeling and simulation, researchers explored how this design variable affects real-world outcomes. The key 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.
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
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.
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.
Method & Evidence
Variables
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?
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.
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.
Add to My Project
Quick Cite
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).
Source
American Economic Review
Expecting the Unexpected: Emissions Uncertainty and Environmental Market Design
journal · 2019
View sourceQuestions 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.