Working Paper

What Ails the European Union's Emissions Trading System? Two Diagnoses Calling for Different Treatments

Jun 25, 2015 | Stephen W. Salant

Abstract

In theory, how a fixed number of storable pollution permits are allocated in a cap-and-trade program should not aff ect intertemporal prices unless participants fail to receive permit endowments before they plan to use them. "Backloading" can create inefficiency; "frontloading" cannot. The European Union's Emissions Trading System, however, is regarded as a counterexample where frontloading itself is creating inefficiency. This view underlies current policy proposals to backload permits or to create a Market Stability Reserve. The goal of these policies is to shrink the current inventory of permits carried by the private sector without tightening the cap. We question the most prominent theory of why frontloading has been excessive by comparing its implications to a theory that attributes recent movements in the spot price of permits to ongoing regulatory risk of a price collapse much like what occurred in the 1970's in anticipation of the devaluation of the Mexican peso or the sale of massive government gold stockpiles. Correct diagnosis should precede treatment advice: if frontloading is excessive, inefficiency can be eliminated by suitable backloading of permits; if regulatory risk is excessive, however, backloading either directly or with a market stability reserve is unlikely to reduce inefficiency.