Competitive Permit Storage and Market Design: An Application to the EU-ETS

We develop a model of competitive inter-temporal emissions trading under uncertainty that features the core design elements of the EU-ETS to assess the recent market reform, essentially the market stability reserve. Modeling novelties include the introduction of myopia on the part of covered firms, of their ability to understand the interaction between their decisions and the MSR actions over time, as well as the implementation of a recursive procedure to solve for the certainty-equivalent market equilibrium solution. We calibrate the model on 2008-2017 market data to match observed price and banking paths. We find that the MSR always raises the permit price and never preserves the overall cap integrity, irrespective of the permit cancellation provision. Our results also suggest that the purported MSR responsiveness to demand shocks (e.g. recession, renewable deployment) would be limited, especially when firms are unable to anticipate future MSR-driven supply changes.