Price containment in emissions permit markets: Balancing market risk and environmental outcomes

While cap-and-trade policies have been advocated as an efficient market-based approach in regulating greenhouse gas (GHG) emissions from the power sector, a major criticism is that the resulting prices of emissions permit may be volatile, adding more uncertainty to market participants, and hence deter their interests in participating the electricity market. To ease such a concern, various permit price-containment instruments, such as a price ceiling, floor, or collar, have been proposed. Though such instruments may prevent permit prices from being extreme, they may incur inadvertent results such as underinvestment in low-emission technologies or little reduction of system-wide GHG emissions, hence defeating the purpose of establishing a cap-and-trade policy in the first place. To address such issues, this article examines the effect of imposing various price-containment policies on investment decisions and spot market equilibria in an electricity market. Our major contribution is that, unlike other work in this area in which the price-containment schemes are exogenous to their market models we endogenously incorporate a price ceiling/floor in our models and hence can analyze the interactions between the policies and their corresponding market outcomes. We further introduce uncertainties in our market models and use California's data as a case study.