Designing a U.S. Market for CO2

The United States may soon have a market for carbon. If so, that market will grow out of a cap‐and‐trade system like the EU's Emissions Trading System for CO2 or the U.S. Acid Rain Program for SO2. This article reviews the historical performance of these two markets, with particular focus on how the flexibility afforded by, as well as restrictions on, the “banking” and borrowing of allowances has affected the evolution of prices. While both markets have generally functioned well, four episodes are used to illustrate the importance of designing the rules to encourage such flexibility. The 2005 opening of the EU CO2 market was marked by a surprisingly high price, one that resulted from a delay in institutions with long positions in allowances (“longs”) bringing supply to the market. The 2007 close of the first phase produced a sharp divergence between the spot price at the end of 2007 and the futures price for 2008, reflecting the restriction against carrying over (or “banking”) allowances from one phase to the next. The U.S. SO2 market's transition to a tighter system in 2000 avoided such a divergence by allowing unlimited banking of allowances into the second phase. In 2005‐2006, the U.S. SO2 market experienced a surprising price spike attributable to a combination of changing fundamentals and institutional features (notably, the tax treatment of “longs”) that undermined the flexibility of the bank.