This paper reviews the interaction of cap and trade with other (companion) air quality and sectoral policies and discusses mechanisms that address inefficiencies, with lessons for the EU.
- Air quality regulations, renewable subsidies and other policies help achieve long-run climate goals.
- As companions to cap and trade, these policies create a waterbed effect, pushing down emissions in one location but leaving overall emissions unchanged.
- The North American cap-and-trade programs reduce the waterbed effect with a minimum allowance auction price, which restricts the supply of allowances when the price is low.
- The EU cap-and-trade program reduces the waterbed effect with the Market Stability Reserve, which cancels allowances based on the number of surplus allowances in circulation.
- Under the MSR, companion policies in the EU will have a greater effect on overall emissions in the next decade the sooner they are implemented.