BEPP Set 5: Compliance Carbon Markets

Why price carbon? :: Emissions are an externality; without a price, firms overproduce pollution

A carbon tax or cap-and-trade makes firms internalize the cost

Marginal cost of abatement :: The cost of cutting one more ton of emissions; efficient policy has the lowest-cost abaters cut first

How cap-and-trade works :: The regulator sets a cap, distributes or auctions allowances, firms trade, and each firm surrenders one allowance per ton emitted

Why cap-and-trade is cost-effective :: Low-cost abaters cut more and sell allowances to high-cost abaters, so the cap is met at the lowest total cost

Marginal abatement cost after trading :: Equal across all firms; any difference creates a profitable trade

Do all firms abate the same fraction? :: No; low-cost firms abate more and high-cost firms buy allowances

Free allocation vs

auctioning :: Total emissions are set by the cap, so free allocation doesn't change emissions; it only changes who pays

What the carbon price signals :: How binding or ambitious the cap is; a higher price means a tighter cap relative to abatement costs

Banking :: Saving unused allowances for future years; smooths prices over time

Risk of banking :: Firms may bank allowances and delay emissions cuts to later years

Borrowing :: Using future allowances today; almost no carbon markets allow it

Why future caps affect today's price :: With banking, allowances can be saved, so a tight future cap raises demand and prices today

Stricter future cap (with banking) :: Carbon price rises today

Renewable energy subsidy :: Lower emissions and less demand for allowances, so the carbon price falls

Recession fears :: Lower production and emissions, so the carbon price falls

Coal price up or gas price down :: Power shifts from coal to gas, emissions fall, so the carbon price falls

Marginal technology cost :: The more expensive the technology needed to meet future caps, the higher the carbon price today

Discount rate and carbon price :: A higher discount rate means a lower carbon price today

Competitiveness under cap-and-trade :: Domestic heavy industry pays for carbon and imports may not, creating carbon leakage risk; free allocation or a border tax (CBAM) protects it

CBAM :: Carbon border adjustment: importers pay the difference between the carbon price where goods were made and the EU carbon price

Regulatory risk :: Carbon markets are created by government, so caps can change or markets can close; high prices require an ambitious cap and trust it will persist