Managing Cost Variability in Emission Allowance Markets

The issue of managing costs in an emissions-trading program a controversial one, with short-run and long-run dimensions. Short-run disruptions in fuel supply due to natural or geo-political events can cause price fluctuations in fuel markets that have negative consequences on the economy, so in the short run policy makers might want to ameliorate these price fluctuations. Another concern has to do with cost management in the long run, where the issue has often played a role as a political proxy for the level of economic commitment to climate policy. Of course, the ultimate cost management tool is an emissions tax because the cost of the tax is predetermined and not subject to vacillations of an allowance market. We develop another idea, which is symmetric cost management within an emissions-trading program, in some detail. This approach would place a 'collar' on prices by combining a high-side price safety valve with a price floor. By providing for a ceiling and a floor on allowance prices, the mechanism we propose preserves incentives for investors to invest in clean technologies, which helps address the long-run issue of the cost of emissions reductions, and also guards against short-run variability. Such a mechanism could help the world to achieve the near term incentives to trim emissions that come with putting a price on CO2 with the longer run gains that come from greater investment in clean technologies such as renewables that might spark cost-reductions and technological breakthroughs that will be necessary to fight global warming effectively