Market Stability Mechanisms in Emissions Trading Systems

A new ICAP paper explores different market stability mechanisms (MSMs) used in ETSs around the world to balance policy predictability with the need for flexibility to respond to changing circumstances or unexpected shocks.

MSMs in ETS respond to these developments by adjusting the supply of allowances, ranging from more quantity-based mechanisms such as the EU’s Market Stability Reserve to more price-based mechanisms such as price ceilings and price floors. This latest ICAP paper examines the experiences gathered by ETSs in using these tools, including implementation, effectiveness, and tradeoffs.

The key challenge MSMs seek to address arises from the fact that a regulator needs to impose a cap on GHG emissions without knowing the future abatement costs of the facilities covered under the system. By contrast to other markets, the number of allowances in circulation is fixed by regulation or law and can thus not freely adjust to unexpected changes in demand.